Default Linkages in a Structural Credit Model

54 Pages Posted: 5 May 2021 Last revised: 18 Jan 2022

See all articles by Jan Ericsson

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Alexandre Jeanneret

UNSW Business School

Lucie Y. Lu

McGill University, Desautels Faculty of Management, Students

Date Written: January 18, 2022

Abstract

We propose an explanation for default risk linkages across independent borrowers. The transmission mechanism is that variation in the size of one borrower impacts the default decision for all. If a negative shock hits one borrower's fundamentals, the other becomes a larger player in the economy and bears more systematic risk. The increased risk premium raises the cost of debt and tilts that borrower's decision towards default, increasing default risk and equity volatility. This effect is stronger for borrowers with greater rollover needs. Our model sheds light on co-movement in risk premia, default probabilities, and equity volatilities across unrelated borrowers.

Keywords: Credit Risk, Structural Models, Asset Prices, Leverage, Volatility, Spillovers

JEL Classification: G12, G13, G32, G33

Suggested Citation

Ericsson, Jan and Jeanneret, Alexandre and Lu, Lucie Yiliu, Default Linkages in a Structural Credit Model (January 18, 2022). Available at SSRN: https://ssrn.com/abstract=3839885 or http://dx.doi.org/10.2139/ssrn.3839885

Jan Ericsson (Contact Author)

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Alexandre Jeanneret

UNSW Business School ( email )

Sydney, NSW 2052
Australia

Lucie Yiliu Lu

McGill University, Desautels Faculty of Management, Students ( email )

1001 Sherbrooke St. West
Montreal
Canada

HOME PAGE: http://https://www.mcgill.ca/desautels/yiliu-lu

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