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

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  • Howard Chan
  • Robert Faff
  • Paul Kofman

Abstract

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
    DOI: 10.1177/0312896211407528
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    3. Daniel Chai & Robert Faff & Philip Gharghori, 2013. "Liquidity in asset pricing: New Australian evidence using low-frequency data," Australian Journal of Management, Australian School of Business, vol. 38(2), pages 375-400, August.
    4. 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.
    5. repec:wyi:journl:002153 is not listed on IDEAS
    6. 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.
    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.
    8. Kebin Deng & Zhong Ding & Yushu Zhu & Qing Zhou & Kathy Walsh, 2017. "Investment–cash flow sensitivity measures investment thirst, but not financial constraint," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 57(1), pages 165-197, March.
    9. 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.
    10. Kim, Dongcheol & Lee, Inro & Na, Haejung, 2019. "Financial distress, short sale constraints, and mispricing," Pacific-Basin Finance Journal, Elsevier, vol. 53(C), pages 94-111.
    11. 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.
    12. Adrian Melia & Paul Docherty & Steve Easton & Tom Smith, 2016. "Net share issues and the cross-section of equity returns under a dividend imputation tax system," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 56(4), pages 1097-1117, December.

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