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

  • Hwang, Young-Soon
  • Min, Hong-Ghi
  • McDonald, Judith A.
  • Kim, Hwagyun
  • Kim, Bong-Han

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.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 34 (2010)
Issue (Month): 12 (December)
Pages: 2995-3009

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Handle: RePEc:eee:jbfina:v:34:y:2010:i:12:p:2995-3009
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