Cyclical Dispersion in Expected Defaults

A growing literature shows that credit indicators forecast aggregate real outcomes. While researchers have proposed various explanations, the economic mechanism behind these results remains an open question. In this paper, we show that a simple, frictionless model explains empirical findings commonly attributed to credit cycles. Our key assumption is that firms have heterogeneous exposures to underlying economy-wide shocks. This leads to endogenous dispersion in credit quality that varies over time and predicts future excess returns and real outcomes.Received August 7, 2017; editorial decision June 26, 2018 by Editor Stijn Van Nieuwerburgh. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.