Default Linkages in a Structural Credit Model | Lucie Y. Lu

Default Linkages in a Structural Credit Model


We propose an explanation for default risk linkages based on a Lucas model with across independent debt-financed borrowers. The transmission mechanism is that variation in the size of a borrower impacts the default decision for all borrowers. If a negative shock hits one borrower’s fundamentals, the other borrower becomes a larger player in the economy and thus bears more systematic risk. The resulting higher risk premium increases the cost of debt and tilts that borrower’s decision towards default, thereby increasing its default risk and equity volatility. This effect is particularly strong for borrowers with greater rollover needs. Our model helps better understand co-movement in risk premia, default probabilities, and equity volatility across fundamentally-unrelated borrowers.

Working Paper