The Credit Risk Premium in a Disaster-Prone World

Paris December 2008 Finance International Meeting AFFI - EUROFIDAI

21 Pages Posted: 13 Oct 2008

See all articles by Laurence Copeland

Laurence Copeland

Cardiff University - Cardiff Business School

Yanhui Zhu

Cardiff University - Cardiff Business School - Economics Section

Multiple version iconThere are 2 versions of this paper

Date Written: May 31, 2008

Abstract

The seminal Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events ("disasters") allowed for leverage in the form of risky corporate debt which defaulted only in states when the Government defaulted on its debt. The probability of default was therefore exogenous and independent of the degree of leverage. In this paper, we take the model a step closer reality by assuming that, on the one hand, the Government never defaults, and on the other hand, that the "corporate sector" in the form of the Lucas tree owner pays its debts in full if and only if its asset value is sufficient, which is always the case in non-crisis states. Otherwise, in exceptionally severe crises, it defaults and hands over the whole "firms" its creditors. The probability of default by the tree owner is thus endogenous, dependent both on the volume of debt issued (taken as exogenous) and on the uncertain value of output. We show, using data from both Barro (2006) and Barro and Ursua (2008), that the model can generate values of the riskless rate, equity risk premium and credit risk spread broadly consistent with those typically observed in the data.

Keywords: equity risk premium, default risk, credit spread, leverage, corporate debt

Suggested Citation

Copeland, Laurence S. and Zhu, Yanhui, The Credit Risk Premium in a Disaster-Prone World (May 31, 2008). Paris December 2008 Finance International Meeting AFFI - EUROFIDAI, Available at SSRN: https://ssrn.com/abstract=1282101 or http://dx.doi.org/10.2139/ssrn.1282101

Laurence S. Copeland (Contact Author)

Cardiff University - Cardiff Business School ( email )

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Cardiff, CF10 3EU
United Kingdom
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+44 29 20874419 (Fax)

Yanhui Zhu

Cardiff University - Cardiff Business School - Economics Section ( email )

Cardiff CF10 3EU
United Kingdom

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