Modeling Credit Contagion via the Updating of Fragile Beliefs

by Luca Benzoni of Federal Reserve Bank of Chicago,
Pierre Collin-Dufresne of Columbia University,
Robert S. Goldstein of University of Minnesota, and
Jean Helwege of University of South Carolina

February 28, 2011

Abstract: We propose a general equilibrium framework for pricing defaultable bonds that are subject to contagion-risk when the representative agent has fragile beliefs (Hansen and Sargent (2009)). We identify conditions for which the marginal utility of the agent with fragile beliefs generate time-consistent state prices. Even though capturing contagion implies that our intensity-based model falls outside of the "doubly stochastic" framework, bond prices remain tractable, in turn facilitating empirical investigation. We apply this model to sovereign countries in the European Union (EU). The model can justify large and highly correlated credit spreads even when default probabilities and correlations in macroeconomic fundamentals are low.

JEL Classification: G12, G13.

Previously titled: Is Credit Event Risk Priced? Modeling Contagion via the Updating of Beliefs --and before that-- Are Jumps in Corporate Bond Yields Priced? Modeling Contagion via the Updating of Beliefs

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