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As the recent financial crisis illustrated, the default of certain entities can have disastrous effects on the economy. This paper presents a framework aimed at analysing the asset pricing and macro implications of the existence of “systemic defaults”. This framework is flexible and tractable enough to simultaneously replicate the price fluctuations of various far-out-of-the-money (disaster-exposed) credit and equity derivatives. According to our estimation results, market data imply that the default of a systemic entity is anticipated to be followed by a 4%decrease in consumption. The recessionary influence of systemic defaults implies that financial instruments whose payoffs are exposed to such credit events carry substantial risk premiums.
