Abstract
This study examines whether systematic default risks affect a cross section of credit risk premiums. Using a structural framework, I derive a theoretical cross-sectional relationship, develop a testable hypothesis, and provide a method to estimate the systematic default risk. The empirical results of US corporate credit default swap data are consistent with my hypothesis. The findings show that, while credit market factors have positive effects on a cross section of credit risk premiums, stock market factors have a negative impact. Regression analyses reveal that the market’s average default probability and the value factor have a significant effect on the credit risk premium. In addition, credit market factors are more influential than equity market factors as systematic default risk factors. The results suggest that systematic and idiosyncratic default risks are priced differently in a cross section of credit risk premiums.
Highlights
Even though credit risk events, such as debt restructuring, bankruptcy, and payment default, are firm specific, they have the potential to affect the sustainability of the firm and that of the economy overall
This study examines the effect of systematic default risk on a cross section of credit risk premiums
Based on the Merton model assumptions, I developed a testable hypothesis that firms with higher systematic default risk tend to have higher credit risk premium (CRP) when the market price of the risk is positive. The sign of this relation depends on the sign of the market price of risk
Summary
Even though credit risk events, such as debt restructuring, bankruptcy, and payment default, are firm specific, they have the potential to affect the sustainability of the firm (in terms of assured incomes) and that of the economy overall. Managing the risks arising from such events is important It might be questionable how corporate default events harm the wider financial system; there are prominent examples of this effect: for instance, subprime mortgage loan defaults in the US in 2007 triggered bankruptcies in the financial sector, such as the Lehman Brothers bankruptcy and the American International Group (AIG) bailout, and eventually led to the global financial crisis (often referred to as a credit crisis). According to the Bank for International Settlements, the notional amount outstanding under single-name CDSs had skyrocketed to $33,484 billion in 2007. This figure has since dropped, amounting to $395 billion as of 2018; the CDS market continues to be large
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