On Bounding Credit-Event Risk Premia

Jennie Bai, Pierre Collin-Dufresne, Robert S. Goldstein and Jean Helwege

The Review of Financial Studies, 2015, vol. 28, issue 9, 2608-2642

Abstract: Reduced-form models of default that attribute a large fraction of credit spreads to compensation for credit-event risk typically preclude the most plausible economic justification for such risk to be priced, namely, a contemporaneous drop in the market portfolio. When this "contagion" channel is introduced within a general equilibrium framework for an economy comprising a large number of firms, credit-event risk premia have an upper bound of a few basis points, and are dwarfed by the contagion premium. We provide empirical evidence that indicates credit-event risk premia are less than 1 bp, but contagion risk premia are significant.

Date: 2015
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