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The Credit Risk Premium in a Disaster-Prone World

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  • Zhu, Yanhui

    ()
    (Cardiff Business School)

  • Copeland, Laurence

    ()
    (Cardiff Business School)

Abstract

The seminal Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events ("disasters") allowed for leverage in the form of risky corporate debt which defaulted only in states when the Government defaulted on its debt. The probability of default was therefore exogenous and independent of the degree of leverage. In this paper, we take the model a step closer to reality by assuming that, on the one hand, the Government never defaults, and on the other hand, that the .corporate sector. in the form of the Lucas tree owner pays its debts in full if and only if its asset value is sufficient, which is always the case in non-crisis states. Otherwise, in exceptionally severe crises, it defaults and hands over the whole .firm. to its creditors. The probability of default by the tree owner is thus endogenous, dependent both on the volume of debt issued (taken as exogenous) and on the uncertain value of output. We show, using data from both Barro (2006) and Barro and Ursua (2008), that the model can generate values of the riskless rate, equity risk premium and credit risk spread broadly consistent with those typically observed in the data.

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Bibliographic Info

Paper provided by Cardiff University, Cardiff Business School, Economics Section in its series Cardiff Economics Working Papers with number E2008/13.

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Length: 22 pages
Date of creation: Jul 2008
Date of revision: Oct 2008
Handle: RePEc:cdf:wpaper:2008/13

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Keywords: equity risk premium; default risk; credit spread; leverage; corporate debt;

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