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A Model of Credit Risk, Optimal Policies and Asset Prices

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  • Basak, Suleyman
  • Shapiro, Alex

Abstract

This Paper studies the optimal policies of borrowers (firms or individuals) who may default subject to default costs, and analyses the asset pricing implications. Borrowers defaulting under adverse economic conditions may, despite incurring default costs, emerge as wealthier than non-borrowers or those who can default costlessly. Under many economic scenarios, borrowers take on less risk exposure than non-borrowers. A larger risk exposure by borrowers may occur as well, however, depending on the structure of default costs and on how debt maturity relates to the planning horizon. In the latter case, borrowers' default policies render binary options useful instruments for lenders in hedging the credit-risk component of their assets. In our model, the asset-value dynamics are endogenously determined, and are shown to exhibit stochastic mean return and volatility in contrast to the exogenously assumed constant mean and volatility in many credit risk models. We consider a variety of extensions, including equilibrium, where a lower (higher) risk exposure by borrowers manifests itself in an attenuated (amplified) market volatility and risk premium, but the market value is always higher in economic downturns, and lower in upturns, compared to an economy without the presence of credit risk.

Suggested Citation

  • Basak, Suleyman & Shapiro, Alex, 2002. "A Model of Credit Risk, Optimal Policies and Asset Prices," CEPR Discussion Papers 3413, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:3413
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    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 & PoblaciĆ³n, 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

    Keywords

    asset prcing; credit risk; defaultable debt; investments; volatility;

    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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