On Bounding Credit-Event Risk Premia
48 Pages Posted: 13 Nov 2012 Last revised: 23 Jul 2018
Date Written: February 28, 2015
Reduced-form models of default that attribute a large fraction of credit spreads to compensation for credit-event risk typically preclude the most plausible economic justification for such risk to be priced, namely, a contemporaneous drop in the market portfolio. When this "contagion" channel is introduced within a general equilibrium framework for an economy comprising a large number of firms, credit-event risk premia have an upper bound of a few basis points, and are dwarfed by the contagion premium. We provide empirical evidence that indicates credit-event risk premia are less than 1 bp but contagion risk premia are significant.
Keywords: credit risk model, contagion
JEL Classification: G12, G13
Suggested Citation: Suggested Citation