On bounding credit event risk premia

Bai, Jennie; Collin-Dufresne, Pierre; Goldstein, Robert S.; Helwege, Jean

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On bounding credit event risk premia

Abstract: 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.

Keywords: Default (Finance); Credit; Risk; Financial crises;