Marc Arnold

We investigate the compensation of counterparty exposure in the prices of structured products. Our analysis reveals that product issuers did not compensate retail investors for counterparty exposure before the Lehman default. Post‐Lehman, retail prices have no longer neglected this risk. We also measure retail investor attention towards issuer credit risk. For a given level of issuer credit risk, counterparty exposure is compensated more when attention is higher. Furthermore, issuers tend to construct products with larger counterparty exposure. Overall, our results shed light on the conditions under which financial engineering generates neglected risk.

This paper develops a structural equilibrium model with intertemporal macroeconomic risk, incorporating the fact that firms are heterogeneous in their asset composition. Compared to firms that are mainly composed of invested assets, firms with growth options have higher costs of debt because they are more volatile and have a greater tendency to default during recession when marginal utility is high and recovery rates are low. Our model matches empirical facts regarding credit spreads, default probabilities, leverage ratios, equity premiums, and investment clustering. Importantly, it also makes predictions about the cross-section of all these features.