The Cross-Section of Credit Risk Premia and Equity Returns

Nils Friewald, Christian Wagner, Josef Zechner

Research output: Contribution to conferencePaperResearchpeer-review


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.
Original languageEnglish
Publication date2012
Number of pages71
Publication statusPublished - 2012
EventThe 39th European Finance Association Annual Meeting (EFA 2012) - Copenhagen Business School, Frederiksberg, Denmark
Duration: 15 Aug 201218 Aug 2012
Conference number: 39


ConferenceThe 39th European Finance Association Annual Meeting (EFA 2012)
LocationCopenhagen Business School
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