Is Credit Event Risk Priced? Modeling Contagion via the Updating of Beliefs
AbstractEmpirical tests of reduced form models of default attribute a large fraction of observed credit spreads to compensation for jump-to-default risk. However, these models preclude a "contagion-risk'' channel, where the aggregate corporate bond index reacts adversely to a credit event. In this paper, we propose a tractable model for pricing corporate bonds subject to contagion-risk. We show that when investors have fragile beliefs (Hansen and Sargent (2009)), contagion premia may be sizable even if P-measure contagion across defaults is small. We find empirical support for contagion in bond returns in response to large credit events. Model calibrations suggest that while contagion risk premia may be sizable, jump-to-default risk premia have an upper bound of a few basis points.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15733.
Date of creation: Feb 2010
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Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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- NEP-ALL-2010-02-20 (All new papers)
- NEP-BAN-2010-02-20 (Banking)
- NEP-BEC-2010-02-20 (Business Economics)
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- Ramaprasad Bhar & Nedim Handzic, 2011. "A Multifactor Model of Credit Spreads," Asia-Pacific Financial Markets, Springer, Springer, vol. 18(1), pages 105-127, March.
- Díaz, Antonio & Groba, Jonatan & Serrano, Pedro, 2013. "What drives corporate default risk premia? Evidence from the CDS market," Journal of International Money and Finance, Elsevier, Elsevier, vol. 37(C), pages 529-563.
- Dumontaux, Nicolas & Pop, Adrian, 2013. "Understanding the market reaction to shockwaves: Evidence from the failure of Lehman Brothers," Journal of Financial Stability, Elsevier, Elsevier, vol. 9(3), pages 269-286.
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