A Model of Credit Risk, Optimal Policies, and Asset Prices

Abstract

This paper studies the optimal policies of borrowers (firms or individuals) who may default subject to default costs, and analyzes the asset pricing implications. Borrowers defaulting under adverse economic conditions may, despite incurring default costs, emerge as wealthier than non-borrowers or those who can default costlessly. In many scenarios, borrowers take on less risk exposure than non-borrowers. However, a larger risk exposure by borrowers may occur as well, depending on the structure of default costs and on how debt maturity relates to the planning horizon. In the latter case, borrowers' default policies render binary options useful instruments for lenders in hedging the credit-risk component of their assets. In equilibrium, a lower (higher) risk exposure by borrowers manifests itself in an attenuated (amplified) market volatility and risk premium, but the market value is always higher in economic downturns, and lower in upturns, compared to an economy without the presence of credit risk