The Cross-Section of Credit Risk Premia and Equity Returns

Nils Friewald, Christian Wagner, Josef Zechner

Research output: Contribution to conferencePaperResearchpeer-review

Abstract

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.
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.

Conference

ConferenceThe 39th European Finance Association Annual Meeting (EFA 2012)
Number39
LocationCopenhagen Business School
CountryDenmark
CityFrederiksberg
Period15/08/201218/08/2012
Internet address

Keywords

    Cite this

    Friewald, N., Wagner, C., & Zechner, J. (2012). The Cross-Section of Credit Risk Premia and Equity Returns. Paper presented at The 39th European Finance Association Annual Meeting (EFA 2012), Frederiksberg, Denmark.
    Friewald, Nils ; Wagner, Christian ; Zechner, Josef . / The Cross-Section of Credit Risk Premia and Equity Returns. Paper presented at The 39th European Finance Association Annual Meeting (EFA 2012), Frederiksberg, Denmark.71 p.
    @conference{81645b8196c04ed980a3265eb9497488,
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    abstract = "Structural models a la Merton (1974) imply that rms' risk premia in equityand 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.",
    keywords = "Equity returns, Default risk, Risk premia, Credit default swaps, Cross-sectional asset pricing",
    author = "Nils Friewald and Christian Wagner and Josef Zechner",
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    note = "null ; Conference date: 15-08-2012 Through 18-08-2012",
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    Friewald, N, Wagner, C & Zechner, J 2012, 'The Cross-Section of Credit Risk Premia and Equity Returns' Paper presented at, Frederiksberg, Denmark, 15/08/2012 - 18/08/2012, .

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

    2012. Paper presented at The 39th European Finance Association Annual Meeting (EFA 2012), Frederiksberg, Denmark.

    Research output: Contribution to conferencePaperResearchpeer-review

    TY - CONF

    T1 - The Cross-Section of Credit Risk Premia and Equity Returns

    AU - Friewald,Nils

    AU - Wagner,Christian

    AU - Zechner,Josef

    PY - 2012

    Y1 - 2012

    N2 - Structural models a la Merton (1974) imply that rms' risk premia in equityand 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.

    AB - Structural models a la Merton (1974) imply that rms' risk premia in equityand 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.

    KW - Equity returns

    KW - Default risk

    KW - Risk premia

    KW - Credit default swaps

    KW - Cross-sectional asset pricing

    M3 - Paper

    ER -

    Friewald N, Wagner C, Zechner J. The Cross-Section of Credit Risk Premia and Equity Returns. 2012. Paper presented at The 39th European Finance Association Annual Meeting (EFA 2012), Frederiksberg, Denmark.