Working Paper: CEPR ID: DP3413
Authors: Suleyman Basak; Alex Shapiro
Abstract: This Paper studies the optimal policies of borrowers (firms or individuals) who may default subject to default costs, and analyses the asset pricing implications. Borrowers defaulting under adverse economic conditions may, despite incurring default costs, emerge as wealthier than non-borrowers or those who can default costlessly. Under many economic scenarios, borrowers take on less risk exposure than non-borrowers. A larger risk exposure by borrowers may occur as well, however, depending on the structure of default costs and on how debt maturity relates to the planning horizon. In the latter case, borrowers' default policies render binary options useful instruments for lenders in hedging the credit-risk component of their assets. In our model, the asset-value dynamics are endogenously determined, and are shown to exhibit stochastic mean return and volatility in contrast to the exogenously assumed constant mean and volatility in many credit risk models. We consider a variety of extensions, including equilibrium, where a lower (higher) risk exposure by borrowers manifests itself in an attenuated (amplified) market volatility and risk premium, but the market value is always higher in economic downturns, and lower in upturns, compared to an economy without the presence of credit risk.
Keywords: asset pricing; credit risk; defaultable debt; investments; volatility
JEL Codes: C61; D51; G11; G22; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| borrowers' default policies (G33) | wealth outcomes (D31) |
| default costs (G31) | risk exposure (G22) |
| debt maturity (H63) | risk exposure (G22) |
| credit risk dynamics (G21) | asset pricing (G19) |