On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle
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Date: 02-22-2007
Start Time:
5:30pm
End Time: 7:00pm
Speaker: Pierre Collin-Dufresne, UC Berkeley & Goldman Sachs
Location: Dahesh Auditorium, 580 Madison Ave (Madison & 56th street)
ABSTRACT
We examine whether `large' historical (Baa - Aaa)
credit spreads can be explained within a structural framework that is
calibrated to match historical default rates, recovery rates, and
Sharpe ratios. We find this to be the case if:
i) the model generates strong time-varying market prices of risks, and
ii) the model captures the empirical fact that default rates are highly
(counter) cyclical. Campbell and Cochrane (1999) recently advocate time
varying sharpe ratios to explain the equity premium puzzle. We
therefore investigate the prediction of their model for credit spreads.
We show that, due to both substantial firm-specific risks (Sharpe
ratios of individual firms are about one-half those of the market
portfolio) and the fact that high Sharpe ratios during recessions tend
to push ¯rm value away from the default boundary, it is difficult to
generate most defaults to occur during recessions within the CC
framework. However, if we introduce some mechanism to do so (e.g., time
varying default boundaries), then we can capture historical spread
level, volatility, and forward default correlations. We use the model
to back out a time series of implied credit spreads from historical
consumption growth and find that they fit both the level and time
series dynamics of historical credit spreads rather well.
BIO
Pierre Collin-Dufresne is a Vice President in the Quantitative Strategies Group of GSAM which he joined in July 2005, on leave from the Haas School of Business of U.C. Berkeley where he has been an Associate Professor of Finance since 2004. After obtaining his Ph.D. in 1998 from the HEC School of Management, Paris, France, he started as an Assistant Professor of Finance at Carnegie Mellon. Pierre’s research interests include Fixed Income Securities, Default Risk, International Finance, and Real Estate Economics. He is a member of the NBER and of the Advisory Research Board of Moody's.