By estimating the default jump risk premium, this paper essentially tests the assumptions underlying the conditional diversification hypothesis of JLY (2001). These authors prove that, if default jumps are conditionally independent across firms and if the economy contains an infinite number of bonds, default jump risk cannot be priced. Intuitively, in this case the default jump risk can be fully diversified. Our results indicate that default jumps are not conditionally independent across firms and/or that not enough corporate bonds are traded to fully diversify default jump risk. A particularly appealing explanation for the existence of a default jump risk premium is that investors take into account the.
