Christopher L. Culp
Johns Hopkins Institute
for Applied Economics
Global Health and Study
of Business Enterprise
3400 North Charles St.
Baltimore, MD 21218
NBER Working Papers and Publications
|December 2014||Option-Based Credit Spreads|
with Yoshio Nozawa, Pietro Veronesi: w20776
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’ over-estimation 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.