Default Risk in Equity Returns

Sammanfattning: Purpose: The current thesis assignment aims to quantitatively verify systematic character of default risk and the statistical quality of the competing three- and four-factor asset pricing models. Method: The experimental design applied to this study is premised on the three-factor model of Fama and French enhanced by default risk factor. The study utilizes the factor mimicking portfolio technique for modeling the risks underlying size, value and default risk factors. Distance-to-default estimate, deduced from the option-based model, is adopted by this study as a proxy for default risk. Regression analysis is applied on the time series of average returns on the portfolios of stocks possessing the pre-specified corporate characteristics. Conclusions: The augmentation of the three-factor model with default risk factor improves the performance of a conventional asset pricing specification on average. The factor loadings of the portfolios of size, value and default risk factors exhibit strong properties of risk factor sensitivities for stocks. However, this holds only for the model that explains the average returns on the portfolio of stocks characterized by high value of market capitalization, high value of book-to-market equity, and short distance-to-default estimate. The size and value factors are found to be common in equity returns, but at the same time not being proxies for default related information. The study provides no evidence for the default risk being proxy for sensitivity to common risk factor in returns.