Working Paper: NBER ID: w20776
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, pseudo 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, and corporate frictions 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 Risk; Credit Spreads; Pseudo Firms; Economic Growth
JEL Codes: G0; 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 |
|---|---|
| idiosyncratic asset volatility (G19) | credit spreads (G12) |
| credit spreads (G12) | future economic growth (O49) |
| risk premium component of credit spreads (G19) | economic downturns (F44) |
| pseudo bond spreads (G12) | future economic growth (O49) |
| integration of corporate bond and options markets (G12) | similar risk premia (G40) |