On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle

Long Chen (), Pierre Collin-Dufresne and Robert S. Goldstein

The Review of Financial Studies, 2009, vol. 22, issue 9, 3367-3409

Abstract: Structural models of default calibrated to historical default rates, recovery rates, and Sharpe ratios typically generate Baa--Aaa credit spreads that are significantly below historical values. However, this "credit spread puzzle" can be resolved if one accounts for the fact that default rates and Sharpe ratios strongly covary; both are high during recessions and low during booms. As a specific example, we investigate credit spread implications of the Campbell and Cochrane (1999) pricing kernel calibrated to equity returns and aggregate consumption data. Identifying the historical surplus consumption ratio from aggregate consumption data, we find that the implied level and time variation of spreads match historical levels well. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Date: 2009
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