Working Paper: CEPR ID: DP12827
Authors: Harjoat Singh Bhamra; LarsAlexander Kuehn; Ilya Strebulaev
Abstract: 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.
Keywords: equity premium; corporate bond; credit spread; predictability; macroeconomic conditions; jumps; capital structure; default
JEL Codes: E44; G12; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| macroeconomic conditions (E66) | equity risk premium (G12) |
| macroeconomic conditions (E66) | credit spreads (G12) |
| credit spreads (G12) | equity risk premium (G12) |
| intertemporal risk preferences (D15) | credit spreads (G12) |
| macroeconomic conditions (E66) | optimal leverage choices (G11) |
| optimal leverage choices (G11) | credit spreads (G12) |
| optimal leverage choices (G11) | equity risk premium (G12) |