Abstract
The current study was aimed to examine the relationship between default risk premium and equity return by using sample of hundred companies from period between 2000 and 2015, listed at Karachi Stock Exchange. The firms are chosen on the basis of market capitalization. To examine the role of market premium, size premium, value premium and default premium in estimating the equity returns, the two pass regression was used. It was found that CAPM is valid model as market premium is priced but explanatory power is low. Similarly, the findings suggested that the CAPM model is not better than Fama and French model. Default risk premium is also significantly influencing equity returns. The study findings provided evidence about premium of default risk anomaly in Pakistani markets during the sample period. In default sorted portfolio the low default stocks earn lower than the high default stocks. This study has implications for decision markers in estimating cost of equity as well as weighted average cost of capital as it provides more information in comparison to CAPM. Moreover, information about premium of size, value and default anomaly may facilitate under developing investment strategies.
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