Rare Disasters and Credit Market Puzzles
Du Du () and
Redouane Elkamhi ()
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Du Du: Hong Kong University of Science & Technology, Postal: Clearwater Bay, Kowloon, Hong Kong
Redouane Elkamhi: University of Toronto, Postal: Department of Mechanical & Industrial Engineering, Toronto, Ontario M5S 3G8, Canada
CREATES Research Papers from Department of Economics and Business Economics, Aarhus University
We embed systematic default, procyclic recovery rates and habit persistance into a model with a slight possibility of a macroeconomic disaster of reasonable magnitude. We derive analytical solutions for defaultable bond prices and show that a single set of structural parameters calibrated to the real economy and not to bond prices can simultaneously explain several key empirical regularities in credit markets. Our model captures the empirical level and volatility of credit spreads, generates a flexible credit risk term structure, and provides a good fit to a century of observed spreads. The model also matches the widespread skewness in index options. Finally, our model reveals a nonlinear relationship between bond and option prices that depends on the state of the economy and that helps explain conflicting empirical evidence found in the literature.
Keywords: Credit spreads; volatility; term structure; option skewness; stochastic recovery; consumption risk (search for similar items in EconPapers)
JEL-codes: C60 G12 G13 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2013-45
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