Persistent Crises and Levered Asset Prices

This figure depicts consumption growth, leverage, equity volatility and credit spreads during the Great Depression in red. The blue line refer to the Wachter (2013) or Seo and Wachter (2018) models. The black line is our model of long lasting crises.

This paper shows that standard disaster risk models are inconsistent with the behavior of stock market volatility and credit spreads during disasters. We resolve this shortcoming by incorporating persistent macroeconomic crises into a structural credit risk model. The model successfully captures the joint dynamics of aggregate consumption, financial leverage, and asset market risks, both unconditionally and during crises. Leverage provides a strong amplification mechanism for fundamental shocks because it continues to rise while crises endure. We structurally estimate the model and show that it replicates the firm-level implied volatility curve and its cross-sectional relation with observable proxies of default risk.

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, 2021 Midwest Finance Association, 2021 PHBS Workshop in Macroeconomics and Finance, 10th ITAM Finance Conference