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The Credit Risk Premium in a Disaster-Prone World




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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  • Zhu, Yanhui & Copeland, Laurence, 2008. "The Credit Risk Premium in a Disaster-Prone World," Cardiff Economics Working Papers E2008/13, Cardiff University, Cardiff Business School, Economics Section, revised Oct 2008.
  • Handle: RePEc:cdf:wpaper:2008/13

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    References listed on IDEAS

    1. Jeremy Berkowitz & James O'Brien, 2002. "How Accurate Are Value-at-Risk Models at Commercial Banks?," Journal of Finance, American Finance Association, vol. 57(3), pages 1093-1111, June.
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    6. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
    7. Kerkhof, Jeroen & Melenberg, Bertrand, 2004. "Backtesting for risk-based regulatory capital," Journal of Banking & Finance, Elsevier, vol. 28(8), pages 1845-1865, August.
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    9. Christoffersen, Peter F, 1998. "Evaluating Interval Forecasts," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 841-862, November.
    10. Tasche, Dirk, 2002. "Expected shortfall and beyond," Journal of Banking & Finance, Elsevier, vol. 26(7), pages 1519-1533, July.
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    More about this item


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

    JEL classification:

    • F3 - International Economics - - International Finance
    • G1 - Financial Economics - - General Financial Markets

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