Ambiguity, Volatility and Credit Risk

Patrick Augustin and Yehuda Izhakian

Abstract

We explore the implications of ambiguity, or Knightian uncertainty, for the pricing of credit default swaps (CDS). We find that ambiguity, as opposed to risk, has a negative impact on spreads, and its economic significance is as important as that of risk. A one standard deviation increase in the level of ambiguity is associated with a decrease in spreads of at least six percent. Our analysis provides broader insights for the impact of ambiguity on the pricing of other classes of insurance claims and equity options.