Credit Event Risk Priced?

NBER WORKING PAPER SERIES

IS CREDIT EVENT RISK PRICED? MODELING CONTAGION VIA THE UPDATING OF BELIEFS. Pierre Collin-Dufresne Robert S. Goldstein Jean Helwege Working Paper 15733 http://www.nber.org/papers/w15733

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 February 2010

The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. © 2010 by Pierre Collin-Dufresne, Robert S. Goldstein, and Jean Helwege. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Is Credit Event Risk Priced? Modeling Contagion via the Updating of Beliefs. Pierre Collin-Dufresne, Robert S. Goldstein, and Jean Helwege NBER Working Paper No. 15733 February 2010 JEL No. G12,G13 ABSTRACT Empirical tests of reduced form models of default attribute a large fraction of observed credit spreads to compensation for jump-to-default risk. However, these models preclude a "contagion-risk'' channel, where the aggregate corporate bond index reacts adversely to a credit event. In this paper, we propose a tractable model for pricing corporate bonds subject to contagion-risk. We show that when investors have fragile beliefs (Hansen and Sargent (2009)), contagion premia may be sizable even if P-measure contagion across defaults is small. We find empirical support for contagion in bond returns in response to large credit events. Model calibrations suggest that while contagion risk premia may be sizable, jump-to-default risk premia have an upper bound of a few basis points.

Pierre Collin-Dufresne Graduate School of Business Columbia University Uris Hall 404 3022 Braodway New York, NY 10027 and NBER pc2415@columbia.edu Robert S. Goldstein University of Minnesota Finance Department 3-125 Carlson School of Management 321 19th Avenue South Minneapolis, MN...