Using Yield Spreads to Estimate Expected Returns on Debt and Equity

34 Pages Posted: 4 Apr 2003

See all articles by Ian A. Cooper

Ian A. Cooper

London Business School

Sergei A. Davydenko

University of Toronto - Finance Area

Date Written: December 2003

Abstract

This paper develops and tests a method of extracting expectations about default losses on corporate debt from yield spreads. It is based on calibrating theMerton (1974) model to yield spread, leverage and equity volatility. For rating classes, the approach generates forwardlooking expected default loss estimates similar to historical losses, and is also applicable for individual bonds. The information content of the estimate is superior to linear ex ante functions of the variables it uses as inputs. We also find that estimates of equity risk premia consistent with historical default experiences range from 3.1% for AA companies to 8.5% for B companies.

Keywords: Credit spreads, Expected default, Credit risk, Cost of capital, Equity premium

JEL Classification: G12; G32; G33

Suggested Citation

Cooper, Ian Anthony and Davydenko, Sergei A., Using Yield Spreads to Estimate Expected Returns on Debt and Equity (December 2003). London Business School IFA Working Paper; EFA 2003 Annual Conference Paper No. 901. Available at SSRN: https://ssrn.com/abstract=387380 or http://dx.doi.org/10.2139/ssrn.387380

Ian Anthony Cooper (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 171 262 5050 (Phone)

Sergei A. Davydenko

University of Toronto - Finance Area ( email )

Toronto, Ontario M5S 3E6
Canada

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