DP12827 The Levered Equity Risk Premium and Credit Spreads: A Unified Framework

Author(s): Harjoat Singh Bhamra, Lars-Alexander Kuehn, Ilya Strebulaev
Publication Date: March 2018
Keyword(s): Capital Structure, corporate bond credit spread, default, Equity premium, jumps, macroeconomic conditions, predictability
JEL(s): E44, G12, G32, G33
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12827

We embed a structural model of credit risk inside a dynamic continuous-time consumption-based asset pricing model, which allows us to price equity and corporate debt in a unified framework. Our key economic assumptions are that the first and second moments of earnings and consumption growth depend on the state of the economy which switches randomly, creating intertemporal risk, which agents prefer to resolve sooner rather than later, because they have Epstein-Zin-Weil preferences. Agents optimally choose dynamic capital structure and default times. For a dynamic cross-section of firms, our model endogenously generates a realistic average term structure and time series of actual default probabilities and credit spreads, together with a reasonable levered equity risk premium, which varies with macroeconomic conditions.