Reduced-form models of default that attribute a large fraction of credit spreads to compensation for credit-event risk typically preclude the most plausible economic justification for such risk to be priced, namely, a contemporaneous drop in the market portfolio. When this "contagion" channel is introduced within a general equilibrium framework for an economy comprising a large number of firms, credit-event risk premia have an upper bound of a few basis points, and are dwarfed by the contagion premium. We provide empirical evidence that indicates credit-event risk premia are less than 1 bp, but contagion risk premia are significant.

We propose an equilibrium model for defaultable bonds that are subject to contagion risk. Contagion arises because agents with "fragile beliefs" are uncertain about the underlying economic state and its probability. Estimation on sovereign European credit default swaps (CDS) data shows that agents require a time-varying risk premium for bearing state uncertainty. The model outperforms affine specifications with the same number of state variables, suggesting that there are important nonlinearities in credit spreads that are captured by our model. Contagion drives most of the variation in CDS spreads, especially before the crisis. However, economic fundamentals account for a significant fraction during the crisis.

We propose an equilibrium model for defaultable bonds that are subject to contagion risk. Contagion arises because agents with “fragile beliefs” are uncertain about the underlying economic state and its probability. Estimation on sovereign European credit default swaps (CDS) data shows that agents require a time-varying risk premium for bearing state uncertainty. The model outperforms affine specifications with the same number of state variables, suggesting that there are important nonlinearities in credit spreads that are captured by our model. Contagion drives most of the variation in CDS spreads, especially before the crisis. However, economic fundamentals account for a significant fraction during the crisis.

Reduced-form models of default that attribute a large fraction of credit spreads to compensation for credit-event risk typically preclude the most plausible economic justification for such risk to be priced, namely, a contemporaneous drop in the market portfolio. When this “contagion” channel is introduced within a general equilibrium framework for an economy comprising a large number of firms, credit-event risk premia have an upper bound of a few basis points, and are dwarfed by the contagion premium. We provide empirical evidence that indicates credit-event risk premia are less than 1 bp, but contagion risk premia are significant.

Many leading asset pricing models are specified so that the term structure of dividend volatility is either flat or upward sloping. These models predict that the term structures of expected returns and volatilities on dividend strips (i.e., claims to dividends paid over a prespecified interval) are also upward sloping. However, the empirical evidence suggests otherwise. This discrepancy can be reconciled if these models replace their proposed dividend dynamics with processes that generate stationary leverage ratios. Under such policies, shareholders are forced to divest (invest) when leverage is low (high), which shifts risk from long‐ to short‐horizon dividend strips.