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Default Risk Premium and Asset Prices

We propose a novel methodological approach to estimate a corporate structural model, by using data from credit and stock market, and we reconstruct the dynamics of the market value of assets and debt, and the default boundary, for a sample of non-financial firms. We exploit our results to extract the default risk premium, which combines the risk-neutral and the real-world measure of default probability. We show that the equity and the credit market exhibit a relationship with the default risk premium which is opposite to each other, by implementing a long-short portfolio strategy based on the default risk premium, which generates significant performance. Therefore, we argue that the 'distress puzzle', that is the counterintuitive negative relationship between default risk and stock return, can be solved, if the credit and the equity market securities are related through a default risk indicator, resulting from an appropriate structural model estimation, using only market data.