Default Risk and Equity Returns: A Comparison of the Bank-Based German and the U.S. Financial System
AbstractIn this paper, we address the question whether the impact of default risk on equity returns depends on the financial system firms operate in. Using an implementation of Merton's option-pricing model for the value of equity to estimate firms' default risk, we construct a factor that measures the excess return of firms with low default risk over firms with high default risk. We then compare results from asset pricing tests for the German and the U.S. stock markets. Since Germany is the prime example of a bank-based financial system, where debt is supposedly a major instrument of corporate governance, we expect that a systematic default risk effect on equity returns should be more pronounced for German rather than U.S. firms. Our evidence suggests that a higher firm default risk systematically leads to lower returns in both capital markets. This contradicts some previous results for the U.S. by Vassalou/Xing (2004), but we show that their default risk factor looses its explanatory power if one includes a default risk factor measured as a factor mimicking portfolio. It further turns out that the composition of corporate debt affects equity returns in Germany. Firms' default risk sensitivities are attenuated the more a firm depends on bank debt financing.
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Bibliographic InfoPaper provided by University of Munich, Munich School of Management in its series Discussion Papers in Business Administration with number 10978.
Date of creation: 27 Mar 2009
Date of revision:
Asset pricing; Stochastic Discount Factor; Default Risk;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-09-11 (All new papers)
- NEP-BAN-2009-09-11 (Banking)
- NEP-BEC-2009-09-11 (Business Economics)
- NEP-EEC-2009-09-11 (European Economics)
- NEP-RMG-2009-09-11 (Risk Management)
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