by Tobias Berg of the Technische Universität München, and Christoph Kaserer of the Technische Universität München
January 6, 2008
Abstract: In this paper, we propose a new measure for extracting risk premia out of credit valuations (e.g. CDS spreads) which is based on structural models (including models with unobservable asset values). This approach is able to - qualitatively - explain the observed variations in the risk-neutral-to-actual-default-probability-ratio from empirical studies and directly yields the market Sharpe ratio and therefore allows for a direct comparison with the equity risk premium.
Based on CDS spreads of the 125 most liquid CDS in the U.S. from 2003 to 2007, we show that appr. 80% of the CDS spreads can be explained by credit risk based on structural models with unobservable asset values. We derive an average implicit market Sharpe ratio of appr. 40%, adjusting for taxes yields an average market Sharpe ratio of appr. 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 7-8% and a volatility of 15-20%) was partly due to one-time effects.
