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. Under many economic scenarios, borrowers takes on less risk exposure than non-borrowers, and asset substitution is not pronounced. 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 to be useful credit derivatives for lenders in hedging the credit-risk component of their assets. In our model, the asset-value dynamics are endogenously determined, and are shown to exhibit stochastic mean return and volatility in contrast to the exogenously assumed constant mean and volatility in many credit risk models. We consider a variety of extensions, including equilibrium, where 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.