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The Levered Equity Risk Premium and Credit Spreads: A Unified Framework

Harjoat Singh Bhamra
University of British Columbia - Sauder School of Business

Lars-Alexander Kuehn
Carnegie Mellon University - David A. Tepper School of Business

Ilya A. Strebulaev
Stanford University - Graduate School of Business

February 22, 2009

The Review of Financial Studies, Forthcoming

Abstract:
We embed a structural model of credit risk inside a dynamic continuous-time consumption-based asset pricing model, which allows us to price equity and corporate debt in a unified framework. Our key economic assumptions are that the first and second moments of earnings and consumption growth depend on the state of the economy which switches randomly, creating intertemporal risk, which agents prefer to resolve sooner rather than later, because they have Epstein-Zin-Weil preferences. Agents optimally choose dynamic capital structure and default times. For a dynamic cross-section of firms, our model endogenously generates a realistic average term structure and time series of actual default probabilities and credit spreads, together with a reasonable levered equity risk premium, which varies with macroeconomic conditions.

Keywords: Equity premium, corporate bond credit spread, predictability, macroeconomic conditions, jumps, capital structure, default

JEL Classifications: E44, G12, G32, G33

Working Paper Series

Date posted: September 30, 2007 ; Last revised: March 03, 2009

Suggested Citation

Bhamra, Harjoat Singh, Kuehn, Lars-Alexander and Strebulaev, Ilya A., The Levered Equity Risk Premium and Credit Spreads: A Unified Framework (February 22, 2009). The Review of Financial Studies, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1016891

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Contact Information

Harjoat Singh Bhamra (Contact Author) University of British Columbia - Sauder School of Business ( email ) 2053 Main Mall Vancouver, BC V6T 1Z2 V6T 1Z2 Canada
Lars-Alexander Kuehn Carnegie Mellon University - David A. Tepper School of Business ( email ) 5000 Forbes Avenue Pittsburgh, PA 15213-3890 United States
Ilya A. Strebulaev Stanford University - Graduate School of Business ( email ) 518 Memorial Way Stanford, CA 94305-5015 United States