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Is default risk priced in Australian equity? Exploring the role of the business cycle


  • Howard Chan
  • Robert Faff


  • Paul Kofman


Using an extensive Australian sample, we explore two related issues in the context of a default risk asset-pricing factor (DEF) over the business cycle: (a) whether a DEF can explain the size premium in the three-factor Fama–French (FF) model; and (b) whether a DEF has a separate role itself in a four-factor version of the FF model. While we find that the default factor does not explain the success of size, our evidence shows it has a complementary role to small minus big and high minus low. Notably, subgroups of test portfolios likely to seriously challenge any asset-pricing model show evidence that the four-factor model is not perfect. Finally, while we find that conditioning on the business cycle itself has little impact, when we condition on a leading indicator, it has a positive (negative) effect on the estimated default (market) risk premium.

Suggested Citation

  • Howard Chan & Robert Faff & Paul Kofman, 2011. "Is default risk priced in Australian equity? Exploring the role of the business cycle," Australian Journal of Management, Australian School of Business, vol. 36(2), pages 217-246, August.
  • Handle: RePEc:sae:ausman:v:36:y:2011:i:2:p:217-246

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    1. repec:bla:acctfi:v:57:y:2017:i:1:p:165-197 is not listed on IDEAS
    2. Maria H. Kim & Graham Partington, 2015. "Dynamic forecasts of financial distress of Australian firms," Australian Journal of Management, Australian School of Business, vol. 40(1), pages 135-160, February.
    3. Heaney, Richard & Koh, SzeKee & Lan, Yihui, 2016. "Australian firm characteristics and the cross-section variation in equity returns," Pacific-Basin Finance Journal, Elsevier, vol. 37(C), pages 104-115.
    4. Docherty, Paul & Chan, Howard & Easton, Steve, 2013. "Can we treat empirical regularities as state variables in the ICAPM? Evidence from Australia," Pacific-Basin Finance Journal, Elsevier, vol. 22(C), pages 107-124.
    5. Linnenluecke, Martina K. & Chen, Xiaoyan & Ling, Xin & Smith, Tom & Zhu, Yushu, 2016. "Emerging trends in Asia-Pacific finance research: A review of recent influential publications and a research agenda," Pacific-Basin Finance Journal, Elsevier, vol. 36(C), pages 66-76.
    6. repec:bla:acctfi:v:56:y:2016:i:4:p:1097-1117 is not listed on IDEAS
    7. Faff, Robert & Gharghori, Philip & Nguyen, Annette, 2014. "Non-nested tests of a GDP-augmented Fama–French model versus a conditional Fama–French model in the Australian stock market," International Review of Economics & Finance, Elsevier, vol. 29(C), pages 627-638.

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    asset pricing; business cycle; default risk;


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