The Effects of Rare Economic Crises on Credit Spreads and Leverage

Rare disasters have been shown to explain several asset pricing puzzles, such as the equity risk premium and credit spread puzzles. Existing analysis ignores the impact of corporate financing decisions on asset prices by taking them as exogenous. The aim of this paper is to investigate how rare disasters affect endogenous default and capital structure decisions by firms and how, in turn, these corporate financial decisions affect the way in which rare disasters impact credit spreads, leverage and the equity risk premium. We find that the possibility of rare disasters makes firms more conservative in their financial policy, leading to higher interest coverage, but lower leverage ratios, together with larger credit spreads and equity risk premia.