Ambiguity and Corporate Yield Spreads

Yehuda Izhakian, Ryan Lewis and Jaime Zender

Abstract

We derive a model of bond pricing under ambiguity, showing that ambiguity interacts with risk to determine spreads. Since default is an inherently ``unfavorable" outcome, ambiguity-averse bondholders overweigh its probability and demand higher yields for bonds with higher ambiguity. Empirically, the economic effect of ambiguity on credit spreads is of the same magnitude as that of risk. Furthermore, ambiguity and risk amplify each-other; spreads on higher risk bonds are more sensitive to ambiguity and vice versa. Incorporating ambiguity substantially improves the model's fit relative to observed spreads, providing a potential resolution to the credit spread puzzle.