We rationalize the joint behavior of aggregate consumption, asset prices, and financial leverage by incorporating persistent macroeconomic crises into a structural credit risk model. As in the data, longer-lasting crises are associated with more severe macroeconomic contractions and larger increases in leverage ratios, credit risk, and return volatility. Leverage provides a strong propagation mechanism for fundamental shocks because it continues to rise while crises endure. The model replicates the firm-level implied volatility curve and its cross-sectional relation with observable proxies of default risk. Lastly, a structural estimation reveals that common idiosyncratic risk is an important driver of credit spreads.
Conference presentations: 2017 University of Connecticut Annual Academic Conference on Risk Management, 2017 University of Minnesota Macro Asset Pricing Conference, 2017 FMA Conference on Derivatives and Volatility, 2018 SFS Cavalcade, 2019 European Finance Association, 2020 Winter Econometric Society Meetings, 2020 Arizona Junior Finance Conference, 2021 American Finance Association