Article ID | Journal | Published Year | Pages | File Type |
---|---|---|---|---|
5090203 | Journal of Banking & Finance | 2010 | 15 Pages |
This paper takes an option-theoretic approach to explain why pricing anomalies are observed when traditional CAPM is used. By extending CAPM to incorporate the option-risk factor of stocks, we show that stockholders' limited liability can explain Fama and French's size and value effects. We use bonds' excess credit spread as a proxy for stocks' default risk to control for the changing non-diversifiable option-risk characteristic of stocks. Because sensitivity to the excess credit spread becomes smaller as size increases and as value decreases, excess credit spread explains the CAPM anomalies in a fashion similar to the Fama-French factors. While the excess credit spread is significant in explaining Fama and French's size and value effects, adding the Fama-French factors does not improve the performance of our model. Our revised model resembles conditional CAPM, but it offers a more intuitive explanation for the size and value effects.