Option-Based Credit Spreads
Christopher L. Culp, Yoshio Nozawa, Pietro Veronesi
American Economic Review · 2018 · Volume 108 · Issue 2
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.
Keywords
Macroeconomics: Production, Business Fluctuations, Cycles, Financial Markets and the Macroeconomy, Contingent Pricing, Futures Pricing, option pricing, Investment Banking, Venture Capital, Brokerage, Ratings and Ratings Agencies, Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill
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