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On Bounding Credit Event Risk Premia |
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| October 2012 Number 577 |
| JEL classification: G12, G10 |
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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.
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