On the Relation between the Credit Spread Puzzle and the Equity Premium Puzzle
Cheung Kong Graduate School of Business
Columbia Business School - Finance and Economics; Ecole Polytechnique Fédérale de Lausanne - Swiss Finance Institute; National Bureau of Economic Research (NBER)
Robert S. Goldstein
University of Minnesota - Twin Cities - Carlson School of Management; National Bureau of Economic Research (NBER)
Review of Financial Studies, Forthcoming
Structural models of default calibrated to historical default rates, recovery rates, and Sharpe ratios typically generate Baa-Aaa credit spreads that are significantly below historical values. However, this credit spread puzzle can be resolved if one accounts for the fact that default rates and Sharpe ratios strongly covary; both are high during recessions and low during booms. As a specific example, we investigate credit spread implications of the Campbell and Cochrane (1999) pricing kernel calibrated to equity returns and aggregate consumption data. Identifying the historical surplus consumption ratio from aggregate consumption data, we find that the implied level and time-variation of spreads match historical levels well.
Accepted Paper Series
Date posted: November 12, 2007
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