The cross-section of credit risk premia and equity returns; European evidence
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School of Business |
Master's thesis
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Author
Date
2017
Department
Major/Subject
Mcode
Degree programme
Finance
Language
en
Pages
33
Series
Abstract
Objectives of the study The purpose of this study is to show that the Distress Puzzle – the lack of a positive relation between equity returns and default probabilities – can be explained with insufficiently informative proxies for credit risk premia. My research follows the paper made by Friewald et al. (2014) in which the authors show that this seems to be the case in the U.S.. I use recent European data to test whether the same applies here. Data and methods Along the footsteps of the original paper, I construct a Merton model to show theoretically that risk-neutral and physical default probabilities together provide requisite information to correctly assess credit risk premia for 125 European firms. Using information held in CDS forwards, I calculate estimates for several measures of credit risk premia and market price of risk and use them to sort firms into portfolios according to their riskiness. Finally, I calculate the excess returns of the portfolios to see whether they are in line with the credit risk they bear. Results I am only partly able to verify the strong evidence presented by the original study with the US data. I find that the relation between risk premia in CDS and equity markets in Europe is weaker than in the US, which implies that European investors are not as consistent in pricing default risks in different markets as their US counterparts. They either demand too much premia for CDS’s or too little for equities leaving money on the table. However, the power of my results is weakened by the limited amount of data.Description
Thesis advisor
Kaustia, MarkkuKeywords
default risk premia, forward CDS spread, CDS term structure, distress puzzle
