An Empirical Analysis of a Default Risk Anomaly in the Korean Stock Market

This study examines the relationship between default risk (credit rating) and stock price return in the Korean stock market. The empirical results show that relationship between default risk and stock returns has a negative relationship as found in the U.S market. As the credit rating deteriorates, the excess return of the credit rating based portfolio decreases. After adjusting for risk with the CAPM model, the Fama, French (1993) three-factor model, and the Carhart (1997) four-factor model, the excess return of the credit rating portfolio is negatively correlated with the credit rating. The risk-adjusted excess return of the credit rating portfolio decreases as the credit rating deteriorates even after controlling for firm size and BM. These results suggest that there is credit rating anomalies in the Korean stock market. The results of the Fama-Macbeth cross-sectional regression analysis reveal that the regression coefficient of the credit rating has a negative value. BM and momentum variables are found to have insignificant explanatory power whereas credit risk plays an meaningful role in stock return forecasting.