Corporate Default and Asset Pricing in Stock Market

Objective: The main objective of this research is to study the relationship between corporate default and key investment strategies in the Iranian stock market. These strategies are value strategies and continuation of past performance (momentum). The concept of market anomalies including value premium, size premium and momentum premium has been studied mainly in relation to the stock market of the United States of America or another group of countries. Researches that have focused exclusively on the Iranian stock market are limited and related to the past years. Considering Iran's influential role in the region's economy and its damage from the recent global crises, it will be important to answer the question of whether there are abnormal returns resulting from value premium, size premium and continuation of past returns in the Iranian stock market or not. Another goal of this research is to establish and investigate the theoretical relationship between corporate default and investment strategies.

Methods: In this research, using four corporate default indicators, including the probability of default calculated by Campbell, Hilscher and Szilagyi (2008) (named as CHS score), the criterion based on Merton model (1974) (named as M score), Altman's Z score (1968) and Ohlson's O score (1980), the role of this factor in pricing capital assets, as well in explaining the profitability of investment strategies known as value premium, size premium and momentum premium, is investigated and analyzed. In this way, a total of 10 models are used and tested: (1) Fama-French three-factor model (1993), (2) Carhart four-factor model (1997), (3) augmented Fama-French model including CHS score, (4) augmented Carhart model including CHS score, (5) augmented Fama-French model including Z score, (6) augmented Carhart model including Z score, (7) augmented Fama-French model including O score, (8) augmented Carhart model including O score, (9) augmented Fama-French model including M score, and (10) augmented Carhart model including M score. In this research, the data of 168 companies listed on Tehran Stock Exchange and Iran Fara Bourse over a period of 114 months are used.

Results: According to the results of this research, the inclusion of the corporate default factor in Fama-French three-factor model (1993) and Carhart four-factor model (1997) improves the performance of these models in pricing stocks. In the meantime, the indicator of the probability of default calculated by Campbell, Hilscher and Szilagyi (2008) has the greatest contribution in increasing the explanatory power of the mentioned models. After that, Ohlson's O score (1980) and Altman's Z score (1968) are ranked second and third, and the measure based on Merton's model (1974) stands at the last place. Additionally, it is found that value premium, while is indifferent to the presence or absence of the corporate default factor in asset pricing models, is mainly seen among value stocks, both small and big. After augmenting these models with the corporate default factor, the significance of the size effect disappears among big value stocks, but this variable still maintains its influence in explaining the fluctuations of returns of three other stock portfolios, including small value stocks, small growth stocks and big growth stocks. In addition, the findings show that the excess returns of none of the stock portfolios contain momentum premium. More importantly, the research results suggest that the probability of corporate default and the excess returns of stock portfolios are significantly negatively correlated.

Conclusion: According to the results, the first hypothesis of the research that “the corporate default factor explains the stock returns of firms listed on Tehran Stock Exchange and Iran Fara Bourse” is confirmed. The second hypothesis of the research, based on which, “including the corporate default factor improves the performance of Fama-French three-factor model (1993) and Carhart four-factor model (1997) in the pricing of capital assets”, is also confirmed. The third hypothesis of the research, according to which, “the corporate default factor changes the effect of risk factors related to size, book value to market value and momentum in Fama-French three-factor model (1993) and Carhart four-factor model (1997)”, is confirmed about size and value effects, but there is no evidence that with the inclusion of the corporate default factor in Carhart four-factor model (1997), the impact of the momentum variable on the excess returns of stock portfolios will increase or decrease. The fourth research hypothesis that “market-based corporate default criteria have more power in explaining the profitability of value premium, size premium, and momentum premium, compared to the criteria based on accounting data”, is not fully confirmed or rejected. According to the above findings, the value, size and momentum effects are not compensation for the risk of corporate default. It is suggested that individual and institutional investors in stock market pay attention to the financial health of the firm, the size of the firm and its book to market ratio, respectively, instead of focusing on the past performance of its stocks.