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.