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Asset Prices and Default-Free Term Structure in an Equilibrium Model of Default

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  • Ganlin Chang

    (Columbia University)

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    Abstract

    We present an equilibrium production economy in which default occurs in equilibrium. The borrower chooses optimal default and consumption policies, taking into account that default is costly and the lender gains access to the technology upon default. We derive asset prices and default premia in this economy. The borrower's relative risk aversion in wealth increases with decreases in wealth due to the increased possibility of default at low wealth levels. This produces a time-varying pricing kernel and a countercyclical equity premium. We thus provide an equilibrium rationale for the default premium to influence expected asset returns.

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    File URL: http://www.journals.uchicago.edu/cgi-bin/resolve?JB780309
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    Bibliographic Info

    Article provided by University of Chicago Press in its journal Journal of Business.

    Volume (Year): 78 (2005)
    Issue (Month): 3 (May)
    Pages: 997-1022

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    Handle: RePEc:ucp:jnlbus:v:78:y:2005:i:3:p:997-1022

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    Web page: http://www.journals.uchicago.edu/JB/

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    Cited by:
    1. Dragon Tang & Hong Yan, 2006. "Macroeconomic Conditions, Firm Characteristics, and Credit Spreads," Journal of Financial Services Research, Springer, vol. 29(3), pages 177-210, June.

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