Economics Brown Bag Seminar Series – Sarah Mouabbi (Bank of France)

Room 605, Level 6, FBE Building, 111 Barry Street, Carlton

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Faisal Sohail and Aaron Barkley

Title: Disastrous Defaults

Abstract: The default of certain entities can have disastrous effects on the economy. This paper presents a framework aimed at analyzing the asset pricing and macro implications of “systemic defaults”. This framework is flexible and tractable enough to simultaneously replicate the price fluctuations of various far-out-of-the-money (disaster-exposed) credit and equity derivatives. According to our estimation results, market data imply that the default of a systemic entity is expected to be followed by a 3% decrease in consumption. The recessionary influence of systemic defaults implies that financial instruments whose payoffs are exposed to such credit events carry substantial risk premiums.