Nils Friewald, Christian Wagner and Josef Zechner—authors of the study “The Cross-Section of Credit Risk Premia and Equity Returns,” which appears in the December 2014 edition of the Journal of Finance—studied the relationship between a firm’s default risk and that firm’s equity premium.
Their study covered the 10-year period from 2001 through 2010, and estimated credit risk premiums from the credit default swap (CDS) forward curve.
The financial theory behind the study posits that the risk premia on equity and credit instruments are related because all claims on assets must earn the same compensation per unit of risk. In other words, information incorporated in the market for a company’s credit instruments, such as CDSs, must be connected to expected returns on its equity.
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