The Cross-Section of Credit Risk Premia and Equity Returns

Structural models a la Merton (1974) imply that rms' risk premia in equity
and credit markets are related. We explore this relation, using the joint crosssection of stock returns and risk premia estimated from forward credit default swap (CDS) spreads. Consistent with structural models, we nd that rms' equity returns and Sharpe ratios increase with estimated credit risk premia and that the returns of buying high and selling low credit risk premium rms cannot be explained by traditional risk factors. Credit risk premia contain equity-relevant information neither captured by risk-neutral nor by actual default probabilities. This sheds new light on the distress puzzle, i.e. the lack of a positive relation between equity returns and default probabilities reported in previous studies. Our results are robust across pre-crisis and crisis sub-samples, return weighting schemes, full- and out-of-sample parameter estimations, and CDS data sources.