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Linking credit risk premia to the equity premium

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  • Berg, Tobias
  • Kaserer, Christoph

Abstract

Although the equity premium is - both from a conceptual and empirical perspective - a widely researched topic in finance, there is still no consensus in the academic literature about its magnitude. In this paper, we propose a different estimation method which is based on credit valuations. The main idea is straigtforward: We use structural models to link equity valuations to credit valuations. Based on a simple Merton model, we derive an estimator for the market Sharpe ratio. This estimator has several advantages. First, it offers a new line of thought for estimating the equity premium which is not directly linked to current methods. Second, it is only based on observable parameters. We do neither have to calibrate dividend or earnings growth - which is usually necessary in dividend/earnings discount models - nor do we have to calibrate asset values or default barriers - which is usually necessary in traditional applications of structural models. Third, it is robust to model changes. We examine the model of Duffie/Lando (2001) - which is one of the most sophisticated structural models currently discussed in the literature - to show this robustness. In an empirical analysis we have used CDS spreads of the 125 most liquid CDS in the U.S. from 2003 to 2007 to estimate the equity premium. We derive an average implicit market Sharpe ratio of appr. 40%. Adjusting for taxes and other parts of the credit spread not attributable to credit risk yields an average market Sharpe ratio below 30%. This confirms research on the equity premium, which indicates that the historically observed Sharpe ratio of 40-50% - corresponding to an equity premium of 7-9% and a volatility of 15-20% - was partly due to one-time effects. In addition, our research can be used to explain empirical findings about credit risk premia, which are usually measured as the ratio of risk-neutral to actual default probabilities. We show that the behavior of these ratios can be directly inferred from a simple Merton model and that this behavior is robust to model changes. --

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Bibliographic Info

Paper provided by Center for Entrepreneurial and Financial Studies (CEFS), Technische Universität München in its series CEFS Working Paper Series with number 2008-01.

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Date of creation: 2008
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Handle: RePEc:zbw:cefswp:200801

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Related research

Keywords: equity premium; credit risk premium; credit risk; structural models of default;

References

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  1. Hans Gersbach & Alexander Lipponer, 2003. "Firm Defaults and the Correlation Effect," European Financial Management, European Financial Management Association, vol. 9(3), pages 361-378.
  2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  3. Fons, Jerome S, 1987. " The Default Premium and Corporate Bond Experience," Journal of Finance, American Finance Association, vol. 42(1), pages 81-97, March.
  4. James Claus, 2001. "Equity Premia as Low as Three Percent? Evidence from Analysts' Earnings Forecasts for Domestic and International Stock Markets," Journal of Finance, American Finance Association, vol. 56(5), pages 1629-1666, October.
  5. Delianedis, Gordon & Geske, Robert, 1998. "Credit Risk and Risk Neutral Default Probabilities: Information About Migrations and Defaults," University of California at Los Angeles, Anderson Graduate School of Management qt7dm2d31p, Anderson Graduate School of Management, UCLA.
  6. Liu, Jun & Longstaff, Francis A. & Mandell, Ravit E., 2000. "The Market Price of Credit Risk: An Empirical Analysis of Interest Rate Swap Spreads," University of California at Los Angeles, Anderson Graduate School of Management qt0zw4f9w6, Anderson Graduate School of Management, UCLA.
  7. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers RPF-259, University of California at Berkeley.
  8. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
  9. Liu, Sheen & Shi, Jian & Wang, Junbo & Wu, Chunchi, 2007. "How much of the corporate bond spread is due to personal taxes?," Journal of Financial Economics, Elsevier, vol. 85(3), pages 599-636, September.
  10. Duffie, Darrell & Lando, David, 2001. "Term Structures of Credit Spreads with Incomplete Accounting Information," Econometrica, Econometric Society, vol. 69(3), pages 633-64, May.
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