Extracting the Equity Premium from CDS Spreads

Abstract

The capital asset pricing model that relates a stock’s expected risk premium to the risk premium on the market portfolio and the stock’s beta coefficient relative to the market is one of the pillars of modern finance. Unfortunately, expected equity risk premia are not observable, and extracting them from realized returns produces very noisy estimates at best. In this article, Berg and Kaserer offer a new approach based on analyzing spreads on credit default swaps (CDS). A “structural” default model computes a firm’s probability of default as a function of the mean and standard deviation of the changes in the firm’s asset value and how far that value can fall before it would precipitate insolvency. This (risk-neutral) probability can be deduced from the market spread on the firm’s CDS. Moody’s KMV’s expected default frequency (EDF) is an estimate of the empirical probability of default. Combining the risk-neutral and the empirical default probabilities allows the expected equity risk premium to be extracted. The article develops the theory and applies it to the individual stocks contained in the CDX.NA.IG CDS index.

TOPICS: Credit default swaps, security analysis and valuation, quantitative methods