Using the credit spread as an option-risk factor: Size and value effects in CAPM

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This paper takes an option-theoretic approach to explain why pricing anomalies are observed when traditional CAPM is used. By extending CAPM to incorporate the option-risk factor of stocks, we show that stockholders' limited liability can explain Fama and French's size and value effects. We use bonds' excess credit spread as a proxy for stocks' default risk to control for the changing non-diversifiable option-risk characteristic of stocks. Because sensitivity to the excess credit spread becomes smaller as size increases and as value decreases, excess credit spread explains the CAPM anomalies in a fashion similar to the Fama-French factors. While the excess credit spread is significant in explaining Fama and French's size and value effects, adding the Fama-French factors does not improve the performance of our model. Our revised model resembles conditional CAPM, but it offers a more intuitive explanation for the size and value effects. (C) 2010 Elsevier B.V. All rights reserved.
Publisher
ELSEVIER SCIENCE BV
Issue Date
2010-12
Language
English
Article Type
Article; Proceedings Paper
Keywords

ASSET PRICING MODEL; CROSS-SECTION; CORPORATE LIABILITIES; MULTIVARIATE TESTS; TEMPORAL BEHAVIOR; CONDITIONAL CAPM; SYSTEMATIC-RISK; YIELD SPREADS; DEFAULT RISK; RETURNS

Citation

JOURNAL OF BANKING FINANCE, v.34, pp.2995 - 3009

ISSN
0378-4266
URI
http://hdl.handle.net/10203/25489
Appears in Collection
RIMS Journal Papers
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