Working Paper: CEPR ID: DP10318
Authors: Christopher L. Culp; Yoshio Nozawa; Pietro Veronesi
Abstract: 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.
Keywords: credit spreads; default; Merton model; options
JEL Codes: G1; G12; G13; G21; G24; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| pseudo bond spreads (G12) | lower future economic growth (F69) |
| increases in credit spreads (G19) | declines in economic activity (F44) |
| excess bond premium (EBP) (G12) | lower future economic growth (F69) |
| positive shock to EBP (E32) | lower consumption and GDP growth (E20) |
| idiosyncratic asset risk (G19) | average corporate credit spreads (G12) |
| higher residual volatility (G17) | increased credit spreads (G19) |