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

Suleyman Basak and Alexander Shapiro
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Alexander Shapiro: Stern School of Business, New York University

The Journal of Business, 2005, vol. 78, issue 4, 1215-1266

Abstract: 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.

Date: 2005
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Working Paper: A Model of Credit Risk, Optimal Policies and Asset Prices (2002)
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Persistent link: https://EconPapers.repec.org/RePEc:ucp:jnlbus:v:78:y:2005:i:4:p:1215-1266

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