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Option-Based Credit Spreads

Christopher L. Culp, Yoshio Nozawa and Pietro Veronesi

American Economic Review, 2018, vol. 108, issue 2, 454-88

Abstract: We present a novel empirical benchmark for analyzing credit risk using "pseudo firms" that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, pseudo bonds are equivalent to Treasuries minus put options on pseudo firm assets. Empirically, like corporate spreads, pseudo bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors' overestimation of default risks, and corporate frictions do not seem to explain excessive observed credit spreads but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.

JEL-codes: E23 E32 E44 G13 G24 G32 (search for similar items in EconPapers)
Date: 2018
Note: DOI: 10.1257/aer.20151606
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