A Model of Credit Market Sentiment
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CitationGreenwood, Robin, Samuel G. Hanson, and Lawrence J. Jin. "A Model of Credit Market Sentiment." Harvard Business School Working Paper, No. 17-015, August 2016.
AbstractWe present a model of credit market sentiment in which investors form beliefs about future creditworthiness by extrapolating past defaults. Our key contribution is to model the endogenous two-way feedback between credit market sentiment and credit market outcomes. This feedback arises because investors’ beliefs depend on past defaults, but beliefs also drive future defaults through investors’ willingness to refinance debt at low interest rates. Our model is able to capture many documented features of credit booms and busts, including the link between credit growth and future returns, and the “calm before the storm” periods in which fundamentals have deteriorated but the credit market has not yet turned.
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