Idiosyncratic Tail Risk and the Credit Spread Puzzle

Abstract

This paper studies the asset pricing implications of idiosyncratic labor income tail risk on credit spread. I propose a model featuring an incomplete market, heterogeneous households with recursive preference, and comovement of tail risk in labor income and firm cash flow growth. The model produces strong covariation of households' marginal utility and default rates, which helps to explain the stylized fact that the credit spread (1) is on average large and (2) is positively related to labor tail risk. Quantitatively, the tail risk premium can account for as much as 68% of the observed credit spread. My framework provides a new insight, drawn from an option perspective, that the implications of idiosyncratic tail risk for stocks and bonds can be very different.

Keywords: Idiosyncratic Tail Risk, Labor Income, Incomplete Market, Credit Spread

JEL Classification: E2, E3, G12