Default Risk Premium in Credit and Equity Markets
46 Pages Posted: 30 May 2015 Last revised: 16 Feb 2018
Date Written: February 1, 2018
The default risk premium expresses the difference between the actual default risk of a company and the default risk implied by the securities issued by the company. In this paper, we study the simultaneous relationship between the dynamics of the default risk premium and both the dynamics of the stock price and the CDS (Credit Default Swap) spread of a company. We show that an increase in the default risk premium can be associated, at the same time, to either an increase in the stock price and a decrease in the CDS spread, or to a decrease in the stock price and an increase in the CDS spread. We document that the first type of relationship features securities belonging to a consistent risk-return framework, while the second type of relationship describes securities following a counterintuitive risk-return puzzle. We show this result theoretically end empirically, by adopting a contingent claim model. We estimate the model with a non-linear Kalman filter in conjunction with quasi-maximum likelihood, and we shed light on the relationship over time between the default risk premium and both the equity value and the CDS spreads for a sample of non-financial firms.
Keywords: Structural Estimation, Kalman Filter, Default Risk, Distress Puzzle
JEL Classification: C4, G12, G32, G33
Suggested Citation: Suggested Citation