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| On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle by Long Chen of Michigan State University, March 17, 2006 Abstract: We examine whether 'large' historical credit spreads can be explained in the face of low historical default rates within a structural framework. For this to be the case, we show that the pricing kernel must covary strongly and negatively with asset prices - a characteristic which is also needed to explain the equity premium puzzle. As such, we explore whether those pricing kernels that have been successful at capturing historical equity returns (e.g., Campbell and Cochrane (CC 1999) and Bansal and Yaron (BY 2004)) can also explain the ‘credit spread puzzle'. We find this to be the case if the risk premia are strongly time-varying and the default boundary is counter-cyclical. These properties are necessary because observed ratios of market volatility to total volatility make it difficult for structural models to generate large spreads. We also investigate the time-series implications of these models by backing out predicted year-by-year credit spreads from both models using macroeconomic data (e.g., historical consumption growth and price-dividend ratio). We find that the predicted credit spreads from CC model fit both the level and dynamics of historical credit spreads rather well. Books Referenced in this Paper: (what is this?)
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