Estimating Equity Premia from CDS Spreads

Abstract

We propose a new approach to estimate the equity premium using CDS spreads and structural models of default. Our estimates yield equity premia of 6.50% for the U.S., 5.44% for Europe and 6.21% for Asia based on 5-year CDS spreads from 2003-2007. Due to some conservative assumptions these estimates are upper limits for the equity premium. Using 3-, 7- and 10-year CDS maturities yields similar results and offers an opportunity to estimate the term structure of risk premia. Although our estimator is developed in a Merton framework it is robust with respect to model changes. In fact, we obtain similar results when extending the approach to a first-passage-time framework, strategic default frameworks or a framework with unobservable asset values (Duffie/Lando (2001)).

Keywords: credit risk premim, equity premium, market sharpe ratio, credit risk, structural models of default

JEL Classification: G13, G31