The Impact of Credit Risk and Implied Volatility on Stock Returns

Abstract

This paper examines the possibility of using derivative-implied risk premia to explain stock returns. The rapid development of derivative markets has led to the possibility of trading various kinds of risks, such as credit and interest rate risk, separately from each other. This paper uses credit default swaps and equity options to determine risk premia which are then used to form portfolios that are regressed against the returns of stock portfolios. It turns out that both, credit risk and implied volatility, have high explanatory power in regard to stock returns. Especially the returns of distressed stocks are highly dependent on credit risk fluctuations. This finding leads to practical implications, such as cross-hedging opportunities between equity and credit instruments and potentially allows forecasting stock returns based on movements in the credit market.