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Economic uncertainty, disagreement, and credit markets

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We study the link between credit spreads and the heterogeneous formation of expectations in an economy where agents with different perception of economic uncertainty disagree about future cash flows of a defaultable firm. The intertemporal risk-sharing of disagreeing investors gives rise to three testable implications: First, larger belief heterogeneity increases credit spreads and their volatility. Second, it implies a higher frequency of capital structure arbitrage violations. Third, it reduces expected equity returns of low levered firms, but the link can be reversed for high levered firms. We use a data-set of firm-level differences in beliefs, credit spreads, and stock returns to empirically test these predictions. The economic and statistical significance of the intertemporal risk-sharing channel of disagreement is substantial and robust to the inclusion of control variables such as Fama and French, liquidity, and implied volatility factors.

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