Credit Beta

I propose a new daily measure of time-varying systematic credit risk directly estimated from the cross-section of CDS returns. I find that exposure to systematic credit risk, i.e., credit beta, has a strong relation to expected stock returns, while it is distinct from exposures to other equity, bond, and derivatives market risks. Consistent with theory, credit beta subsumes the abnormal returns of stocks with higher firm-level measures of observable default proxies such as credit risk premium and the distance-to-default. Credit betas also predict firms' cash flows, emphasizing a strong role of cash flow dynamics in a risk-based view of abnormal returns. The paper lends credence to the conjecture that the pricing in credit markets matters on the equity risk premium investors demand.