The Credit Spread Puzzle: Evidence from the CDS Market before, during and after the Financial Crisis

Astrid Oleander Iversen & Pernille Skov

Student thesis: Master thesis


This paper examines the difference between CDS-implied and actual default probabilities, also known as the “credit spread puzzle”, and its drivers over the sample period from 2002 to 2019 in the US. In line with previous research, our study confirms the presence of a credit spread puzzle in the CDS market and, by extension, that CDS spreads cannot be considered a pure measure of credit risk. Moreover, we find evidence that the absolute spread between actual and CDS-implied default probabilities is time-varying reaching elevated levels during the financial crisis. Following this analysis, the drivers of the credit spread puzzle are examined. Firstly, an increasing, concave relationship between deteriorating credit quality and the difference between actual and CDS-implied default probabilities is identified. Furthermore, both asset-specific illiquidity and firm-specific volatility are found to be strong drivers with a magnified impact during the crisis period. Moreover, financial leverage has a significant, positive impact on the credit spread puzzle in the post-crisis era, whereas counterparty risk seemingly has no impact in any period. Finally, systematic variables are found to be less important predictors of the credit spread puzzle.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
Publication date2020
Number of pages120
SupervisorsSøren Plesner