In order to understand the lingering credit risk puzzle and the apparent segmentation of the stock market from credit markets, we need to be able to assess the strength of the cross-sectional dependence in credit spreads. This turns out to be a non-trivial task due to the extreme data sparsity that is typical for any panel of credit spreads that is extracted from corporate bond transactions. The problem of data sparsity has led to some erroneous conclusions in the literature, including inferences that have been drawn from spurious cross-sectional dependence in credit spread changes. Understanding the pitfalls leads to a new and improved estimator of the latent factor in credit spread changes and its characteristics.

Credit spread puzzle, Market segmentation, Latent factors, Spurious cross-sectional dependence
Asset Pricing (jel G12), Contingent Pricing; Futures Pricing (jel G13), Financial Forecasting (jel G17), Determination of Interest Rates; Term Structure of Interest Rates (jel E43)
hdl.handle.net/1765/110016
Econometric Institute Research Papers
Department of Econometrics

Jaskowski, M, & McAleer, M.J. (2018). Spurious Cross-Sectional Dependence in Credit Spread Changes (No. EI 208-34). Econometric Institute Research Papers. Retrieved from http://hdl.handle.net/1765/110016