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The credit risk premium in a disaster-prone world

Zhu, Yanhui and Copeland, Laurence 2008. The credit risk premium in a disaster-prone world. [Working Paper]. Cardiff Economics Working Papers, Cardiff: Cardiff University.

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Abstract

The seminal Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events ("disasters") allowed for leverage in the form of risky corporate debt which defaulted only in states when the Government defaulted on its debt. The probability of default was therefore exogenous and independent of the degree of leverage. In this paper, we take the model a step closer reality by assuming that, on the one hand, the Government never defaults, and on the the other hand, that the "corporate sector" in the form of the Lucas tree owner pays its debts in full if and only if its asset value is sufficient, which is always the case in non-crisis states. Otherwise, in exceptionally severe crises, it defaults and hands over the whole "firm" to its creditors. The probability of default by the tree owner is thus endogenous, dependent both on the volume of debt issued (taken as exogenous) and on the uncertain value of output. We show, using data from both Barro (2006) and Barro and Ursua (2008), that the model can generate values of the riskless rate, equity risk premium and credit risk spread broadly consistent with those typically observed in the data.

Item Type: Monograph (Working Paper)
Date Type: Publication
Status: Published
Schools: Business (Including Economics)
Subjects: H Social Sciences > HB Economic Theory
Publisher: Cardiff University
Date of First Compliant Deposit: 30 March 2016
Last Modified: 04 Jun 2017 08:25
URI: http://orca-mwe.cf.ac.uk/id/eprint/77795

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