Idiosyncratic Tail Risk and the Credit Spread Puzzle

62 Pages Posted: 8 Dec 2018

See all articles by Chenjie Xu

Chenjie Xu

Shanghai University of Finance and Economics - Department of Finance

Date Written: November 21, 2018

Abstract

This paper studies the asset pricing implications of idiosyncratic labor income tail risk on credit spread. I propose a model featuring an incomplete market, heterogeneous households with recursive preference, and comovement of tail risk in labor income and firm cash flow growth. The model produces strong covariation of households' marginal utility and default rates, which helps to explain the stylized fact that the credit spread (1) is on average large and (2) is positively related to labor tail risk. Quantitatively, the tail risk premium can account for as much as 68% of the observed credit spread. My framework provides a new insight, drawn from an option perspective, that the implications of idiosyncratic tail risk for stocks and bonds can be very different.

Keywords: Idiosyncratic Tail Risk, Labor Income, Incomplete Market, Credit Spread

JEL Classification: E2, E3, G12

Suggested Citation

Xu, Chenjie, Idiosyncratic Tail Risk and the Credit Spread Puzzle (November 21, 2018). Available at SSRN: https://ssrn.com/abstract=3289498 or http://dx.doi.org/10.2139/ssrn.3289498

Chenjie Xu (Contact Author)

Shanghai University of Finance and Economics - Department of Finance ( email )

Shanghai, 200433
China

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