The Nordic Credit Spread Puzzle: Assessing the Performance of a Structural Modeling Framework for Credit Risk

Victor Thomas Anton Karlsson & Nicolina Rollof Knudtzon

Student thesis: Master thesis


The credit spread puzzle alludes to the examination that structural models of credit risk, such as the one presented by Robert Merton (1974), generate credit spreads smaller than the market, when calibrated to observed default frequencies. The purpose of this thesis is to analyze whether the credit spread puzzle exist in the Nordics through the use of a structural model, an extension of Merton’s model of default. In contrast to the existing literature, we use CDS as reference data instead of bond data, because of advantages related to liquidity and its contractual nature. We use a sample of 25 individual companies from the Nordic region (Denmark, Finland, Norway and Sweden) and cover the period from 2006-02-14 to 2014-02-14, during which three sub-periods have been assigned with regards to the financial crisis (Pre-Crisis, Crisis and Post-Crisis) in order to determine whether times of economic turbulence influence financial figures. All necessary data is obtained from available data sources such as Bloomberg, Datastream and Moody’s. When contrasting our results against previous studies, we find that this paper contribute to the existing literature on the study of the credit spread puzzle. First, we confirm that our results are qualitatively in line with the existing literature, in that the majority of our model-implied spreads, across all rating categories, tend to underpredict observed market spreads. Second, when contrasting our quantitative figures against existing studies trying to resolve the credit spread puzzle using bond data, our model spreads show a better match with observed spreads compared to what is found in the literature. Possible reasons for this might be related to the approach that we apply, the fact that we look at a different time horizon or that we use Nordic data. Although our model predictions prove to match market spreads fairly well, when comparing the different sub-periods, we find that the accuracy of the predictions differs, where the Post-Crisis period shows the most accurate predictions, the Crisis the least accurate in absolute terms and the Pre-Crisis the worst in relative terms. We find a credit spread puzzle in the Nordics and that CDS data serve as a better proxy compared to bond data. Hence, our results are qualitatively in line with the existing literature, but not quantitatively, where the predictions errors of our model spreads tend to be less severe compared to previous studies. Overall, our results suggest that the credit spread puzzle is not as eminent in the Nordics compared to what is seen in the U.S.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
Publication date2014
Number of pages111