Default Risk and Equity Returns: A Comparison of the Bank-Based German and the U.S. Financial System

29 Pages Posted: 6 Mar 2008 Last revised: 23 Jul 2009

See all articles by Christoph M. Breig

Christoph M. Breig

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Ralf Elsas

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Date Written: March 27, 2009

Abstract

In this paper, we address the question whether the impact of default risk on equity returns depends on the financial system firms operate in. Using an implementation of Merton's option-pricing model for the value of equity to estimate firms' default risk, we construct a factor that measures the excess return of firms with low default risk over firms with high default risk. We then compare results from asset pricing tests for the German and the U.S. stock markets. Since Germany is the prime example of a bank-based financial system, where debt is supposedly a major instrument of corporate governance, we expect that a systematic default risk effect on equity returns should be more pronounced for German rather than U.S. firms. Our evidence suggests that a higher firm default risk systematically leads to lower returns in both capital markets. This contradicts some previous results for the U.S. by Vassalou/Xing (2004), but we show that their default risk factor looses its explanatory power if one includes a default risk factor measured as a factor mimicking portfolio. It further turns out that the composition of corporate debt affects equity returns in Germany. Firms' default risk sensitivities are attenuated the more a firm depends on bank debt financing.

Keywords: Asset pricing, Stochastic Discount Factor, Default Risk

JEL Classification: G12

Suggested Citation

Breig, Christoph M. and Elsas, Ralf, Default Risk and Equity Returns: A Comparison of the Bank-Based German and the U.S. Financial System (March 27, 2009). Available at SSRN: https://ssrn.com/abstract=1102441 or http://dx.doi.org/10.2139/ssrn.1102441

Christoph M. Breig (Contact Author)

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Kaulbachstr. 45
Munich, DE 80539
Germany

Ralf Elsas

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Kaulbachstr. 45
Munich, DE 80539
Germany

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
318
Abstract Views
3,953
Rank
180,829
PlumX Metrics