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A Credit Spread Decomposition: A Resolution of the Credit Spread Puzzle

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  • Robert A. Jarrow

    (SC Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853-6201, USA)

Abstract

The empirical evidence showing that a corporate bond’s expected loss is only a small portion of a bond’s credit spread is called the credit spread puzzle. This paper, using a reduced-form credit risk model, characterizes a risky bond’s credit spread. This characterization provides a more general measure of a risky bond’s credit risk and it shows that, in an arbitrage-free market, a bond’s credit risk is only a fraction of the credit spread and not linearly related to the one-year, risk-neutral expected loss, resolving the credit spread puzzle.

Suggested Citation

  • Robert A. Jarrow, 2024. "A Credit Spread Decomposition: A Resolution of the Credit Spread Puzzle," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 14(04), pages 1-14, December.
    • Handle: RePEc:wsi:qjfxxx:v:14:y:2024:i:04:n:s2010139224500162
    DOI: 10.1142/S2010139224500162
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    More about this item

    Keywords

    Credit spread; credit risk; default probabilities; recovery rates; bond prices;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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