The Cross-Section of Credit Risk Premia and Equity Returns

56 Pages Posted: 12 Jul 2011 Last revised: 12 Apr 2015

Nils Friewald

Norwegian School of Economics (NHH)

Christian Wagner

Copenhagen Business School

Josef Zechner

Vienna University of Economics and Business

Date Written: May 3, 2013

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.

Keywords: equity returns, default risk, credit risk premia, credit default swaps, cross-sectional asset pricing

JEL Classification: G12, G13

Suggested Citation

Friewald, Nils and Wagner, Christian and Zechner, Josef, The Cross-Section of Credit Risk Premia and Equity Returns (May 3, 2013). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1883101 or http://dx.doi.org/10.2139/ssrn.1883101

Nils Friewald

Norwegian School of Economics (NHH) ( email )

Helleveien 30
Bergen, NO-5045
Norway

Christian Wagner (Contact Author)

Copenhagen Business School ( email )

Department of Finance
Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

Josef Zechner

Vienna University of Economics and Business ( email )

Welthandelsplatz 1
Vienna, Wien A-1019
Austria

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