American Economic Review
ISSN 0002-8282 (Print) | ISSN 1944-7981 (Online)
Option-Based Credit Spreads
American Economic Review
vol. 108,
no. 2, February 2018
(pp. 454–88)
Abstract
We present a novel empirical benchmark for analyzing credit risk using "pseudo firms" that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, pseudo bonds are equivalent to Treasuries minus put options on pseudo firm assets. Empirically, like corporate spreads, pseudo bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors' overestimation of default risks, and corporate frictions do not seem to explain excessive observed credit spreads but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.Citation
Culp, Christopher L., Yoshio Nozawa, and Pietro Veronesi. 2018. "Option-Based Credit Spreads." American Economic Review, 108 (2): 454–88. DOI: 10.1257/aer.20151606Additional Materials
JEL Classification
- E23 Macroeconomics: Production
- E32 Business Fluctuations; Cycles
- E44 Financial Markets and the Macroeconomy
- G13 Contingent Pricing; Futures Pricing; option pricing
- G24 Investment Banking; Venture Capital; Brokerage; Ratings and Ratings Agencies
- G32 Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill