A Model of Credit Risk, Optimal Policies, and Asset Prices

46 Pages Posted: 11 Nov 2008

See all articles by Suleyman Basak

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Alex Shapiro

New York University (NYU) - Department of Finance

Multiple version iconThere are 5 versions of this paper

Date Written: November 2003

Abstract

This paper studies the optimal policies of borrowers (firms or individuals) who may default subject to default costs, and analyzes the asset pricing implications. Borrowers defaulting under adverse economic conditions may, despite incurring default costs, emerge as wealthier than non-borrowers or those who can default costlessly. Under many economic scenarios, borrowers takes on less risk exposure than non-borrowers, and asset substitution is not pronounced. However, a larger risk exposure by borrowers may occur as well, depending on the structure of default costs and on how debt maturity relates to the planning horizon. In the latter case, borrowers default policies render binary options to be useful credit derivatives for lenders in hedging the credit-risk component of their assets. In our model, the asset-value dynamics are endogenously determined, and are shown to exhibit stochastic mean return and volatility in contrast to the exogenously assumed constant mean and volatility in many credit risk models. We consider a variety of extensions, including equilibrium, where a lower (higher) risk exposure by borrowers manifests itself in an attenuated (amplified) market volatility and risk premium, but the market value is always higher in economic downturns, and lower in upturns, compared to an economy without the presence of credit risk.

Keywords: Credit Risk, Defaultable Debt, Investments, Assets Pricing, Volatility

Suggested Citation

Basak, Suleyman and Shapiro, Alex, A Model of Credit Risk, Optimal Policies, and Asset Prices (November 2003). NYU Working Paper No. FIN-03-047. Available at SSRN: https://ssrn.com/abstract=1299507

Suleyman Basak (Contact Author)

London Business School ( email )

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

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alex Shapiro

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0362 (Phone)
212-995-4233 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~ashapiro/

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