Credit Risk and Disaster Risk

Francois Gourio

No 8201, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Macroeconomic models with financial frictions typically imply that the excess return on a well-diversified portfolio of corporate bonds is close to zero. In contrast, the empirical finance literature documents large and time-varying risk premia in the corporate bond market (the "credit spread puzzle"). This paper introduces a parsimonious real business cycle model where firms issue defaultable debt and equity to finance investment. The mix between debt and equity is determined by a trade-off between tax savings and bankruptcy costs. By their very nature, corporate bonds, while safe in normal times, are highly exposed to the risk of economic depression. This motivates introducing a small, time-varying risk of large economic disaster. This simple feature generates large, volatile and countercyclical credit spreads as well as novel business cycle implications. An increase in disaster risk makes default more systematic, leading to higher risk premia, and higher expected discounted bankruptcy costs, hence worsening ?nancial frictions. This leads to a reduction in investment, output, and leverage. Financial frictions amplify significantly the effects of disaster risk: the response of investment and output is about three times larger than in the frictionless model.

Keywords: Financial frictions; Financial accelerator; Systematic risk; Asset pricing; Credit spread puzzle; Business cycles; Equity premium; Time-varying risk premium; Disasters; Rare events (search for similar items in EconPapers)
JEL-codes: E32 E44 G12 (search for similar items in EconPapers)
Date: 2011-01
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Citations: View citations in EconPapers (9)

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Related works:
Journal Article: Credit Risk and Disaster Risk (2013)
Working Paper: Credit risk and disaster risk (2012)
Working Paper: Credit Risk and Disaster Risk (2011)
Working Paper: Credit risk and Disaster risk (2010)
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