A Model of Credit Risk, Optimal Policies, and Asset Prices

41 Pages Posted: 4 Nov 2008

See all articles by Suleyman Basak

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Alex Shapiro

New York University (NYU) - Department of Finance

Multiple version iconThere are 5 versions of this paper

Date Written: October 2000


This paper studies the optimal policies of borrowers (firms or individuals) who may default subject to default costs, and analyzes the asset pricing implications. Borrowers defaulting under adverse economic conditions may, despite incurring default costs, emerge as wealthier than non-borrowers or those who can default costlessly. In many scenarios, borrowers take on less risk exposure than non-borrowers. However, a larger risk exposure by borrowers may occur as well, depending on the structure of default costs and on how debt maturity relates to the planning horizon. In the latter case, borrowers' default policies render binary options useful instruments for lenders in hedging the credit-risk component of their assets. In equilibrium, a lower (higher) risk exposure by borrowers manifests itself in an attenuated (amplified) market volatility and risk premium, but the market value is always higher in economic downturns, and lower in upturns, compared to an economy without the presence of credit risk

Suggested Citation

Basak, Suleyman and Shapiro, Alex, A Model of Credit Risk, Optimal Policies, and Asset Prices (October 2000). NYU Working Paper No. FIN-00-029, Available at SSRN: https://ssrn.com/abstract=1295233

Suleyman Basak

London Business School ( email )

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HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

United Kingdom

Alex Shapiro

New York University (NYU) - Department of Finance ( email )

Stern School of Business
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New York, NY 10012-1126
United States
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HOME PAGE: http://www.stern.nyu.edu/~ashapiro/

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