Default and Systemic Risk in Equilibrium

TL;DR

This paper presents a finite horizon continuous-time market model analyzing how endogenous financial contagion and investor preferences influence default risk, stock prices, and market dynamics, highlighting the impact of default events on equilibrium prices.

Contribution

It introduces a novel equilibrium model capturing endogenous contagion effects and the influence of investor heterogeneity on default risk and asset prices.

Findings

Stock prices jump at default despite no causal link to dividends.

Investor preferences and default intensity cyclicality determine jump direction.

Heterogeneity affects default exposure among investors.

Abstract

We develop a finite horizon continuous time market model, where risk averse investors maximize utility from terminal wealth by dynamically investing in a risk-free money market account, a stock written on a default-free dividend process, and a defaultable bond, whose prices are determined via equilibrium. We analyze financial contagion arising endogenously between the stock and the defaultable bond via the interplay between equilibrium behavior of investors, risk preferences and cyclicality properties of the default intensity. We find that the equilibrium price of the stock experiences a jump at default, despite that the default event has no causal impact on the dividend process. We characterize the direction of the jump in terms of a relation between investor preferences and the cyclicality properties of the default intensity. We conduct similar analysis for the market price of risk and for the investor wealth process, and determine how heterogeneity of preferences affects the exposure to default carried by different investors.