1 Vienna University of Economics and Business · 2 Leibniz University Hannover · 3 University of Piraeus · 4 Copenhagen Business School · 5 Lund University · 6 University of Gothenburg · 7 Nils Friewald and Josef Zechner are at the Department of Finance, Accounting and Statistics at WU Vienna University of Economics and Business. Christian Wagner is at the Department of Finance at Copenhagen Business School. We thank Rui Albuquerque, Doron Avramov, Jennie Bai, Tobias Berg, Nina Boyarc · 8 Nils Friewald and Josef Zechner are at the Department of Finance, Accounting and Statistics at WU Vienna University of Economics and Business. Christian Wagner is at the Department of Finance at Copenhagen Business School. We thank Rui Albuquerque, Doron Avramov, Jennie Bai, Tobias Berg, Nina Boyarc
open access
Abstract
We explore the link between a firm's stock returns and credit risk using a simple insight from structural models following Merton ( ): risk premia on equity and credit instruments are related because all claims on assets must earn the same compensation per unit of risk. Consistent with theory, we find that firms' stock returns increase with credit risk premia estimated from CDS spreads. Credit risk premia contain information not captured by physical or risk‐neutral default probabilities alone. This sheds new light on the “distress puzzle”—the lack of a positive relation between equity returns and default probabilities—reported in previous studies.