The Cross-Section of Credit Risk Premia and Equity Returns





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    • Nils Friewald and Josef Zechner are at the Department of Finance, Accounting and Statistics at WU Vienna University of Economics and Business. Christian Wagner is at the Department of Finance at Copenhagen Business School. We thank Rui Albuquerque, Doron Avramov, Jennie Bai, Tobias Berg, Nina Boyarchenko, Michael Brandt, Nicole Branger, Michael Brennan, Haibo Chen, Pierre Collin-Dufresne, Andreas Danis, Patrick Gagliardini, Andrea Gamba, Lorenzo Garlappi, Amit Goyal, Mark Grinblatt, Charles Jones, Miriam Marra, Elena-Claudia Moise, Caren Yinxia Nielsen, Ali Ozdagli, Juliusz Radwanski, Lucio Sarno, Paul Schneider, Clemens Sialm, Leopold Sögner, Pinar Uysal, Toni Whited, and participants at the Swissquote Conference on Asset Management 2011 at EPFL, the CAPR, NFI Workshop on “Time-Varying Expected Returns” at the Norwegian Business School, the joint ECB and BoE Workshop on “Asset pricing models in the aftermath of the financial crisis,” the European Winter Finance Summit 2012, the Swiss Society for Financial Market Research Conference 2012, the German Finance Association Meeting 2012, the Western Finance Association Meetings 2012, the European Finance Association Meeting 2012, as well as seminar participants at Cass Business School, Humboldt Universität Berlin, Leibniz Universität Hannover, University of Gothenburg, University of Lund, University of Piraeus, Warwick Business School, and WU Vienna for helpful comments. We are especially indebted to Campbell Harvey (the Editor), an anonymous referee, and an Anonymous Associate editor for their extensive comments that have greatly helped to improve the paper.


We explore the link between a firm's stock returns and credit risk using a simple insight from structural models following Merton (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.