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A Model of Credit Risk, Optimal Policies, and Asset Prices


  • Suleyman Basak

    (London Business School)

  • Alexander Shapiro

    (Stern School of Business, New York University)


This article studies an economy with borrowers (firms or individuals) under costly default. Borrowers defaulting under adverse economic conditions may, despite incurring default costs, emerge as wealthier than nonborrowers. Asset substitution is generally not pronounced, although a larger risk exposure by borrowers may also occur, and then binary options emerge as useful credit derivatives. The asset-value dynamics are endogenously determined and shown to exhibit stochastic mean and volatility, in contrast to many credit risk models. In equilibrium, the market level is increased (decreased) in economic downturns (upturns) by the presence of credit risk.

Suggested Citation

  • Suleyman Basak & Alexander Shapiro, 2005. "A Model of Credit Risk, Optimal Policies, and Asset Prices," The Journal of Business, University of Chicago Press, vol. 78(4), pages 1215-1266, July.
  • Handle: RePEc:ucp:jnlbus:v:78:y:2005:i:4:p:1215-1266

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    References listed on IDEAS

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    Cited by:

    1. repec:eee:corfin:v:45:y:2017:i:c:p:428-466 is not listed on IDEAS
    2. Colonnello, Stefano & Curatola, Giuliano & Hoang, Ngoc Giang, 2017. "Direct and indirect risk-taking incentives of inside debt," Journal of Corporate Finance, Elsevier, vol. 45(C), pages 428-466.
    3. Correia, Ricardo & Población, Javier, 2015. "A structural model with Explicit Distress," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 112-130.
    4. Li Chen & H. Vincent Poor, 2003. "Information Asymmetry, Corporate Debt Financing and Optimal Investment Decisions: A Reduced Form Approach," Finance 0312008, EconWPA.

    More about this item

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation


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