An Equity Duration-Based Rationale for the Default Risk Puzzle

42 Pages Posted: 4 Jan 2020

See all articles by Kothai Priyadharshini Alagarsamy

Kothai Priyadharshini Alagarsamy

University of Washington - Department of Finance and Business Economics, Students

Date Written: November 1, 2019

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

Suggested Citation

Alagarsamy, Kothai Priyadharshini, An Equity Duration-Based Rationale for the Default Risk Puzzle (November 1, 2019). Available at SSRN: https://ssrn.com/abstract=3501971 or http://dx.doi.org/10.2139/ssrn.3501971

Kothai Priyadharshini Alagarsamy (Contact Author)

University of Washington - Department of Finance and Business Economics, Students ( email )

WA
United States

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