Is Credit Event Risk Priced? Modeling Contagion Via the Updating of Beliefs
48 Pages Posted: 27 Jan 2010 Last revised: 1 Jul 2011
Date Written: January 26, 2010
Empirical tests of reduced form models of default attribute a large fraction of observed credit spreads to compensation for jump-to-default risk. However, these models preclude a “contagion-risk” channel, where the aggregate corporate bond index reacts adversely to a credit event. In this paper, we propose a tractable model for pricing corporate bonds subject to contagion-risk. We show that when investors have fragile beliefs (Hansen and Sargent (2009)), contagion premia may be sizable even if P-measure contagion across defaults is small. We find empirical support for contagion in bond returns in response to large credit events. Model calibrations suggest that while contagion risk premia may be sizable, jump-to-default risk premia have an upper bound of a few basis points.
Keywords: contagion risk, fragile beliefs
JEL Classification: G12, G13
Suggested Citation: Suggested Citation