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On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle

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  • Long Chen
  • Pierre Collin-Dufresne
  • Robert S. Goldstein

Abstract

Structural models of default calibrated to historical default rates, recovery rates, and Sharpe ratios typically generate Baa--Aaa credit spreads that are significantly below historical values. However, this "credit spread puzzle" can be resolved if one accounts for the fact that default rates and Sharpe ratios strongly covary; both are high during recessions and low during booms. As a specific example, we investigate credit spread implications of the Campbell and Cochrane (1999) pricing kernel calibrated to equity returns and aggregate consumption data. Identifying the historical surplus consumption ratio from aggregate consumption data, we find that the implied level and time variation of spreads match historical levels well. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rfs/hhn078
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Bibliographic Info

Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 22 (2009)
Issue (Month): 9 (September)
Pages: 3367-3409

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Handle: RePEc:oup:rfinst:v:22:y:2009:i:9:p:3367-3409

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