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On Bounding Credit Event Risk Premia

by Jennie Bai of Federal Reserve Bank of New York,
Pierre Collin-Dufresne of Columbia University,
Robert S. Goldstein of University of Minnesota, and
Jean Helwege of University of South Carolina

October 2012

Abstract: Reduced form models of default that attribute a large fraction of credit spreads to compensation for credit event risk typically preclude the most plausible economic justification for such risk to be priced: namely, a "contagious" response of the market portfolio to the credit event. When this channel is introduced within a general equilibrium framework for an economy containing a large number of firms, the typical credit event risk premium has an upper bound of just a few basis points, and it is dwarfed by the contagion premium. Empirically, returns on the market portfolio covary with credit events, which indicates that ex ante compensation for the risk that a bond will jump to default is signi cantly lower than the upper bound we identify in our calibrations.

JEL Classification: G12, G10.

Keywords: credit risk model, contagion.

Previously titled: Is Credit Event Risk Priced?

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