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Credit risk premium in a disaster-prone world

Copeland, Laurence; Zhu, Yanhui

Authors

Laurence Copeland

Yanhui Zhu Yanhui.Zhu@uwe.ac.uk
Senior Lecturer in Economics



Abstract

The seminal Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events("disasters") allowed for leverage in the form of risky corporate debt which defaulted only in states when the Government defaulted on its debt. The probability of default was therefore exogenous and independent of the degree of leverage. In this paper, we take the model a step closer reality by assuming that, on the one hand, the Government
never defaults, and on the the other hand, that the corporate sector�in the form of the Lucas tree owner pays its debts in full if and only if its asset value is su¢ cient, which is always the case in non-crisis states. Otherwise, in exceptionally severe crises, it defaults and hands over the whole ��rm�to its creditors. The probability of default by the tree owner is thus endogenous, dependent both on the volume of debt issued (taken as exogenous) and on the uncertain value of output. We show, using data from both Barro (2006) and Barro and Ursua (2008), that the model can generate values of the riskless rate, equity risk premium and credit risk spread broadly consistent with those typically observed in the data.

Citation

Copeland, L., & Zhu, Y. (2008, November). Credit risk premium in a disaster-prone world. Paper presented at European Monetary Forum in Leuven

Presentation Conference Type Conference Paper (unpublished)
Conference Name European Monetary Forum in Leuven
Start Date Nov 1, 2008
End Date Nov 1, 2008
Peer Reviewed Not Peer Reviewed
Keywords credit spread, disaster, equity premium