Cyclical Dispersion in Expected Defaults

Gomes, J F, Grotteria, M and Wachter, J A (2019) Cyclical Dispersion in Expected Defaults. Review of Financial Studies, 32 (4). pp. 1275-1308. ISSN 0893-9454

Abstract

A growing literature shows that credit indicators forecast aggregate real outcomes. While researchers have proposed various explanations, the economic mechanism behind these results remains an open question. In this paper, we show that a simple, frictionless model explains empirical findings commonly attributed to credit cycles. Our key assumption is that firms have heterogeneous exposures to underlying economy-wide shocks. This leads to endogenous dispersion in credit quality that varies over time and predicts future excess returns and real outcomes.