Endogenous Risk Structure of Interest Rates

In this paper we investigate the behavior of credit yield spreads in an equilibrium framework in which the risk-free interest rate and yields on risky debt are jointly and endogenously determined. The model is one of a partially observable pure exchange economy in which debt is a contingent claim on the cash flow. We find that an increase in risk aversion or an increase in uncertainty about growth prospects results in widening yield spreads, as does a worsening of the state of the economy. We also examine the effect of stochastic risk-free rates on credit yield dynamics by comparing our model to an economy with a log-normal dividend process and a constant risk-free rate. Our approach provides a new perspective to help understand the behavior of credit spreads and to reconcile discrepancies between theoretical predictions and empirical findings about credit spreads.