On Bounding Credit Event Risk Premia
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.
Keywords: credit risk model, contagion.
Previously titled: Is Credit Event Risk Priced?