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

Abstract

This article studies an economy with borrowers (firms or individuals) under costly default. Borrowers defaulting under adverse economic conditions may, despite incurring default costs, emerge as wealthier than nonborrowers. Asset substitution is generally not pronounced, although a larger risk exposure by borrowers may also occur, and then binary options emerge as useful credit derivatives. The asset-value dynamics are endogenously determined and shown to exhibit stochastic mean and volatility, in contrast to many credit risk models. In equilibrium, the market level is increased (decreased) in economic downturns (upturns) by the presence of credit risk.

JEL Classification: G33, G11, G12, C61, D51