The Cross-Section of Credit Risk Premia and Equity Returns

Niels Friewald, Christian Wagner, Josef Zechner

Research output: Working paperResearch

Abstract

We explore the link between a firm's stock returns and its 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 by risk-neutral default probabilities alone. 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.
We explore the link between a firm's stock returns and its 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 by risk-neutral default probabilities alone. 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.
LanguageEnglish
Place of Publicationwww
PublisherSSRN: Social Science Research Network
Number of pages49
StatePublished - 2013

Keywords

  • Equity Returns
  • Default Risk
  • Credit Risk Premia
  • Credit Default Swaps
  • Cross-sectional Asset Pricing

Cite this

Friewald, N., Wagner, C., & Zechner, J. (2013). The Cross-Section of Credit Risk Premia and Equity Returns. www: SSRN: Social Science Research Network.
Friewald, Niels ; Wagner, Christian ; Zechner, Josef. / The Cross-Section of Credit Risk Premia and Equity Returns. www : SSRN: Social Science Research Network, 2013.
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Friewald, N, Wagner, C & Zechner, J 2013 'The Cross-Section of Credit Risk Premia and Equity Returns' SSRN: Social Science Research Network, www.

The Cross-Section of Credit Risk Premia and Equity Returns. / Friewald, Niels ; Wagner, Christian; Zechner, Josef.

www : SSRN: Social Science Research Network, 2013.

Research output: Working paperResearch

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Friewald N, Wagner C, Zechner J. The Cross-Section of Credit Risk Premia and Equity Returns. www: SSRN: Social Science Research Network. 2013.