Working Paper: NBER ID: w15733
Authors: Pierre Collin-Dufresne; Robert S. Goldstein; Jean Helwege
Abstract: Empirical tests of reduced form models of default attribute a large fraction of observed credit spreads to compensation for jump-to-default risk. However, these models preclude a "contagion-risk'' channel, where the aggregate corporate bond index reacts adversely to a credit event. In this paper, we propose a tractable model for pricing corporate bonds subject to contagion-risk. We show that when investors have fragile beliefs (Hansen and Sargent (2009)), contagion premia may be sizable even if P-measure contagion across defaults is small. We find empirical support for contagion in bond returns in response to large credit events. Model calibrations suggest that while contagion risk premia may be sizable, jump-to-default risk premia have an upper bound of a few basis points.
Keywords: credit risk; contagion; bond pricing; belief updating
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Credit events (G19) | Market-wide credit spreads (G19) |
| Contagion risk (F65) | Market-wide credit spreads (G19) |
| Credit events (G19) | Changes in beliefs about default risk (G21) |
| Contagion risk premium (E44) | Market-wide credit spreads (G19) |
| Contagion effects are more pronounced for larger firms (F65) | Market-wide credit spreads (G19) |
| Jump-to-default risk premium (G19) | Market-wide credit spreads (G19) |