What Drives the Consumer Credit Spread? An Explanation Based on Rare Event Risk and Belief Dispersion

Abstract

What drives consumers borrowing/lending and the credit spread over their debt? This paper offers a novel explanation based on rare event risk and belief dispersion in a dynamic general equilibrium model. Heterogeneous beliefs drive consumers to borrow, but the market is incomplete and subject to rare event risk and thus default endogenously occurs in equilibrium. The paper derives the credit spread in closed form and yields a credit spread similar to real data when the model is calibrated. The model also well captures the relationship between belief dispersion, risk-free rate and credit spread. It shows that belief dispersion, rare event risk and wealth distribution together drive both credit spread and risk-free rate. An increase in either rare event risk or belief dispersion leads to a higher credit spread and a lower risk-free rate. However, the underlying mechanisms are quite different, as the former (rare event risk) is due to substitution effect while the latter (belief dispersion) is due to wealth effect. The paper also makes a contribution to the literature on rare disaster by endogenizing default and clarifies Barro(2006)'s argument on the countervailing effects of rare disasters on interest rates.