Default risk and stock returns: From a perspective of measurement errors

Abstract

The risk-return tradeoff underlies the conceptual framework for the asset pricing model and investment decisions under the efficient markets hypothesis. Many empirical study, however, demonstrate negative relation between credit risk and cross-section of stock returns. The main effort of this study is to attempt detangling the puzzle from the perspective of measurement error by representing the first treatment of a wide class of nonlinear models with discrete variables using instruments. We found measurement error has great impact on the relationship between stock returns and firm's risk of default. In addition, this relation found to be crucially dependent on credit cycles and firm financial status.