Rare Macro Disasters in Credit and Option Markets

54 Pages Posted: 16 Mar 2012

See all articles by Du Du

Du Du

Hong Kong University of Science & Technology (HKUST)

Redouane Elkamhi

University of Toronto - Rotman School of Management

Date Written: Febuary 15, 2012

Abstract

We show that the slight possibility of a macroeconomic disaster of moderate magnitude can explain important features across credit, option, and equity markets. Our consumption-based equilibrium model captures the empirical level and volatility of credit spreads, generates a flexible credit term structure and provides a good fi…t to a century of observed spreads. The model matches the widespread volatility smirk in index options as well as the …first two moments of government bond and equity market returns. Our model reveals a dynamic relationship between credit and option markets that helps explain the inconclusive evidence found in the empirical literature when regressing credit spreads on the option smirk.

Keywords: Peso problem, credit spread, volatility, smirk premium, market integration

JEL Classification: C60, G12, G13

Suggested Citation

Du, Du and Elkamhi, Redouane, Rare Macro Disasters in Credit and Option Markets (Febuary 15, 2012). Available at SSRN: https://ssrn.com/abstract=2023127 or http://dx.doi.org/10.2139/ssrn.2023127

Du Du (Contact Author)

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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