RFS Advance Access published online on October 26, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp082
The Levered Equity Risk Premium and Credit Spreads: A Unified Framework
Sauder School of Business, University of British Columbia
Tepper School of Business, Carnegie Mellon University
Graduate School of Business, Stanford University
Send correspondence to Harjoat S. Bhamra, Sauder School of Business at the University of British Columbia, 2053 Main Mall, Vancouver BC, Canada V6T 1Z2; telephone: (604) 822-3314; fax: (604) 822-4695. E-mail: harjoat.bhamra{at}sauder.ubc.ca.
JEL Classification: E44, G12, G32, G33
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Abstract |
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We embed a structural model of credit risk inside a dynamic continuous-time consumption-based asset pricing model, which allows us to price equity and corporate debt in a unified framework. Our key economic assumptions are that the first and second moments of earnings and consumption growth depend on the state of the economy, which switches randomly, creating intertemporal risk, which agents prefer to resolve sooner rather than later, because they have Epstein-Zin-Weil preferences. Agents optimally choose dynamic capital structure and default times. For a dynamic cross-section of firms, our model endogenously generates a realistic average term structure and time series of actual default probabilities and credit spreads, together with a reasonable levered equity risk premium, which varies with macroeconomic conditions.
We are grateful for comments from two anonymous referees, Malcolm Baker, Ravi Bansal, Alexander David, Glen Donaldson, Darrell Duffie, Bernard Dumas, Marcelo Fernandes, Adlai Fisher, Lorenzo Garlappi, Ron Giammarino, Bob Goldstein, Dirk Hackbarth, Cam Harvey, Kris Jacobs, Dmitry Livdan, Hanno Lustig, Marcin Kacperczyk, Adriano Rampini, Stephen Schaefer, Lukas Schmid, Costis Skiadas, Suresh Sundaresan, Raman Uppal, and participants at the PIMS/Banff Workshop on Optimization Problems in Financial Economics, the CEPR Gerzensee European Summer Symposium on Financial Markets 2006, NFA 2006, WFA 2007, SITE 2007 Workshop on Dynamic Investment and Financing, Duke/UNC 2007 conference on asset pricing, EFA 2007, and seminar participants at Boston College, Calgary, Cass Business School, Duke, Goethe University (Frankfurt), HKUST, London Business School, Penn State, Singapore Management University, Stanford, Nanyang Technological University, National University of Singapore, University of Southern Denmark, Vienna, Wharton, UBC and UNC-Chapel Hill for helpful suggestions. This work was supported by the Social Sciences and Humanities Research Council of Canada and the Bureau of Asset Management at the Sauder School of Business.