Is Credit Event Risk Priced? Modeling Contagion via the Updating of Beliefs

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Is Credit Event Risk Priced? Modeling Contagion via the Updating of Beliefs

by Pierre Collin-Dufresne of Carnegie-Mellon University,
Robert S. Goldstein of Washington University, and
Jean Helwege of Ohio State University

December 10, 2003

Abstract: We propose a reduced-form model where jumps-to-default are priced because they generate a market-wide jump in credit spreads. While this framework is consistent with a counterparty risk interpretation (e.g., Jarrow and Yu (2001)), it is most naturally interpreted as an updating of beliefs due to an unexpected event. Simple analytic solutions are obtained for the prices of risky debt regardless of the number of firms that share in the contagious response. Empirically, we find that credit events of large firms generate a market wide increase in credit spreads and a significant 'flight-to-quality' response in the Treasury market. A calibration argument suggests that the premium associated with jump-to-default risk for a typical investment grade firm has an upper bound of a few basis points per year, but that the risk premium for contagion-risk may be considerably larger.

Previously titled: Are Jumps in Corporate Bond Yields Priced? Modeling Contagion via the Updating of Beliefs

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