RFS Advance Access originally published online on August 31, 2007
Review of Financial Studies 2008 21(6):2487-2534; doi:10.1093/rfs/hhm041
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Inflation Uncertainty, Asset Valuations, and the Credit Spreads Puzzle
Haskayne School of Business, University of Calgary
Send correspondence to Alexander David, 2500 University Drive NW, Calgary, Alberta T2N 1N4, Canada. Appendices are available at: http://homepages.ucalgary.ca/~adavid. E-mail: adavid{at}ucalgary.ca
JEL Classification: G12, G13, G14, C3, C5
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Abstract |
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Investors' learning of the state of future real fundamentals from current inflation leads to macroeconomic state dependence of asset valuations and solvency ratios of firms within given rating categories. Since credit spreads are convex functions of solvency ratios, average spreads are higher than spreads at average solvency ratios. Macroeconomic shocks carry risk premiums so that expected default losses are more sensitive to changes in the price of risk than are credit spreads. By incorporating state dependence and increasing the price of risk, the econometrician obtains high credit spreads while maintaining average default losses at historical levels—the credit spreads puzzle.
I am grateful to an anonymous referee, Yacine Ait-Sahalia, the Editor at RFS, Kerry Back, Michael Brandt, Michael Brennan, Mark Carey, Darrell Duffie, Greg Duffee, Pierre Collin-Dufresne, Phil Dybvig, Bob Goldstein, Alfred Lehar, Vadim Linetsky, Francis Longstaff, Mark Lowenstein, Gordon Sick, Pietro Veronesi and Frank Zhang for helpful comments, and to seminar participants at the Mathematical Finance Conference in honor of Robert J. Elliott, the Credit Risk and Asset Pricing Conference at the Wharton School of the University of Pennsylvania, the 16th Annual Conference on Financial Economics and Accounting at UNC Chapel Hill, HEC-Montreal Finance Department, the McGill-IFM Risk Management Conference, the Western Finance Association Meetings at Keystone, Colorado, the Third Annual Empirical Asset Pricing Retreat at the University of Amsterdam, and the Gutmann Center Symposium on Credit Risk and the Management of Fixed Income Portfolios at the University of Vienna. I am grateful for a research grant from the SSHRC.