Ambiguity, Volatility, and Credit Risk

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.