The basic paradigm of asset pricing is in vibrant f lux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models.

/pdf/investor-psychology-and-asset-pricing-c95w5p60ck.pdf

Investor Psychology and Asset Pricing

We examine the accuracy and contribution of the Merton distance to default (DD) model, which is based on Merton's (1974) bond pricing model. We compare the model to a “naive” alternative, which uses the functional form suggested by the Merton model but does not solve the model for an implied probability of default. We find that the naive predictor performs slightly better in hazard models and in out-of-sample forecasts than both the Merton DD model and a reduced-form model that uses the same inputs. Several other forecasting variables are also important predictors, and fitted values from an expanded hazard model outperform Merton DD default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with Merton DD probabilities after adjusting for agency ratings and bond characteristics. We conclude that while the Merton DD model does not produce a sufficient statistic for the probability of default, its functional form is useful for forecasting defaults.

https://www.jstor.org/stable/pdfplus/40056852.pdf

Forecasting Default with the Merton Distance to Default Model

This is the first study that uses Merton's (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the book-to-market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama-French (FF) factors SMB and HML contain some default-related information, but this is not the main reason that the FF model can explain the cross-section of equity returns.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID297319_code020120600.pdf?abstractid=297319&mirid=1&type=2

Default Risk in Equity Returns

We re-examine the evidence on the relationship between credit spreads and economic activity, by constructing a credit spread index based on an extensive data set of prices of outstanding corporate bonds trading in the secondary market. Compared with the standard default-risk indicators, our credit spread index is a robust predictor of economic activity at both the short- and longer-term horizons. Using an empirical framework, we decompose the index into a predictable component that captures the available firm-specific information on expected defaults and a residual component—the excess bond premium—which we argue likely reflects variation in the price of default risk rather than variation in the risk of default. Our results indicate that the predictive content of credit spreads for economic activity is due primarily to movements in the excess bond premium. Innovations in the excess bond premium that are orthogonal to the current state of the economy are shown to lead to significant declines in economic activity and equity prices. We also show that a deterioration in the creditworthiness of broker-dealers—key financial intermediaries in the corporate cash market—causes an increase in the excess bond premium. These findings support the notion that a rise in the excess bond premium represents a reduction in the e!ective risk-bearing capacity of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy.

/pdf/credit-spreads-and-business-cycle-fluctuations-2hg0cfvcs2.pdf

Credit Spreads and Business Cycle Fluctuations

This paper explores the determinants of corporate failure and the pricing of financially distressed stocks using US data over the period 1963 to 2003. Firms with higher leverage, lower profitability, lower market capitalization, lower past stock returns, more volatile past stock returns, lower cash holdings, higher market-book ratios, and lower prices per share are more likely to file for bankruptcy, be delisted, or receive a D rating. When predicting failure at longer horizons, the most persistent firm characteristics, market capitalization, the market-book ratio, and equity volatility become relatively more significant. Our model captures much of the time variation in the aggregate failure rate. Since 1981, financially distressed stocks have delivered anomalously low returns. They have lower returns but much higher standard deviations, market betas, and loadings on value and small-cap risk factors than stocks with a low risk of failure. These patterns hold in all size quintiles but are particularly strong in smaller stocks. They are inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress.

https://papers.ssrn.com/sol3/Delivery.cfm/nber_w12362.pdf?abstractid=917567&mirid=1

In Search of Distress Risk

This is the first study that uses Merton’s (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the bookto-market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama‐French (FF) factors SMB and HML contain some default-related information, but this is not the main reason that the FF model can explain the cross section of equity returns. A FIRM DEFAULTS WHEN IT FAILS to service its debt obligations. Therefore, default risk induces lenders to require from borrowers a spread over the risk-free rate of interest. This spread is an increasing function of the probability of default of the individual firm. Although considerable research effort has been put toward modeling default risk for the purpose of valuing corporate debt and derivative products written on it, little attention has been paid to the effects of default risk on equity returns. 1 The effect that default risk may have on equity returns is not obvious, since equity holders are the residual claimants on a firm’s cash flows and there is no promised nominal return in equities. Previous studies that examine the effect of default risk on equities focus on the ability of the default spread to explain or predict returns. The default spread is usually defined as the yield or return differential between long-term

/pdf/default-risk-in-equity-returns-1l4tdarday.pdf

In this study we examine the extent to which the profitability of the HML, SMB, and WML trading strategies can be linked to macroeconomic risk factors. Using a large cross-section of securities from ten developed markets, we find that the HML and SMB portfolios contain significant information about future GDP growth. The predictive ability of these strategies is to a large degree independent of any information contained in the domestic market factor, which is known to be a leading indicator of economic growth. Even in the presence of popular business cycle variables, HML and SMB retain their ability to predict future economic growth in some of the countries examined. Examination of the portfolio holdings over the life of the trading strategies shows that more than 50% of the securities in the extreme portfolios of HML and SMB remain the same over a period of three years. In most countries, more than 30% of the stocks never exit the extreme portfolios over the whole life of the trading strategy. High book-to-market and small capitalization stocks in these portfolios may be more sensitive to changes in the economic environment because they seem to be entrenched in their respective categories. The vulnerability of high book-to-market and size stocks to changes in the economic environment appears to give rise to the link between the performance of the HML and SMB trading strategies and future economic growth. Little evidence is found to support this hypothesis for the returns of the WML strategy. Finally, industry factors cannot explain the returns of any of these strategies.

Maria Vassalou

Papers

Default Risk in Equity Returns

Default Risk in Equity Returns

Can Book-to-Market, Size, and Momentum Be Risk Factors That Predict Economic Growth?

Can book-to-market, size and momentum be risk factors that predict economic growth?

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