An Equity Duration-Based Rationale for the Default Risk Puzzle

Abstract

This paper investigates the cross-sectional implications of equity duration, the present-value weighted average time for shareholders to receive cash-flows from a firm. A portfolio that buys the top quintile and sells the bottom quintile of firms differing in the one-year ex-ante probability of bankruptcy earns a -3.36% (-1.95%) Fama and French (1993) three-factor alpha. In expectation, HDR firms take longer than LDR firms to generate cash-flows for shareholders because HDR firms may use most of their short-term cash-flows to ensure their survival. Consequently, equity duration for HDR firms is 4.03 years longer than that for LDR firms. An arbitrage portfolio that buys the top decile and sells the bottom decile of firms differing in equity duration reduces the default risk puzzle by 57% on the value-weighted arbitrage portfolio that buys the top quintile and sells the bottom quintile of default risk firms.

Keywords: equity duration, default risk, term structure of equity returns

JEL Classification: G10, G11, G12, G14