Abstract
This paper explores the role of credit cycles in supporting a risk-based view of equity distress risk premium. I identify a slope factor in CDS returns, which also drives and co-moves with the equity returns of financially constrained firms. The strong sensitivity of cash flows to credit cycles accounts for the observed co-movement among equity and credit returns. An affine dynamic asset pricing model with credit cycle risk parsimoniously replicates the high and volatile risk premium in the data. Differential exposure to credit cycles largely explains the returns for distressed firms beyond firm-specific distress premium.
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