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

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

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Length: 18 pages
Date of creation: 22 Jun 2006
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Handle: RePEc:imf:imfwpa:06/148

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Keywords: Equity returns ; default risk ; credit derivatives ; credit derivatives indices ; collateralized debt obligations ; Credit risk ; Credit tranches ;

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  1. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February. [Downloadable!] (restricted)
  2. Michael S. Gibson, 2004. "Understanding the risk of synthetic CDOs," Finance and Economics Discussion Series 2004-36, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  3. 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. [Downloadable!] (restricted)
  4. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July. [Downloadable!] (restricted)
  5. 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, vol. 60(5), pages 2255-2281, October. [Downloadable!] (restricted)
  6. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July. [Downloadable!] (restricted)
  7. Sydney Ludvigson & Martin Lettau, 1999. "Consumption, aggregate wealth and expected stock returns," Staff Reports 77, Federal Reserve Bank of New York. [Downloadable!]
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  8. 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, vol. 60(5), pages 2213-2253, October. [Downloadable!] (restricted)
  9. Robert J. Barro, 2005. "Rare Events and the Equity Premium," NBER Working Papers 11310, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  10. 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, vol. 28(11), pages 2789-2811, November. [Downloadable!] (restricted)
  11. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, vol. 59(2), pages 831-868, 04. [Downloadable!] (restricted)
  12. Roberto Blanco & Simon Brennan & Ian W Marsh, . "An empirical analysis of the dynamic relationship between investment-grade bonds and credit default swaps," Bank of England working papers 211, Bank of England. [Downloadable!]
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