The Myth of the Credit Spread Puzzle

Abstract - We ask whether a standard structural model (Black and Cox (1976)) is able to explain credit spreads on corporate bonds and, in contrast to much of the literature, we find that the model matches the level of investment grade spreads well. Model spreads for speculative grade debt are too low and we find that bond illiquidity contributes to this underpricing. Our analysis makes use of a new approach for calibrating the model to average historical default rates and we show via simulation that this leads to much more precise estimates of investment grade default probabilities.

Length of Resource
54 pages
Peter Feldhütter and Stephen M Schaefer
Date Published

ResourceID: 177845

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