David Rappoport, FED Board

Paper: Credit Surfaces and Economic Uncertainty

Abstract: Credit is central to the macroeconomy and macroeconomic policy. Traditionally credit spreads are described using option theory, with credit contracts described by what they promise–the option strike price. We argue that the credit surface, where contracts are described by their leverage and creditworthiness, provide a better description of credit spreads. We show that when sorted along these dimensions the credit surface not only becomes higher when economic uncertainty increases, but it also becomes steeper, that is, the relative spread between two contracts widens, as it is observed empirically. These results have important implications for macroprudential policy and the redistributional effects of financial crises.