Credit Risk and Anomalies in Pakistan’s Stock Market

Abstract

This paper investigates the relation between credit risk and stock return for publicly traded firms in the Pakistan Stock Exchange (PSX) over the period 2000-2017. Using credit ratings as a proxy for credit risk, we find that this relation is negative in Pakistan, as low-rated stocks (i.e., those with high credit risk) earn lower returns than high-rated stocks (i.e., those with low credit risk) do. An additional analysis using Altman’s Z-score as a proxy for credit risk confirms the negative relation between credit risk and stock return. In seeking to determine whether this negative relation arises from other anomalies, we discover that stock return is positively related to firm size in Pakistan, so a reverse size effect is present. However, the negative credit risk-return relation in Pakistan persists after controlling for the reverse size effect as well as the momentum and liquidity effects. This study provides evidence that the default-risk anomaly holds in a frontier stock market that lacks adequate information infrastructures and faces high levels of political and economic uncertainty.

Keywords: Default-risk anomaly, credit risk, stock returns, anomalies, size effect, credit ratings, Altman’s Z-score

JEL Classification: G11, G12, G24, G32