The market price of risk in equity and credit markets

Abstract

Structural models such as Merton (1974) imply that all claims on a firm’s assets draw on the same sources of risk. In the simplest case, when asset risk is the only common source of variation, Sharpe ratios for debt and equity must be the same. We study a model where, in addition to asset risk, bond- and shareholders are exposed to asset variance and interest rate risk. In this setting, the predicted Sharpe ratios of debt exceed those of equity for the same firm significantly. We document that this is also the case in a large data set of bond and stock prices.