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The Levered Equity Risk Premium and Credit Spreads: A Unified FrameworkHarjoat Singh BhamraUniversity of British Columbia - Sauder School of Business Lars-Alexander KuehnCarnegie Mellon University - David A. Tepper School of Business Ilya A. StrebulaevStanford University - Graduate School of Business; National Bureau of Economic Research 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.
Number of Pages in PDF File: 56 Keywords: Equity premium, corporate bond credit spread, predictability, macroeconomic conditions, jumps, capital structure, default JEL Classification: E44, G12, G32, G33 working papers seriesDate posted: September 30, 2007 ; Last revised: March 3, 2009Suggested CitationContact Information
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