DP10318 Option-Based Credit Spreads
|Author(s):||Christopher L. Culp, Yoshio Nozawa, Pietro Veronesi|
|Publication Date:||December 2014|
|Keyword(s):||credit spreads, default, Merton model, options|
|JEL(s):||G1, G12, G13, G21, G24, G3|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=10318|
We present a novel empirical benchmark for analyzing credit risk using "pseudo firms" that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, the bonds are equivalent to Treasuries minus put options on pseudo-firm assets. Empirically, like corporate spreads, pseudo-bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors? over-estimation of default risks, corporate frictions, and constraints on aggregate credit supply do not seem to explain excessive observed credit spreads, but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.