A Structural Model of Credit Risk with Counter-Cyclical Risk Premia

It is well-documented that economies experience business cycles. Economic and financial activities fall sharply during recessions and rise sharply during booms. This phenomenon also gives rise to cyclical asset pricing implications: high asset prices (low returns) during booms and low prices (high returns) during recessions. For example, the equity risk premia seem to be higher at business cycle troughs than at peaks. This implies that investors do, in fact, require a higher rate of return on their investments during a recession than during an expansion. The changes in risk premia over time can arise not only from regime-specific continuous (random) changes in income streams, but also from regime (discrete) shifts. It is often assumed that regime-switching risk is diversifiable and, hence, can be ignored when pricing primary and derivative assets. The recent literature has stressed that regime risk premia are not only statistically significant, but also important for pricing purposes. We therefore develop a valuation framework that incorporates regime-switching risk premia and assess how pricing this risk affects on credit risk and dynamic capital structure choice. We show that our model replicates observed credit risk spread and generate strictly positive credit spreads for debt contracts with very short maturities.