Extracting the equity premium from CDS spreads

We are proposing an approach to estimate investors' point-in-time equity premium expectations from CDS spreads by using structural models of default. Our model is based on the simple observation that the difference between physical and risk-neutral default probabilities depends on the Sharpe ratio of the companies' assets. Our methodology benefits from the fact that good estimates of physical probabilities are available for credit instruments. The estimator yields an average equity premium of approximately 6% for the U.S., 4% for Europe and 6% for Asia. These estimates are based on the Merton model and 5-year CDS spreads over the 2003-2007 period. Using different CDS maturities or different structural models of default yields similar results.