Credit Risk and Business Cycles

Abstract

We incorporate long-term defaultable corporate bonds and credit risk in a dynamic stochastic general equilibrium business cycle model. Credit risk amplifies aggregate technology shocks. The debt-capital ratio is a new state variable and its endogenous movements provide a propagation mechanism. The model can match the persistence and volatility of output growth as well as the mean equity premium and the mean risk-free rate as in the data. The model implied credit spreads are countercyclical and forecast future economic activities because they affect firm investment through Tobin's Q. They also forecast future stock returns through changes in the market price of risk. Finally, we show that financial shocks to the credit markets are transmitted to the real economy through Tobin's Q. JEL Classification: E22, E32, G12, G32, G33

Financial crises, bank risk exposure and government financial policy

“…where Ω t+1 is defined in (27). Comparing the terms of n t , s t and x t , we verify that the conjectured form of value function satisfies Bellman equation for any (n t , s t , x t ) if (24,25,26) holds.…”

“…Our preference structure follows Miao and Wang (2010), which is in turn based on Guvenen (2009) and Greenwood, Hercowitz and Huffman (GHH, 1988):…”

Credit Risk and Disaster Risk

“…Hence, model estimation that replicates credit spread variation (such as Christiano, Motto, and Rostagno 2009;and Gilchrist, Ortiz, and Zakrajšek 2009) imply a counter factually high level and volatility of default probability, which makes it difficult to assess the quantitative relevance of the mechanism. Some recent studies attempt to replicate more closely the behavior of asset prices, in particular Gomes and Schmid (2009);Mendoza (2010); Miao and Wang (2010);and Liu, Wang, and Zha (forthcoming). Also related is the work of Amdur (2010), Covas and Den Haan (2009), and Levy and Hennessy (2007), who study the cyclicality of capital structure.…”

Capital Structure, Investment, and Fire Sales

“…Gomes and Schmid (2010) and Miao and Wang (2010) study an environment fairly close to ours: they also examine a representative agent economy where firms' investment can be financed with debt or equity, subject to a similar structure of costs. The liquidation cost, in the event of default is exogenous in their set-up, whereas it is endogenously determined in ours by the equilibrium price of liquidated assets.…”