Default Risk In Equity Returns

Default Risk is a risk that a debtor when the obligation expires, can't or don't want to pay back the capital plus interest, so that makes the creditor suffer Losing. 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, or make use of it to price equity. How to measure default risk in equity returns? Does default risk affect equity returns? Does default Risk help to price stocks? Those are not only the main issues proposed in this paper, but also the core purpose of this research.This thesis uses the listed companies of China's A-stock market during January 4, 1997 to December 28, 2007 as the research sample, It makes use of the structural model of the Merton (1974) to calculate the monthly default likelihood indicator of every single company, and uses it to measure the default risk. Then, Followed by the method of constructing two-dimensional grouping of Vassalou and Xing (2004) and The portfolio-based regression approach of Nijman et al.(2002) To study the relationship between default risk and variation in equity returns. Finally, adding "default risk factor" to the CAPM and Fama-French three factors model respectively, so customize two empirical asset pricing models, and study and compare the four pricing model - CAPM, three factors model and the two-customization model, access to the pricing information of default risk in equity returns.The conclusions of the empirical research of this thesis show that: (1) There issignificant "Default Effect"------the higher the default risk, the lower the return.(2) that default risk is intimately related to the size and book-to-market charac- teristics of a firm. With the size increasing, default risk decreases monotonously. The size effect exists only within the quintiles with the lowest and sub-Lowest default risk. The BM effect exists only in the quintiles with the highest default risk. Value stocks have much higher default risk than growth stocks, and there is a monotonic relation between BM and default risk. (3) The SMB and HML factors of the Fama-French three factor model default-related information. (4) Default risk is systematic risk.This thesis provides the ideas and methods in the default risk measurement and management for commercial banks Financial institutions, and it expands the multi-factors pricing models, and play a great role in the right pricing of equity returns of listed companies.