 Using the credit spread as an option-risk factor: Size and value effects in CAPMYoung-Soon Hwang, Hong-Ghi Min, Judith A. McDonald, Hwagyun Kim () and Bong-Han Kim Journal of Banking & Finance, 2010, vol. 34, issue 12, 2995-3009 Abstract: This paper takes an option-theoretic approach to explain why pricing anomalies are observed when traditional CAPM is used. By extending CAPM to incorporate the option-risk factor of stocks, we show that stockholders' limited liability can explain Fama and French's size and value effects. We use bonds' excess credit spread as a proxy for stocks' default risk to control for the changing non-diversifiable option-risk characteristic of stocks. Because sensitivity to the excess credit spread becomes smaller as size increases and as value decreases, excess credit spread explains the CAPM anomalies in a fashion similar to the Fama-French factors. While the excess credit spread is significant in explaining Fama and French's size and value effects, adding the Fama-French factors does not improve the performance of our model. Our revised model resembles conditional CAPM, but it offers a more intuitive explanation for the size and value effects. Keywords: Credit; spread; Option-risk; factor; CAPM; Size; effect; Value; effect (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:34:y:2010:i:12:p:2995-3009 Access Statistics for this article Journal of Banking & Finance is currently edited by Ike Mathur More articles in Journal of Banking & Finance from Elsevier |
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