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

Posted: 8 Sep 2009

See all articles by Long Chen

Long Chen

Michigan State University

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)

Multiple version iconThere are 3 versions of this paper

Date Written: September 2009

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 () 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.

Keywords: G12, G13

Suggested Citation

Chen, Long and Collin-Dufresne, Pierre and Goldstein, Robert S., On the Relation between the Credit Spread Puzzle and the Equity Premium Puzzle (September 2009). The Review of Financial Studies, Vol. 22, Issue 9, pp. 3367-3409, 2009, Available at SSRN: https://ssrn.com/abstract=1468193 or http://dx.doi.org/hhn078

Long Chen

Michigan State University

Agriculture Hall
East Lansing, MI 48824-1122
United States

Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL-Dorigny, Bâtiment Extranef, # 211
40, Bd du Pont-d'Arve
CH-1015 Lausanne, CH-6900
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

Robert S. Goldstein

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

19th Avenue South
Minneapolis, MN 55455
United States
612-624-8581 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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