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The Levered Equity Risk Premium and Credit Spreads: A Unified Framework

The Review of Financial Studies, Forthcoming

56 Pages Posted: 30 Sep 2007 Last revised: 3 Mar 2009

Harjoat Singh Bhamra

Imperial College Business School

Lars-Alexander Kuehn

Carnegie Mellon University - David A. Tepper School of Business

Ilya A. Strebulaev

Stanford University - Graduate School of Business; National Bureau of Economic Research

Multiple version iconThere are 2 versions of this paper

Date Written: February 22, 2009

Abstract

We embed a structural model of credit risk inside a dynamic continuous-time consumption-based asset pricing model, which allows us to price equity and corporate debt in a unified framework. Our key economic assumptions are that the first and second moments of earnings and consumption growth depend on the state of the economy which switches randomly, creating intertemporal risk, which agents prefer to resolve sooner rather than later, because they have Epstein-Zin-Weil preferences. Agents optimally choose dynamic capital structure and default times. For a dynamic cross-section of firms, our model endogenously generates a realistic average term structure and time series of actual default probabilities and credit spreads, together with a reasonable levered equity risk premium, which varies with macroeconomic conditions.

Keywords: Equity premium, corporate bond credit spread, predictability, macroeconomic conditions, jumps, capital structure, default

JEL Classification: E44, G12, G32, G33

Suggested Citation

Bhamra, Harjoat Singh and Kuehn, Lars-Alexander and Strebulaev, Ilya A., The Levered Equity Risk Premium and Credit Spreads: A Unified Framework (February 22, 2009). The Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1016891 or http://dx.doi.org/10.2139/ssrn.1016891

Harjoat Bhamra (Contact Author)

Imperial College Business School ( email )

Tanaka Building
Exhibition Rd
London, SW7 2AZ
United Kingdom

HOME PAGE: http://www.harjoatbhamra.com

Lars-Alexander Kuehn

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

Ilya Strebulaev

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

HOME PAGE: http://faculty-gsb.stanford.edu/strebulaev/

National Bureau of Economic Research ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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