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Is Credit Event Risk Priced? Modeling Contagion via the Updating of Beliefs

  • Pierre Collin-Dufresne
  • Robert S. Goldstein
  • Jean Helwege
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    Empirical 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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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15733.

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    Date of creation: Feb 2010
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    Handle: RePEc:nbr:nberwo:15733
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