Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2011:38: Hidden in the Factors? The Effect of Credit Risk on the Cross-section of Equity Returns

Caren Yinxia Nielsen ()
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Caren Yinxia Nielsen: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: This paper disentangles the complexity of the distress risk premium in stock returns using the risk-neutral measure of credit risk (valued by CDS spread) and investigates the relationship between credit risk and the market , size, value, and momentum effects. Consistent with the argument for a negative distress premium, firms with higher credit risk have lower stock returns, and a positive value effect is concentrated in high credit quality firms. However, credit risk is positively priced in returns on stocks that won the most in the past year and that, during crisis, co-moved the most with the market. A positive momentum effect is concentrated in high credit risk firms. Furthermore, the size effect, but not the value effect, could be attributed to a positive credit risk effect.

Keywords: Asset pricing; equity returns; size effect; value effect; momentum effect; credit risk effect; credit default swap

JEL-codes: G01; G11; G12

24 pages, First version: November 4, 2011. Revised: October 1, 2016.

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