Linking credit risk premia to the equity premium

Although the equity premium is - both from a conceptual and empirical perspective - a widely researched topic in finance, there is still no consensus in the academic literature about its magnitude. In this paper, we propose a different estimation method which is based on credit valuations. The main idea is straigtforward: We use structural models to link equity valuations to credit valuations. Based on a simple Merton model, we derive an estimator for the market Sharpe ratio. This estimator has several advantages. First, it offers a new line of thought for estimating the equity premium which is not directly linked to current methods. Second, it is only based on observable parameters. We do neither have to calibrate dividend or earnings growth - which is usually necessary in dividend/earnings discount models - nor do we have to calibrate asset values or default barriers - which is usually necessary in traditional applications of structural models. Third, it is robust to model changes. We examine the model of Duffie/Lando (2001) - which is one of the most sophisticated structural models currently discussed in the literature - to show this robustness. In an empirical analysis we have used CDS spreads of the 125 most liquid CDS in the U.S. from 2003 to 2007 to estimate the equity premium. We derive an average implicit market Sharpe ratio of appr. 40%. Adjusting for taxes and other parts of the credit spread not attributable to credit risk yields an average market Sharpe ratio below 30%. This confirms research on the equity premium, which indicates that the historically observed Sharpe ratio of 40-50% - corresponding to an equity premium of 7-9% and a volatility of 15-20% - was partly due to one-time effects. In addition, our research can be used to explain empirical findings about credit risk premia, which are usually measured as the ratio of risk-neutral to actual default probabilities. We show that the behavior of these ratios can be directly inferred from a simple Merton model and that this behavior is robust to model changes. --equity premium,credit risk premium,credit risk,structural models of default

On the complexity of modified instances

Diese Dissertation untersucht die Komplexität modifizierter Instanzen und inwiefern sich NP-vollständige Probleme unter minimaler Veränderung stabil verhalten. Wir betrachten für verschiedene NP-vollständige Probleme, ob die Kenntnis einer Lösung einer Instanz eine Hilfe beim Entscheiden einer geringfügig modifizierten Instanz liefern kann. Außerdem untersuchen wir, inwieweit sich modifizierte Instanzen effizient entscheiden lassen, wenn nicht nur eine Lösung der unmodifizierten Instanz gegeben ist, sondern allgemeinere Hinweise, wie z.B. ein polynomiell langer String. Diese Fragestellung spielt nicht nur überall dort eine große Rolle, wo NP-vollständige Probleme in dynamischen Situationen schnell gelöst werden müssen, sondern liefert auch tiefere Einsichten in die generelle Natur der Klasse der NP-vollständigen Probleme. Des Weiteren betrachten wir das Problem der Reoptimierung. Das heißt, wir untersuchen für verschiedene Optimierungsprobleme, ob man für modifizierte Instanzen eines Optimierungsproblems eine gute Lösung finden kann, wenn bereits eine optimale Lösung einer ähnlichen Instanz bekannt ist

The term structure of risk premia: new evidence from the financial crisis

This study calibrates the term structure of risk premia before and during the 2007/2008 financial crisis using a new calibration approach based on credit default swaps. The risk premium term structure was flat before the crisis and downward sloping during the crisis. The instantaneous risk premium increased significantly during the crisis, whereas the long-run mean of the risk premium process was of the same magnitude before and during the crisis. These findings suggest that (marginal) investors have become more risk averse during the crisis. Investors were, however, well aware that risk premia will revert back to normal levels in the long run. JEL Classification: G12, G13Credit risk, Equity premium, Mean reversion, risk premia, structural models of default

The total costs of corporate borrowing in the loan market : don't ignore the fees

More than 80% of US syndicated loans contain at least one fee type and contracts typically specify a menu of spread and different types of fees. We test the predictions of existing theories about the main purposes of fees and provide supporting evidence that: (1) fees are used to price options embedded in loan contracts such as the draw-down option for credit lines and the cancellation option in term loans; and (2) fees are used to screen borrowers about the likelihood of exercising these options. We also propose a new total-cost-of-borrowing measure that includes various fees charged by lenders