Idiosyncratic tail risk and the credit spread puzzle

Abstract

This paper studies the asset pricing implications of idiosyncratic tail risk on credit spread. I propose a model featuring an incomplete market, heterogeneous households with recursive preference, and comovement of tail risk in labor income and firm-level cash flow growth. The model produces strong covariation between households' marginal utility and default rates, which helps to explain the stylized fact that the credit spread (1) is on average large and (2) is positively related to labor-income tail risk. Quantitatively, the tail risk premium accounts for as much as 68% of the observed credit spread. My framework also provides a new insight, drawn from an option perspective, that the implications of idiosyncratic tail risk for stocks and bonds can be very different.

Date of Award	2019
Original language	English
Awarding Institution	The Hong Kong University of Science and Technology