Credit Risk and Real Investment Dynamics

Kuehn Lars-Alexander and Schmid Lukas

No 2010-E60, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: Empirical evidence documents a tight link between aggregate and firm-level investment and corporate credit spreads. Moreover, it has been shown that credit spreads largely reflect a compensation for bearing macroeconoimc risks. We use a tractable model with recursive preferences and time varying macroeoconomic risk to investigate the link between aggregate risk and corporate policies in a production economy. Quantitatively, the model generates large and realistic credit spreads and replicates the empirical evidence on investment and credit spreads. Crucially, we document that the link between credit spreads and investment is driven by risk premia. We therefore highlight the importance of accounting for macroeconomic risks in explaining corporate financing and investment decisions in the presence of financing and real frictions.

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