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The Cross-Section of Credit Risk Premia and Equity Returns

Publication: Research - peer-reviewJournal article

We explore the link between a firm's stock returns and credit risk using a simple insight from structural models following Merton (1974): risk premia on equity and credit instruments are related because all claims on assets must earn the same compensation per unit of risk. Consistent with theory, we find that firms' stock returns increase with credit risk premia estimated from CDS spreads. Credit risk premia contain information not captured by physical or risk-neutral default probabilities alone. This sheds new light on the “distress puzzle”—the lack of a positive relation between equity returns and default probabilities—reported in previous studies.

Publication information

Original languageEnglish
JournalJournal of Finance
Volume69
Issue number6
Pages (from-to)2419–2469
ISSN0022-1082
DOIs
StatePublished - 2014

ID: 42604929