This thesis focuses on the pricing of risk in equity, credit and corporate bond markets. The first chapter investigates whether financial leverage matter for the cross-section of expected equity returns, above and beyond firm size and book-to-market equity. Using a structural model of capital accumulation and leverage choice I argue that it does. Expected equity returns vary across firms because of differences in productivity, capital and leverage. Firm size and book-to-market equity cannot map all these variables. Everything else equal, leveraged firms are riskier because they disinvest less when capital is less productive. The model can generate qualitatively and, sometimes, quantitatively the cross-sectional relations between equity returns and book-to-market equity, firm size, market leverage, book leverage and debt/equity ratio.

The second chapter explores the source for common variation in the portion of returns observed in U.S. credit markets that is not related to changes in risk-free rates or expected default losses. We extract a latent common component from firm-specific changes in default risk premia that is orthogonal to known systematic risk factors during our sample period from 2001 to 2004. Asset pricing tests suggest that our factor is priced in the corporate bond market and the equity options market but not in the equity market. We develop a theoretical framework supporting our empirical findings. This framework also shows that our factor captures the jump-to-default risk associated with market-wide credit events.

Finally, the third chapter studies the determinants of the default risk premia embedded in the European credit default swap spreads. Using a modified version of the intertemporal capital asset pricing model, we show that default risk premia represent compensation for bearing exposure to systematic risk and to a new common factor capturing the proneness of the asset returns to extreme events. This new factor arises naturally because the returns on defaultable securities are more likely to have fat tails. The pricing implications of this new factor are not limited to credit markets only. We find that this common factor is priced consistently across a broad spectrum of corporate bond portfolios.