On the Relation between the Credit Spread Puzzle and the Equity Premium Puzzle

Posted: 12 Nov 2007

See all articles by Long Chen

Long Chen

Cheung Kong Graduate School of Business; Luohan Academy

Pierre Collin-Dufresne

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)

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Abstract

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.

Suggested Citation

Chen, Long and Chen, Long and Collin-Dufresne, Pierre and Goldstein, Robert S., On the Relation between the Credit Spread Puzzle and the Equity Premium Puzzle. Review of Financial Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1028141

Long Chen

Cheung Kong Graduate School of Business ( email )

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Luohan Academy ( email )

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Pierre Collin-Dufresne (Contact Author)

Ecole Polytechnique Fédérale de Lausanne ( email )

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Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management ( email )

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National Bureau of Economic Research (NBER)

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