The Levered Equity Risk Premium and Credit Spreads: A Unified Framework
Harjoat Singh Bhamra
University of British Columbia - Sauder School of Business
Carnegie Mellon University - David A. Tepper School of Business
Ilya A. Strebulaev
Stanford University - Graduate School of Business; National Bureau of Economic Research
February 22, 2009
The Review of Financial Studies, Forthcoming
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, G33working papers series
Date posted: September 30, 2007 ; Last revised: March 3, 2009
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