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| Inflation Uncertainty, Asset Valuations, and Five Credit Risk Puzzles by Alexander David of the University of Calgary December 2005 Abstract: In an unobservable regime-switching model, investors' learning of the state of future real fundamentals from current inflation leads to dramatic variation in asset valuations and is able to partially resolve five credit risk puzzles: (i) the high level of credit spreads for firms with average solvency ratios and volatility calibrated to their credit rating, (ii) the high volatility of credit spreads, (iii) the positive and slow response of credit spreads to shocks in the short rate (the 'momentum' effect), (iv) the inability of default risk measures to explain the variation in corporate bond returns, and (v) the changing sign of the risk-return relationship for corporate bond excess returns across the past three decades. JEL Classification: G12, G13, G14, C3, C5. Keywords: learning, uncertainty, proxy-hypothesis, predictability, risk-return tradeoff, through-the-cycle-rating, credit spreads puzzle. Books Referenced in this Paper: (what is this?)
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