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On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle

Long Chen1; Pierre Collin-Dufresne; Robert S. Goldstein2

1 Michigan State University · 2 University of Minnesota

Review of Financial Studies 2009 open access

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.

DOI
10.1093/rfs/hhn078
Volume
22 (9)
Pages
3367-3409
Language
en
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