Default Linkages in a Structural Credit Model

Abstract

We propose an explanation for default risk linkages across independent borrowers. The transmission mechanism is that variation in the size of one borrower impacts the default decision for all. If a negative shock hits one borrower's fundamentals, the other becomes a larger player in the economy and bears more systematic risk. The increased risk premium raises the cost of debt and tilts that borrower's decision towards default, increasing default risk and equity volatility. This effect is stronger for borrowers with greater rollover needs. Our model sheds light on co-movement in risk premia, default probabilities, and equity volatilities across unrelated borrowers.

Keywords: Credit Risk, Structural Models, Asset Prices, Leverage, Volatility, Spillovers

JEL Classification: G12, G13, G32, G33