Abstract
In this paper, I analyze the role of credit risk in explaining cross-sectional stock returns. I utilize Credit Default Swap (CDS) spreads to construct a credit risk factor-mimicking portfolio, which I label as Distressed-minus-Stable (DMS). As CDS contracts are written mainly on large firms, our study focuses on explaining the stock returns of large firms. Our main results show that DMS explains stocks returns in the low and medium book-to-market (B/M) portfolios, while HML explains stock returns in the high B/M portfolios. Our finding offers two implications. First, DMS complements HML in explaining stock returns across low, medium and high B/M portfolios. Second, DMS is a more direct measure of credit risk. The fact that it is insignificant in high B/M portfolios suggests that the association of high B/M ratios with higher credit risk in Fama and French (1995), and the nature of the risk that HML represents, warrants further investigation.
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