Bai, Jennie Collin-Dufresne, Pierre Goldstein, Robert S. Helwege, Jean
Year of Publication:
Staff Report, Federal Reserve Bank of New York 577
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.