Ambiguity, Volatility, and Credit Risk
Review of Financial Studies, Forthcoming
86 Pages Posted: 7 May 2016 Last revised: 19 Apr 2019
Date Written: April 15, 2019
We explore the implications of ambiguity for the pricing of credit default swaps (CDSs). A model of heterogeneous investors with independent preferences for ambiguity and risk shows that, since CDS contracts are assets in zero net supply, the net credit risk exposure of the marginal investor determines the sign of the impact of ambiguity on CDS spreads. We find that ambiguity has an economically significant negative impact on CDS spreads, on average, suggesting that the marginal investor is a net buyer of credit protection. A one standard deviation increase in ambiguity is estimated to decrease CDS spreads by approximately 6%.
Keywords: CDS, Derivatives, Heterogeneous Agents, Insurance, Knightian uncertainty, Risk aversion
JEL Classification: C65, D81, D83, G13, G22
Suggested Citation: Suggested Citation