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| Is Credit Event Risk Priced? Modeling Contagion via the Updating of Beliefs by Pierre Collin-Dufresne of the University of California, Berkeley, May 1, 2008 Abstract: 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. Previously titled: "Are Jumps in Corporate Bond Yields Priced? Modeling Contagion via the Updating of Beliefs" Books Referenced in this paper: (what is this?)
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