Is Default Risk Systematic? An Augmentation of the Fama and French Three-Factor Model with Credit-Default Swap Spreads

Abstract: The purpose of the study is to quantitatively verify the systematic property of default risk and to statistically test if adding a default risk factor to the Fama and French Three-Factor Model can enhance its performance. The applied method is derived from the Fama and French Three- factor methodology and enhancing it with an additional default risk factor. The study employs Credit-Default Swap spreads as a proxy for default risk and applies factor mimicking portfolio technique to model the underlying risk factors. Regression analysis is applied to both the constructed portfolios and the entire data sample with the risk factors as independent variables after which the results are statistically tested for significance via cross-sectional regression analysis in line with Fama Macbeth methodology. The data sample includes 101 firms listed on the European iTraxx, spread over different countries within the EU-area. Monthly observations have been utilized from 2004-07-01 to 2010-10-01. The study concludes that adding an additional default risk factor to the three-factor model does not improve its performance. The results show no statistical significance for any of the tested factors. Therefore, the systematic property of default risk, value, size or market risk cannot be confirmed.