In 2008, the ‘credit crunch’ progressed from financial crisis to global economic recession, its impact spreading from the US housing market to western financial markets and, by the end of the year, to most nations and sectors of the international economy. Its origins in the highly technical character of the ‘toxic’ products spawned in the financial world of intermediation and risk management has informed a hesitant and, in turn, managerial analysis of causality. This hesitancy was reflected in the statements expressed by politicians and business leaders throughout much of 2008 as they oscillated between inaction and reaction and expressed fears, in turn, about the crisis realising uncontrollable inflationary or deflationary trends.
For much of 2008, American and British politicians and business leaders were anxious to downplay the problems created by the credit crisis until the financial world reached the brink of collapse. The UK government, spent much of the year in denial about the weakness of the British economy- it was sound in its essentials - blaming US and wider international developments for the position the UK economy is in while the US government dithered over a bailout plan which was initially designed to buy up all the worthless, toxic assets of the finance sector but eventually took the form of buying shares in US banks.
We propose a reduced-form model where jumps-to-default are priced because they generate a market-wide jump in credit spreads. While this framework is consistent with a counterparty risk interpretation (e.g., Jarrow and Yu (2001)), it is most naturally interpreted as an updating of beliefs due to an unexpected event. Simple analytic solutions are obtained for the prices of risky debt regardless of the number of firms that share in the contagious response. Empirically, we find that credit events of large firms generate a market wide increase in credit spreads and a significant ‘flight-to-quality’ response in the Treasury market. A calibration exercise suggests that the risk premium for contagion-risk may be considerable, whereas it implies that jump-to-default risk for a typical investment grade firm has an upper bound of only a few basis points.
Recent research has highlighted the fact that structural models of corporate bond prices are incapable of generating reasonable yield spreads (See Eom, Helwege and Huang (2004) and Huang and Huang (2003)). The problem is especially severe among investment-grade bonds with short maturities, where models tend to predict very low credit spreads (Duffie and Lando (2001, henceforth DL). While some suggest the main factors driving bond spreads are taxes and liquidity (e.g., Elton, Gruber, Aggarwal and Mann (2001) and Collin Dufresne, Goldstein and Martin (2001)), others focus on the risk of a jump to default (e.g., Driessen (2005), Berndt, Douglas, Duffie, Ferguson and Schranz (2007)). The latter literature uses the so-called reduced-form models, which directly specifies the jump to default intensity for individual firms. Conveniently, under certain restrictions, these reduced-form models allow to value risky cash-flows by simply discounting under the risk-neutral measure using a default-adjusted short rate. Therefore, defaultable bonds can be valued very similarly to risk-free bonds using standard affine or quadratic models for example.1 Further, by construction, reduced form models can fit any observed risky term structure of credit spreads, even at the short end. However, the implication of large credit spread at short maturities, is that the risk-neutral jump to default probability is high relative to observed historical jump-to default rates. The ratio of risk-neutral (i.e., price implied) default intensity to historical default intensity estimated in these studies is in the range [2,6]. In the reduced-form framework, this ratio can be explained entirely by a risk-premium associated with the actual jump to default itself. Here, we study the magnitude of these implied jump to default risk-premia and their economic implications.
Early models of economic growth highlighted the importance of saving rates (i.e. how much an economy saves as a proportion of its income) and population growth rates in determining income per person (neoclassical growth theory). One implication of such models is that rich and poor countries? levels of income per person should converge. Difficulties in reconciling the „convergence hypothesis? with the actual data led to the development of „endogenous? growth models that did not feature the same implication (i.e. countries need not converge to the same level of income per person). This framework opened the way for considerations of other determinants of long term growth such as fiscal policy and financial development. The latter has become the focus of a growing literature in the last two decades.
The key role of the financial sector in economic growth is introduced by Schumpeter (1911). He argued that the service provision by financial intermediaries including savings mobilization, risk management, projects evaluation, monitoring the managers, and facilitating transactions are necessary for technological improvement and economic growth. Financial intermediaries need to be capable of efficient allocation of resources facilitating in that way higher returns and desirable risk transformation. The modern literature on economic growth was actually started in mid 1950s when Robert Solow (1956) presented his growth model. At that time the focus was kept on the functioning of labour and capital resources rather than financial markets. Some leading economists like Goldsmith (1969), McKinnon (1973), Levine (1993) emphasized that finance can be an essential component for the growth of an economy.
