The Credit Risk Premium in a Disaster-Prone World

37 Pages Posted: 16 Feb 2009

See all articles by Yanhui Zhu

Yanhui Zhu

University of the West of England

Laurence Copeland

Cardiff University - Cardiff Business School

Multiple version iconThere are 2 versions of this paper

Date Written: February 13, 2009


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 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 firm to 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

JEL Classification: F3, G1

Suggested Citation

Zhu, Yanhui and Copeland, Laurence S., The Credit Risk Premium in a Disaster-Prone World (February 13, 2009). Available at SSRN: or

Yanhui Zhu (Contact Author)

University of the West of England ( email )

Coldharbour Lane
United Kingdom

Laurence S. Copeland

Cardiff University - Cardiff Business School ( email )

Aberconway Building
Colum Drive
Cardiff, CF10 3EU
United Kingdom
+44 29 20875740 (Phone)
+44 29 20874419 (Fax)

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