Premium
The Cross‐Section of Credit Risk Premia and Equity Returns
Author(s) -
FRIEWALD NILS,
WAGNER CHRISTIAN,
ZECHNER JOSEF
Publication year - 2014
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12143
Subject(s) - risk premium , equity (law) , stock (firearms) , credit risk , economics , financial economics , business , monetary economics , actuarial science , mechanical engineering , political science , law , engineering
We explore the link between a firm's stock returns and credit risk using a simple insight from structural models following Merton ([Merton, Robert, 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 risk‐neutral default probabilities alone. This sheds new light on the “distress puzzle”—the lack of a positive relation between equity returns and default probabilities—reported in previous studies.