On the Relation between the Credit Spread Puzzle and the Equity Premium Puzzle
Cheung Kong Graduate School of Business
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)
AFA 2006 Boston Meetings Paper
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.
Number of Pages in PDF File: 59
Keywords: Equity premium, credit spread, habit formation model
JEL Classification: G11, G12
Date posted: March 16, 2005 ; Last revised: July 1, 2011
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