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    A Model of Credit Market Sentiment
    08 Sep 2016Working Paper Summaries

    A Model of Credit Market Sentiment

    by Robin Greenwood, Samuel G. Hanson, and Lawrence J. Jin
    Recent empirical research in finance and economics has revived the idea that investor sentiment drives credit booms and busts. To explore the drivers of sentiment in credit markets, the authors model the two-way feedback between credit market sentiment and credit market outcomes. In their model the propagation of credit cycles is driven by the interplay between expectations and the refinancing nature of credit markets.
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    Author Abstract

    We 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.

    Paper Information

    • Full Working Paper Text
    • Working Paper Publication Date: August 2016
    • HBS Working Paper Number: HBS Working Paper #17-014
    • Faculty Unit(s): Finance
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    Laura Alfaro
    Laura Alfaro
    Warren Alpert Professor of Business Administration
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    Robin Greenwood
    Robin Greenwood
    George Gund Professor of Finance and Banking
    Anne and James F. Rothenberg Faculty Fellow
    Senior Associate Dean for Faculty Development and Research
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    Samuel G. Hanson
    Samuel G. Hanson
    William L. White Professor of Business Administration
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