Asset Prices and Default-Free Term Structure in an Equilibrium Model of Default

Abstract

We present an equilibrium model of asset pricing in which asset prices, default-free term structure and default premia are determined simultane-ously. The consumer chooses his optimal consumption and investment decisions simultaneously with optimal voluntary default. The endogenously determined consumer's relative risk aversion in wealth increases with decreases in wealth due to the increased possibility of default in the economy at low wealth levels. This produces a countercyclical and time-varying equity premium. Our model exhibits a flight to quality phenomenon in which as the wealth drops, the default premium increases, the default-free interest rates go down and the default-free term structure becomes steeper. The expected equity returns are predictable by the default premium in the economy. These results are consistent with some of the stylized facts found in the data on asset prices and default premium. The modeling strategy of our paper offers a new way recast the default risk literature in an equilibrium setting and integrates it with the asset pricing literature.

JEL Classification: D9, E3, G0, G1