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

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.