On Bounding Credit Event Risk Premia - Federal Reserve Bank of New York

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On Bounding Credit Event Risk Premia

2014 October 2012 Number 577

JEL classification: G12, G10

Authors: Jennie Bai, Pierre Collin-Dufresne, Robert S. Goldstein, and Jean Helwege

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 during the credit event. When this channel is introduced within a general equilibrium framework for an economy comprised of a large number of firms, credit event risk premia have an upper bound of just a few basis points and are dwarfed by the contagion premium. We provide empirical evidence supporting the view that credit event risk premia are minuscule.

Available only in PDF pdf

45 pages / 408 kb

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