Yield Spreads as Alternative Risk Factors for Size and Book-to-Market

Abstract

This paper investigates whether the size and book-to-market factors of Fama and French (1993) proxy for the risks associated with business cycle fluctuations. We find that changes in default spread (delta def) and changes in term spread (delta term) capture the systematic differences in average returns along the size and book-to-market dimensions in the way that the Fama-French factors do: small stock portfolios have higher loadings on delta def than large stock portfolios, while high book-to-market portfolios have higher loadings on delta term than low book-to-market portfolios. Furthermore, in the presence of delta def and delta term, the Fama-French factors are superfluous in explaining the size and book-to-market effects. The results suggest that the size and value premiums are compensation for higher exposure to the risks related to changing credit market conditions and interest rates proxied by delta def and delta term.

JEL Classification: G12