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Credit Risk and Disaster Risk

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  • Gourio, François

Abstract

Macroeconomic models with financial frictions typically imply that the excess return on a well-diversified portfolio of corporate bonds is close to zero. In contrast, the empirical finance literature documents large and time-varying risk premia in the corporate bond market (the "credit spread puzzle"). This paper introduces a parsimonious real business cycle model where firms issue defaultable debt and equity to finance investment. The mix between debt and equity is determined by a trade-off between tax savings and bankruptcy costs. By their very nature, corporate bonds, while safe in normal times, are highly exposed to the risk of economic depression. This motivates introducing a small, time-varying risk of large economic disaster. This simple feature generates large, volatile and countercyclical credit spreads as well as novel business cycle implications. An increase in disaster risk makes default more systematic, leading to higher risk premia, and higher expected discounted bankruptcy costs, hence worsening ?nancial frictions. This leads to a reduction in investment, output, and leverage. Financial frictions amplify significantly the effects of disaster risk: the response of investment and output is about three times larger than in the frictionless model.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8201.

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Date of creation: Jan 2011
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Handle: RePEc:cpr:ceprdp:8201

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Keywords: asset pricing; business cycles; credit spread puzzle; disasters; equity premium; financial accelerator; financial frictions; jumps; rare events; systematic risk; time-varying risk premium;

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Citations

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Cited by:
  1. Elias Albagli & Christian Hellwig & Aleh Tsyvinski, 2014. "Dynamic Dispersed Information and the Credit Spread Puzzle," NBER Working Papers 19788, National Bureau of Economic Research, Inc.
  2. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Disaster Risk: Joint Implications for Consumption and Asset Prices," CERGE-EI Working Papers wp507, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  3. Sylvain, Serginio, 2014. "Does Human Capital Risk Explain The Value Premium Puzzle?," MPRA Paper 54551, University Library of Munich, Germany.
  4. Sylvain Leduc & Zheng Liu, 2012. "Uncertainty shocks are aggregate demand shocks," Working Paper Series 2012-10, Federal Reserve Bank of San Francisco.
  5. Peter Christoffersen & Du Du & Redouane Elkamhi, 2013. "Rare Disasters and Credit Market Puzzles," CREATES Research Papers 2013-45, School of Economics and Management, University of Aarhus.
  6. Serena Ng & Jonathan H. Wright, 2013. "Facts and Challenges from the Great Recession for Forecasting and Macroeconomic Modeling," NBER Working Papers 19469, National Bureau of Economic Research, Inc.
  7. Eric T. Swanson, 2012. "Risk aversion, risk premia, and the labor margin with generalized recursive preferences," Working Paper Series 2012-17, Federal Reserve Bank of San Francisco.
  8. Robert J. Barro & José F. Ursua, 2011. "Rare Macroeconomic Disasters," NBER Working Papers 17328, National Bureau of Economic Research, Inc.
  9. Martin Schneider & Cosmin Ilut & Francesco Bianchi, 2013. "Uncertainty Shocks, Asset Supply and Pricing over the Business Cycle," 2013 Meeting Papers 202, Society for Economic Dynamics.
  10. Eric T. Swanson, 2013. "Implications of labor market frictions for risk aversion and risk premia," Working Paper Series 2013-30, Federal Reserve Bank of San Francisco.
  11. Jianjun Miao & PENGFEI WANG, 2010. "Credit Risk and Business Cycles," Boston University - Department of Economics - Working Papers Series WP2010-033, Boston University - Department of Economics.
  12. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Rare Disasters: Implications for Consumptions and Asset Prices," CEU Working Papers 2014_2, Department of Economics, Central European University.

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