Rare Macro Disasters in Credit and Option Markets

Abstract

We show that the slight possibility of a macroeconomic disaster of moderate magnitude can explain important features across credit, option, and equity markets. Our consumption-based equilibrium model captures the empirical level and volatility of credit spreads, generates a flexible credit term structure and provides a good fi t to a century of observed spreads. The model matches the widespread volatility smirk in index options as well as the first two moments of government bond and equity market returns. Our model reveals a dynamic relationship between credit and option markets that helps explain the inconclusive evidence found in the empirical literature when regressing credit spreads on the option smirk.