Rare Disasters, Credit and Option Market Puzzles

56 Pages Posted: 22 Aug 2013 Last revised: 22 Feb 2016

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; University of Aarhus - CREATES

Du Du

Hong Kong University of Science & Technology (HKUST)

Redouane Elkamhi

University of Toronto - Rotman School of Management

Date Written: April 9, 2015

Abstract

We embed systematic default, pro-cyclical recovery rates and habit persistence into a model with a slight possibility of a macroeconomic disaster of reasonable magnitude. We derive analytical solutions for defaultable bond prices and show that a single set of structural parameters calibrated to the real economy can simultaneously explain several key empirical regularities in equity, credit, and options markets. Our model captures the empirical level and volatility of credit spreads, generates a fl‡exible credit risk term structure, and provides a good fi…t to a century of observed spreads. The model also matches high-yield and CDO tranche spreads, equity market moments, and index option skewness. Finally, our model implies a time-varying relationship between bond and option prices that depends on the state of the economy and that explains the con‡flicting empirical evidence found in the literature.

Keywords: Credit spreads, volatility, term structure, option skewness, stochastic recovery, consumption risk

JEL Classification: C60, G12, G13

Suggested Citation

Christoffersen, Peter and Du, Du and Elkamhi, Redouane, Rare Disasters, Credit and Option Market Puzzles (April 9, 2015). Rotman School of Management Working Paper No. 2270517. Available at SSRN: https://ssrn.com/abstract=2270517 or http://dx.doi.org/10.2139/ssrn.2270517

Peter Christoffersen (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

HOME PAGE: http://www.christoffersen.com

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

University of Aarhus - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Du Du

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

Register to save articles to
your library

Register

Paper statistics

Downloads
288
rank
96,564
Abstract Views
1,203
PlumX