On the Relation between the Credit Spread Puzzle and the Equity Premium Puzzle

59 Pages Posted: 16 Mar 2005 Last revised: 1 Jul 2011

Long Chen

Cheung Kong Graduate School of Business

Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne; National Bureau of Economic Research (NBER)

Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management; National Bureau of Economic Research (NBER)

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Date Written: January 2008

Abstract

Structural models of default calibrated to historical default rates, recovery rates, and Sharpe ratios typically generate Baa-Aaa credit spreads that are significantly below historical values. However, this credit spread puzzle can be resolved if one accounts for the fact that default rates and Sharpe ratios strongly covary; both are high during recessions and low during booms. As a specific example, we investigate credit spread implications of the Campbell and Cochrane (1999) pricing kernel calibrated to equity returns and aggregate consumption data. Identifying the historical surplus consumption ratio from aggregate consumption data, we find that the implied level and time-variation of spreads match historical levels well.

Keywords: Equity premium, credit spread, habit formation model

JEL Classification: G11, G12

Suggested Citation

Chen, Long and Collin-Dufresne, Pierre and Goldstein, Robert S., On the Relation between the Credit Spread Puzzle and the Equity Premium Puzzle (January 2008). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=687473 or http://dx.doi.org/10.2139/ssrn.687473

Long Chen

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Pierre Collin-Dufresne

Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL-Dorigny, Bâtiment Extranef, # 211
40, Bd du Pont-d'Arve
CH-1015 Lausanne, CH-6900
Switzerland

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Robert S. Goldstein (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-624-8581 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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