Option-Based Credit Spreads
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.
Document Object Identifier (DOI): 10.3386/w20776
Published: Christopher L. Culp & Yoshio Nozawa & Pietro Veronesi, 2018. "Option-Based Credit Spreads," American Economic Review, vol 108(2), pages 454-488.
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