RFS Advance Access originally published online on August 26, 2008
Review of Financial Studies 2009 22(9):3367-3409; doi:10.1093/rfs/hhn078
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On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle
Michigan State University
Columbia University and NBER
University of Minnesota and NBER
Address correspondence to Robert Goldstein, Carlson School of Management, University of Minnesota, Room 3-122, 321-19th Ave. South, Minneapolis, MN. E-mail: golds144{at}umn.edu.
JEL Classification: G12, G13
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Abstract |
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Structural models of default calibrated to historical default rates, recovery rates, and Sharpe ratios typically generate Baa–Aaa credit spreads that are significantly below historical values. However, this "credit spread puzzle" can be resolved if one accounts for the fact that default rates and Sharpe ratios strongly covary; both are high during recessions and low during booms. As a specific example, we investigate credit spread implications of the Campbell and Cochrane (1999) pricing kernel calibrated to equity returns and aggregate consumption data. Identifying the historical surplus consumption ratio from aggregate consumption data, we find that the implied level and time variation of spreads match historical levels well.
We thank participants at the Skinance 2005 Conference in Norway, the 2005 Wharton conference on "Credit Risk and Asset Pricing," the BIS 2004 workshop on credit risk in Basel, the Moody's-KMV MAARC meeting, the AFA 2006 annual meeting, the San Francisco FED, The Washington FED, Columbia University, Stanford University, the University of California at Berkeley, University of British Columbia, and New York University for insightful comments. We are especially thankful to Monika Piazzesi, Pietro Veronesi, Raman Uppal (the editor), and an anonymous referee for their comments.
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  H. S. Bhamra, L.-A. Kuehn, and I. A. Strebulaev The Levered Equity Risk Premium and Credit Spreads: A Unified Framework Rev. Financ. Stud., October 26, 2009; (2009) hhp082v1. [Abstract] [Full Text] [PDF]
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