The Relationship between Risk-Neutral and Actual Default Probabilities: The Credit Risk Premium

The study investigates empirically the relationship between the risk-neutral measure Q and the real-world measure P. We study the ratio between the risk-neutral and actual default intensities, which we call the coverage ratio or the relative credit risk premium. Actual default intensities are derived from rating agencies annual transition matrices, while risk-neutral default intensities are bootstrapped from CDS quotes of European corporates. We quantify the average risk premium and its changes over time. Compared to related literature, special attention is given to the effects of the recent financial and European sovereign crises. We find that average credit risk premia rose substantially and that post-crisis levels are still higher than those observed before the financial crisis. This observation is especially true for high-quality debt and if it persists, it will have an impact on corporates funding costs. The quantification and revision of risk premia contributes to the discussion of the credit spread puzzle and could give extra insights in valuation models that start from real-world estimates. Our work is furthermore important in the context of state aid assessment. The real economic value (REV) methodology, applied by the European Commission to evaluate impaired portfolios, is based on a long-term average risk premium.