Persistent Crises and Levered Asset Prices

Abstract

This paper shows that standard disaster risk models are inconsistent with the behavior of stock market volatility and credit spreads during disasters. We resolve this shortcoming by incorporating persistent macroeconomic crises into a structural credit risk model. The model successfully captures the joint dynamics of aggregate consumption, financial leverage, and asset market risks, both unconditionally and during crises. Leverage provides a strong amplification mechanism for fundamental shocks because it continues to rise while crises endure. We structurally estimate the model and show that it replicates the firm-level implied volatility curve and its cross-sectional relation with observable proxies of default risk.

Keywords: Disasters, Epstein-Zin preferences, SMM, credit risk, option pricing

JEL Classification: G01,G12, G13,G32