Working Paper: NBER ID: w17026
Authors: Francois Gourio
Abstract: Corporate credit spreads are large, volatile, countercyclical, and significantly larger than expected losses, but existing macroeconomic models with financial frictions fail to reproduce these patterns, because they imply small and constant aggregate risk premia. Building on the idea that corporate debt, while safe in normal times, is exposed to the risk of economic depression, this paper embeds a trade-off theory of capital structure into a real business cycle model with a small, time-varying risk of large economic disaster. This simple feature generates large, volatile and countercyclical credit spreads as well as novel business cycle implications. In particular, financial frictions substantially amplify the effect of shocks to the disaster probability.
Keywords: credit spreads; financial frictions; disaster risk; business cycles
JEL Codes: E22; E32; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in the probability of economic disaster (E32) | Larger, more volatile, and countercyclical credit spreads (G19) |
| Increase in the probability of economic disaster (E32) | Rise in expected discounted bankruptcy costs (G33) |
| Rise in expected discounted bankruptcy costs (G33) | Larger, more volatile, and countercyclical credit spreads (G19) |
| Financial frictions (G19) | Amplification of economic response to shocks in disaster probability (H84) |
| Interaction between disaster risk and capital structure choices (G32) | Significant effects on investment decisions (G11) |
| Probability of disaster (H84) | Investment levels (G31) |