The Swedish Value Premium and Disasters: The Missing Piece of the Puzzle?

Abstract: This paper examines the value premium puzzle in Sweden for the period 2002 - 2016 and attempts to explain the puzzle by accounting for time-varying risk exposure with the inclusion of a proxy for financial disasters risk. The value premium is one of the most persistent financial anomalies and the reasons for its existence have been a hot topic for debate over the past years, with more recent research suggesting that it is a form of compensation for higher exposure to harsh economic downturns, or disasters. We elect to study this possibility empirically, through the conditional CAPM framework using the method presented by Petkova & Zhang. Firstly, we show that the value premium puzzle disappears around the time of the financial crisis and actually inverts post-crisis. We argue that this inversion is mainly due to the effects of financial restrictions which emerged during the crisis and the consequences to firms' capital structures. Secondly, and more importantly, we show that the inclusion of a disaster proxy in the conditional CAPM, the iTraxx credit default swap index, allows for the conclusion of disaster risk being priced into the value premium with our results going in the right direction in capturing the HML portfolio returns and explaining the movements in the portfolio beta.