The Market Price of Credit Risk

Abstract

Risk-averse investors in credit sensitive securities such as equity and bonds require compensation for bearing exposure to non-diversifiable corporate default risk. One component of this compensation is an event premium for the abrupt changes in security prices that occur at default. While empirical research points to the significance of event premia in corporate bond and credit swap markets, the economic nature of the event premium is not fully understood. This paper uses a structural model of corporate default risk to show that informational asymmetries can induce an event premium. If public investors are unable to observe the threshold asset value at which firm management liquidates the firm, then they face instantaneous default risk as they cannot discern the firm's distance to default. Investors are taken by surprise when the firm reaches the default threshold, causing a sudden downward jump in the prices of securities issued by or referenced on the firm. The resulting event premium is governed by the degree of investors' aversion to the randomness in the location of the unobserved default threshold. Firm management has an incentive to improve the threshold transparency in order to reduce the credit premium required by investors, and therefore the cost to the firm of equity and debt financing.