The Cross-Section of Credit Risk Premia and Equity Returns

Nils Friewald, Christian Wagner, Josef Zechner

Research output: Contribution to journalJournal articleResearchpeer-review

Abstract

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.
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.
LanguageEnglish
JournalJournal of Finance
Volume69
Issue number6
Pages2419–2469
ISSN0022-1082
DOIs
StatePublished - 2014

Cite this

Friewald, Nils ; Wagner, Christian ; Zechner, Josef. / The Cross-Section of Credit Risk Premia and Equity Returns. In: Journal of Finance. 2014 ; Vol. 69, No. 6. pp. 2419–2469
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Friewald, N, Wagner, C & Zechner, J 2014, 'The Cross-Section of Credit Risk Premia and Equity Returns' Journal of Finance, vol. 69, no. 6, pp. 2419–2469. DOI: 10.1111/jofi.12143

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

In: Journal of Finance, Vol. 69, No. 6, 2014, p. 2419–2469.

Research output: Contribution to journalJournal articleResearchpeer-review

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AB - 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.

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Friewald N, Wagner C, Zechner J. The Cross-Section of Credit Risk Premia and Equity Returns. Journal of Finance. 2014;69(6):2419–2469. Available from, DOI: 10.1111/jofi.12143