The Market Price of Credit Risk

Aug 1, 2007

The credit risk premium is empirically documented to be a significant component of credit spreads. However, its determinants are not fully understood. We offer a structural model of the credit risk premium in which investors have incomplete information about a firm's default barrier. The premium has two components. One is standard and accounts for investors' aversion towards price volatility that is due to the diffusive fluctuation of the firm value. The other is an event premium induced by investors' uncertainty about the firm's true distance to default, which causes jumps in security prices at default. The event premium is an explicit function of the running minimum firm value that is determined by investors' prior distribution of the unobserved default barrier.