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Knut Wicksell Centre for Financial Studies, Lund University Knut Wicksell Working Paper Series, Knut Wicksell Centre for Financial Studies, Lund University

No 2013/2:
Is Default Risk Priced in Equity Returns?

Caren Yinxia G. Nielsen ()

Abstract: Size and book-to-market equity (BM) strongly explain stock returns’ cross section; the risk they capture is the relative distress of small and value stocks. This study examines the default risk’s pricing power, measured by U.S. firms’ market-revealed credit-default-swap premiums (2004–2010), in average returns across stocks. It also explores whether the size and BM effects stem from proxying the default-risk effect. In the tests, size dominates the size–default-risk effect, while BM and default risk work together. Therefore, size and BM partially proxy the default-risk effect. As expected, size is priced with a negative risk premium and BM is positive. However, higher default risk only engenders higher expected stock returns when BM is below a threshold and unpriced. Additionally, size indeed proxies sensitivity to the default-risk factor. Furthermore, the Fama–French factors SMB (small-minus-big) and HML (high-minus-low) share some common information with the default-risk factor in asset-pricing tests.

Keywords: Asset Pricing; Equity Returns; Size Effect; Book-to-Market Effect; Default-Risk Effect; Credit-Default-Swap Premium; (follow links to similar papers)

JEL-Codes: G12; (follow links to similar papers)

40 pages, January 24, 2013

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