Credit Risk and the Transmission of Interest Rate Shocks

76 Pages Posted: 8 Mar 2021

See all articles by Berardino Palazzo

Berardino Palazzo

Board of Governors of the Federal Reserve System

Ram Yamarthy

Office of Financial Research, US Department of the Treasury

Multiple version iconThere are 2 versions of this paper

Date Written: March 1, 2021

Abstract

Using daily credit default swap (CDS) data, we find a positive relation between corporate credit risk and unexpected monetary policy shocks during FOMC announcement days. Positive shocks to interest rates increase the expected loss component of CDS spreads as well as a risk premium component. However, not all firms respond in the same manner. We show that firm-level credit risk is an important driver of the monetary policy response, both in credit and equity markets, and plays a more prominent role relative to other risk proxies. A stylized corporate model of monetary policy, investment, and financing rationalizes our findings.

Keywords: Credit risk, CDS, monetary policy, shock transmission, equity returns

JEL Classification: E52, G12, G18, G32

Suggested Citation

Palazzo, Berardino and Yamarthy, Ram, Credit Risk and the Transmission of Interest Rate Shocks (March 1, 2021). Available at SSRN: https://ssrn.com/abstract=3795812 or http://dx.doi.org/10.2139/ssrn.3795812

Berardino Palazzo (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Ram Yamarthy

Office of Financial Research, US Department of the Treasury ( email )

717 14th Street, NW
Washington, DC 20220
United States

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