Abstract
The value of an equity investment can be framed as an embedded call option on a firm’s assets. The embedded call option creates a non-linear relationship between stock returns and underlying risk factors; however, such option value and the impact of this non-linearity are often underestimated or overlooked in most asset pricing studies. In this paper, we use the forward-looking measure of default risk in CDS spreads and an associated quadratic term as a non-linear asset pricing model to explain and predict individual stock returns. Notably, in this model, the intercept α disappears in predictions of future risk-adjusted stock returns. The model also provides an alternative to Fama and French (1993)’s three-factor model in substituting functions of our factors for size and value.
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