Credit Risk and Equity Returns: An Augmented Fama-French Five-Factor Model in the Chinese Market

Posted: 8 Sep 2020

See all articles by Tangrong Li

Tangrong Li

Nanjing University - School of Business

Hui Lin

Nanjing University - School of Business

Date Written: June 11, 2020

Abstract

Whether the credit risk should be priced has been widely debated. We study this issue in the Chinese context, where the financial market has been long dominated by indirect financing. We employ the Merton’s (1974) model to measure the credit risk of firms listed on Chinese A-share market monthly. We document a positive relationship between credit risk and subsequent returns. Following a high-minus-low strategy, we construct a credit risk factor DMU, which is then incorporated into Fama-French models. By comparing the performance of 6 competing models, we find that the credit risk factor helps improve the description of portfolio returns while the investment factor makes little contribution. The conclusions are further confirmed by regression details including adjusted-R2, AIC tests and intercepts. Meanwhile, the slopes on DMU are significant for most tested portfolios and present monotonic patterns when the credit risk increases, implying that the credit risk factor can well explain the variation in the cross section of portfolio returns. Our findings show that in the Chinese context, the credit risk factor is relevant and the DMU-augmented Fama-French five-factor model is a preferred model.

Keywords: Credit Risk, Equity Returns, KMV Model, Asset Pricing

JEL Classification: G12, G33

Suggested Citation

Li, Tangrong and Lin, Hui, Credit Risk and Equity Returns: An Augmented Fama-French Five-Factor Model in the Chinese Market (June 11, 2020). Available at SSRN: https://ssrn.com/abstract=3625609 or http://dx.doi.org/10.2139/ssrn.3625609

Tangrong Li

Nanjing University - School of Business ( email )

22 Hankou Road
Nanjing, Jiangsu 210093 210093
China

Hui Lin (Contact Author)

Nanjing University - School of Business ( email )

22 Hankou Road
Nanjing, Jiangsu 210093 210093
China
83593881 (Phone)

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