Is Credit Event Risk Priced? Modeling Contagion Via the Updating of Beliefs

48 Pages Posted: 10 Feb 2010 Last revised: 29 Jun 2010

See all articles by Pierre Collin-Dufresne

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)

Jean Helwege

UC Riverside

Multiple version iconThere are 2 versions of this paper

Date Written: February 2010

Abstract

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.

Suggested Citation

Collin-Dufresne, Pierre and Goldstein, Robert S. and Helwege, Jean, Is Credit Event Risk Priced? Modeling Contagion Via the Updating of Beliefs (February 2010). NBER Working Paper No. w15733. Available at SSRN: https://ssrn.com/abstract=1550602

Pierre Collin-Dufresne (Contact Author)

Ecole Polytechnique Fédérale de Lausanne ( email )

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Swiss Finance Institute

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National Bureau of Economic Research (NBER)

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Robert S. Goldstein

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

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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

Jean Helwege

UC Riverside ( email )

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Riverside, CA 92521
United States
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