The Levered Equity Risk Premium and Credit Spreads: A Unified Framework

Harjoat Bhamra, Lars-Alexander Kuehn and Ilya Strebulaev (istrebulaev@stanford.edu)

The Review of Financial Studies, 2010, vol. 23, issue 2, 645-703

Abstract: We embed a structural model of credit risk inside a dynamic continuous-time consumption-based asset pricing model, which allows us to price equity and corporate debt in a unified framework. Our key economic assumptions are that the first and second moments of earnings and consumption growth depend on the state of the economy, which switches randomly, creating intertemporal risk, which agents prefer to resolve sooner rather than later, because they have Epstein-Zin-Weil preferences. Agents optimally choose dynamic capital structure and default times. For a dynamic cross-section of firms, our model endogenously generates a realistic average term structure and time series of actual default probabilities and credit spreads, together with a reasonable levered equity risk premium, which varies with macroeconomic conditions. The Author 2009. 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: 2010
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