Default Risk Premium in Credit and Equity Markets

46 Pages Posted: 30 May 2015 Last revised: 16 Feb 2018

See all articles by Raffaele Corvino

Raffaele Corvino

University of Torino & CERP

Gianluca Fusai

Università del Piemonte Orientale Dipartimento di Studi per l'Economia e l'Impresa; Sir John Cass Business School - City, University of London

Date Written: February 1, 2018

Abstract

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

Corvino, Raffaele and Fusai, Gianluca, Default Risk Premium in Credit and Equity Markets (February 1, 2018). Available at SSRN: https://ssrn.com/abstract=2611984 or http://dx.doi.org/10.2139/ssrn.2611984

Raffaele Corvino (Contact Author)

University of Torino & CERP ( email )

Corso Unione Sovietica 218bis
Piazza Arbarello 8
Torino, 10134
Italy
+39 3465316931 (Phone)

HOME PAGE: http://raffaelecorvino.com

Gianluca Fusai

Università del Piemonte Orientale Dipartimento di Studi per l'Economia e l'Impresa ( email )

Via Perrone, 18
Novara, 28100
Italy

HOME PAGE: http://https://upobook.uniupo.it/gianluca.fusai

Sir John Cass Business School - City, University of London ( email )

106 Bunhill Row
London, EC2Y 8HB
Great Britain

HOME PAGE: http:// www.cass.city.ac.uk/experts/G.Fusai

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