A DEFAULT RISK PREMIUM AND EQUITY RETURN OF NON-FINANCIALCOMPANIES OF PAKISTAN
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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.Abstract
The present study aimed to examine the relationship between default risk premium and equity returns by analyzing a sample of 100 companies listed on the Karachi Stock Exchange over the period 2000 to 2015. Firms were selected based on market capitalization. To investigate the roles of market premium, size premium, value premium, and default risk premium in explaining equity returns, a two-pass regression approach was employed. The results indicated that while the Capital Asset Pricing Model (CAPM) is valid, as the market premium is priced, its explanatory power is relatively low. Furthermore, the findings suggested that the CAPM performs less effectively than the Fama–French model. Default risk premium was found to have a significant influence on equity returns, providing evidence of a default risk anomaly in the Pakistani market during the study period. Analysis of default-sorted portfolios revealed that low-default-risk stocks earned lower returns compared to high-default-risk stocks. The study offers important implications for decision-makers in estimating the cost of equity and the weighted average cost of capital, as it provides more comprehensive insights than the CAPM alone. Additionally, information regarding size, value, and default risk premiums may support the development of more effective investment strategies.
