Disastrous Defaults
73 Pages Posted: 1 Jun 2018 Last revised: 24 Oct 2020
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Disastrous Defaults
Date Written: January 3, 2020
Abstract
We define a disastrous default as the default of a systemic entity, which has a negative effect on the economy and is contagious. Bringing macroeconomic structure to a no-arbitrage asset pricing framework, we exploit prices of disaster-exposed assets (credit and equity derivatives) to extract information on the expected (i) influence of a disastrous default on consumption and (ii) probability of a financial meltdown. Using European data, we find that the returns of disaster-exposed assets are consistent with a systemic default being followed by a 2% decrease in consumption. The recessionary influence of disastrous defaults implies that financial instruments whose payoffs are exposed to such credit events carry substantial risk premiums. We also produce systemic risk indicators based on the probability of observing a certain number of systemic defaults or a sharp drop of consumption.
Keywords: Disaster Risk, Systemic Entities, Default Dependencies, Credit Derivatives, Equilibrium Model
JEL Classification: E43, E44, E47, G01, G12
Suggested Citation: Suggested Citation