Credit Risk

Paper Session

Friday, Jan. 6, 2017 8:00 AM – 10:00 AM

Sheraton Grand Chicago, Sheraton Ballroom II
Hosted By: American Finance Association
  • Chair: Ilya Strebulaev, Stanford University

Unemployment and Credit Risk

Hang Bai
University of Connecticut


This paper explores the credit risk implications of labor market fluctuations, by
incorporating defaultable debt into a textbook search model of unemployment. In
the model, the present value of cash flows that firms extract from workers drives
both unemployment dynamics and credit risk variation. The model generates fat right
tails in both unemployment and credit spreads, and their strong comovement over the
business cycle, in line with the historical U.S. data from 1929 to 2015. Quantitatively,
the model reasonably replicates the level, volatility and cyclicality of credit spreads.
Overall, the paper highlights labor market fluctuations as a key driver of credit risk

Economic Uncertainty, Aggregate Debt, and the Real Effects of Corporate Finance

Timothy Johnson
University of Illinois-Urbana-Champaign


To explore the real effects of corporate leverage on aggregate risk and welfare, I develop a tractable general equilibrium model with endogenous capital structure driven by time-varying economic uncertainty. Fitting the model leads to interesting insights as to the shortcomings of the standard paradigm. Contrary to the trade-off version, the empirical relation between uncertainty and aggregate leverage is {\em positive}. This association is not attributable to supply-side constraints or adjustment costs. An alternative formulation in which debt incentives rise with uncertainty can account for the observed dynamics of uncertainty, credit spreads and leverage. This version, unlike the trade-off model, implies that the real effects of debt on the equilibrium can become severely negative.

Sovereign CDS Spreads With Credit Rating

Haitao Li
Cheung Kong Graduate School of Business
Tao Li
City University of Hong Kong
Xuewei Yang
Nanjing University


We study the nature of sovereign credit risk through a rating-based continuous-time model for sovereign CDS spreads. Rating transition follows a Markov chain, and countries with the same credit rating share the same level of systematic default risk. Empirical analysis shows that the explicit modeling of the dependence of sovereign credit risk on rating can enable the model to jointly capture the cross-sectional and time-series variations of sovereign CDS spreads of multiple countries. Consequently, a parsimonious version of the model can simultaneously capture the term structure of the CDS spreads of 34 in-sample and 34 out-of-sample countries well. The common factor, along with the observed ratings, can explain more than 60% of the variations of sovereign CDS spreads of all countries. This explanatory power jumps to more than 80% when we replace the observed ratings with the model implied ratings.

The Impact of Sovereign Shocks

Gerardo Manzo
University of Chicago
Antonio Picca
University of Chicago


We investigate the interrelationships between macro-systems of governments and
financial institutions by studying the dynamic propagation mechanisms of macroeconomic
shocks. We propose a novel approach to identify relevant systemic shocks, and to
classify them into sovereign or banking categories. Our econometric framework quantifies
the impact and spillover rates of systemic shocks within and across both systems.
We find that sovereign shocks have a significant and persistent impact on the probability
of a collective banking default, but not vice versa. Finally, we explore sources of
systemic fragility, potential mechanisms of shock transmission, and their implications
for the real economy.
Lukas Schmid
Duke University
Adriano Rampini
Duke University
David Lando
Copenhagen Business School
Timothy McQuade
Stanford University
JEL Classifications
  • G1 - General Financial Markets