Predicting stock market returns using aggregate credit risk

Abstract

We investigate how credit risk predicts stock returns in the time-series at the aggregate level in the Chinese market. We find that the aggregate credit risk, measured by the option-based structural model, is a strong positive predictor of future stock market excess returns at various horizons. The predictive power remains significant even after controlling for a number of widely-researched predictors or under out-of-sample tests. The positive relationship between aggregate credit risk and expected stock market returns accords with the risk-return tradeoff theory. We also find that the predictive power comes from the discount rate channel. A higher level of aggregate credit risk is related to a higher discount rate of future cash flows, and thus generates higher expected returns.