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Is Systematic Default Risk Priced in Equity Returns? A Cross-Sectional Analysis Using Credit Derivatives Prices

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  • Jorge A. Chan-Lau

Abstract

This paper finds that systematic default risk, or the event of widespread defaults in the corporate sector, is an important determinant of equity returns. Moreover, the market price of systematic default risk is one order of magnitude higher than the market price of other risk factors. In contrast to studies by Fama and French (1993, 1996 ) and Vassalou and Xing (2004), this paper uses a market-based measure of systematic default risk. The measure is constructed using price information from credit derivatives prices, namely the spreads of standardized single-tranche collateralized debt obligations on credit derivatives indices.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/148.

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Length: 18
Date of creation: 01 Jun 2006
Date of revision:
Handle: RePEc:imf:imfwpa:06/148

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Keywords: Credit risk; Credit tranches; credit derivatives; equity returns; bond; hedge funds; equity prices; bonds; equity markets; derivatives markets; financial markets; derivative; hedge; financial economics; derivatives instruments; credit derivative; corporate bond; stock shares; bond yields; capital asset; stock market; corporate bond issuers; bond issuers; mature markets; credit market; stock returns; stock market crash; financial systems; capital structure; stock portfolios; equity risk premium; derivatives market; present value; discounting;

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References

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  1. Lettau, Martin & Ludvigson, Sydney, 1999. "Consumption, Aggregate Wealth and Expected Stock Returns," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2223, C.E.P.R. Discussion Papers.
  2. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, American Finance Association, vol. 59(2), pages 831-868, 04.
  3. Roberto Blanco & Simon Brennan & Ian W. Marsh, 2005. "An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps," Journal of Finance, American Finance Association, American Finance Association, vol. 60(5), pages 2255-2281, October.
  4. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, Elsevier, vol. 28(11), pages 2789-2811, November.
  5. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 19(3), pages 425-442, 09.
  6. Roberto Blanco & Simon Brennan & Ian W. Marsh, 2004. "An empirical analysis of the dynamic relationship between investment grade bonds and credit default swaps," Banco de Espa�a Working Papers 0401, Banco de Espa�a.
  7. Francis A. Longstaff & Arvind Rajan, 2006. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," NBER Working Papers 12210, National Bureau of Economic Research, Inc.
  8. Jorge A. Chan-Lau & Yoon Sook Kim, 2004. "Equity Prices, Credit Default Swaps, and Bond Spreads in Emerging Markets," IMF Working Papers 04/27, International Monetary Fund.
  9. Yinqiu Lu & Jorge A. Chan-Lau, 2006. "Idiosyncratic and Systemic Risk in the European Corporate Sector," IMF Working Papers 06/107, International Monetary Fund.
  10. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, American Finance Association, vol. 60(5), pages 2213-2253, October.
  11. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(1), pages 133-136, July.
  12. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(1), pages 117-131, July.
  13. Michael S. Gibson, 2004. "Understanding the risk of synthetic CDOs," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2004-36, Board of Governors of the Federal Reserve System (U.S.).
  14. Robert J. Barro, 2005. "Rare Events and the Equity Premium," NBER Working Papers 11310, National Bureau of Economic Research, Inc.
  15. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, Elsevier, vol. 33(1), pages 3-56, February.
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Cited by:
  1. Nielsen, Caren Yinxia Guo, 2011. "Is Default Risk Priced in Equity Returns?," Working Papers, Lund University, Department of Economics 2011:38, Lund University, Department of Economics.

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