On 9-10 September 2004, the BIS held a workshop on
The pricing of credit risk. This event brought together central
bankers, academics and market practitioners to exchange views on this issue
(see the conference programme in this document). This paper was presented at
the workshop. The views expressed are those of the author(s) and not those of
the BIS.
Abstract:
Why are spreads on corporate bonds so wide relative to expected losses from
default? The spread on Baa-rated bonds, for example, has been about four times
the expected loss. We suggest that the most commonly cited explanations
taxes, liquidity and systematic diffusive risk are inadequate. We argue
instead that idiosyncratic default risk, or the risk of unexpected losses due
to single- name defaults in necessarily "small" credit portfolios, accounts for
the major part of spreads. Because return distributions are highly skewed,
diversification would require very large portfolios. Evidence from arbitrage
CDOs suggests that such diversification is not readily achievable in practice,
and idiosyncratic risk is therefore unavoidable. Taking a cue from CDO
subordination structures, we propose value-at-risk at the Aaa-rated confidence
level as a summary measure of risk in feasible credit portfolios. We find
evidence of a positive linear relationship between this risk measure and
spreads on corporate bonds across rating classes.
JEL classification: C13, C32, G12, G13, G14
Keywords: credit spread puzzle, jump-at-default risk, Sharpe ratio,
collateralised debt obligation