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This paper examines the possibility of using derivative-implied risk premiato explain stock returns. The rapid development of derivative markets has ledto the possibility of trading various kinds of risks, such as credit andinterest rate risk, separately from each other. This paper uses credit defaultswaps and equity options to determine risk premia which are then used to formportfolios that are regressed against the returns of stock portfolios. It turnsout that both, credit risk and implied volatility, have high explanatory powerin regard to stock returns. Especially the returns of distressed stocks arehighly dependent on credit risk fluctuations. This finding leads to practicalimplications, such as cross-hedging opportunities between equity and creditinstruments and potentially allows forecasting stock returns based on movementsin the credit market.

The Impact of Credit Risk and Implied Volatility on Stock Returns