Abstract
This study explores the effect of credit risk on the lottery-type stocks with Taiwan's data during the sample period 2001 to 2010. The lottery-type stocks are identified as the criteria referring to Kumar [1], which have characters of lower stock price, higher idiosyncratic volatility, and higher idiosyncratic skewness. Refer to Merton [2] and Vassalou & Xing [3], a firm's credit risk is proxied by the DLI (default likelihood indicators). The main results show that the lottery-type stocks have higher default probabilities, smaller firm sizes and higher B/M (book to market) ratio comparing to the non-lottery type ones. By adding default likelihood indicator into the Carhart [4] model, the empirical results demonstrate that a firm's credit situation change has significant negative effect on return of equity; lottery-type stocks equity returns are less sensitive to default risk going higher. Furthermore, this research also shows there exists a structure change resulted from the financial tsunami, indicating the investors require more positive excess returns to compensate their risk for holding stocks after 2008 financial crisis.
Highlights
“Risk Aversion” is a prevailing basic description of a person’s attitude to return and risk in financial studies
They infer that investors in low-priced stocks accept lower average returns as the premium paid for the chance to earn an extreme return, and depict this sacrifice in average return to be “lottery premium.”
The extant literatures examine some issue related to the lottery-type stocks, most of the articles focus on underperform of it and do not discuss the relations between credit risk and lottery-type stocks
Summary
“Risk Aversion” is a prevailing basic description of a person’s attitude to return and risk in financial studies. They infer that investors in low-priced stocks accept lower (even negative) average returns as the premium paid for the chance to earn an extreme return, and depict this sacrifice in average return to be “lottery premium.” Their analysis shows that the lottery premium is higher in up markets than in down markets. Ang et al [10] examine the pricing of aggregate volatility risk in the cross-section of stock returns They find stocks with high sensitivities to innovations in aggregate volatility have low average returns; stocks with high idiosyncratic volatility relative to the Fama and French [11] model have low average returns. The purpose of this study is to investigate the effect of credit risk on the lottery-type stocks
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