Research Summary
Research Summary
Time Varying Expected Returns, Stochastic Dividend Yields, and Default Probabilities: Linking the Credit Risk and Equity Literature (with George Chacko and Jens Hilscher)
Description
In standard structural bond pricing models, the firm defaults once the market value of assets has fallen below a threshold. Expected returns, or at least dividend yields, are assumed to be constant, which implies that any asset value movement is permanent and has the same effect on the probability of default. From the equity literature we know that both expected returns and the dividend yield are time varying and persistent, with the dividend yield being a strong predictor of future returns. Movements in asset value are due to cash flow or expected return news, where cash flow news is commonly thought of as being permanent news to fundamentals and expected return news is temporary. This implies that a price increase due to permanent cash flow news will have a higher impact on longer horizon default probabilities. In this paper we bring the credit risk and equity branches of the literature together. Motivated by the dynamics of S&P 500 firms, we present a new Merton-type model in which the underlying asset value exhibits time varying expected returns, producing a stochastic dividend yield in equilibrium. Our model implies significant differences in the reaction of the probability of default and bond prices in response to cash flow versus expected return news. In general, default probabilities are less volatile than those generated from standard Merton-type models. The model is consistent with the standard credit rating agencies' view that focuses on fundamental analysis, in addition to market information, when assessing credit risk. It is particularly relevant in periods of overvaluation and low expected returns such as the recent technology bubble.