Essays on Equity Duration and Default Risk
Alagarsamy, Kothai Priyadharshini
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This dissertation investigates the cross-sectional implications of equity duration, the weighted average time for shareholders to receive cash-flows from a firm in which weights are the ratio of the firm's discounted future cash-flows to the firm's price. The first chapter investigates techniques to more accurately measure equity duration. The second chapter examines the pervasiveness of the default risk puzzle that high default risk (HDR) firms earn lower abnormal returns under existing asset pricing models than low default risk (LDR) firms. The third chapter examines whether firms that differ in default risk also differ in equity duration. In the first chapter, I examine whether cross-sectional variation in firm characteristics affects equity duration of firms. Compared to the existing estimation method, a duration measurement technique that accounts for cross-sectional variation in growth opportunities reduces firm cash-flow forecasting error scaled by the firm market-value throughout the cash-flow projection horizon (ten years). The spread in average scaled forecasting error between the two techniques is 24.16% at the end of the ten years. This less noisy cash-flow prediction translates into a longer duration differential (11.98 years) and a larger return spread (-1.83% per month) between the top and bottom decile of firms differing in equity duration than the previously thought duration differential (8.71 years) and return spread (-1.08% per month). Existing risk factors span only 43% of the new return spread. The new technique also implies a steeper sloped term structure of equity risk premium, a 1.83% decrease as opposed to 1.48% decrease in monthly mean excess returns over the risk-free rate for a one-year increase in equity duration. This chapter suggests that accounting for cross-sectional variation in firm characteristics results in a less noisy measure of equity duration. In the second chapter, I examine whether the default risk puzzle is pervasive across firms. The top 40th percentile of default risk firms can either delist, recover, or possess elevated default risk at the end of the sample. Irrespective of the paths, these firms earn lower abnormal returns under Fama and French (1993) three-factor model than the bottom 40th percentile of default risk firms. Further, firms that recover from elevated default risk levels earn significant positive Fama and French (1993) three-factor alphas. The alphas persist despite allowing six months for the market to assimilate earnings information before rebalancing default risk portfolios, suggesting the possibility of a missed pricing factor. In the third chapter, I investigate whether firms with elevated default risk also have elevated equity duration and earn lower returns than LDR firms due to the downward-sloping term structure of equity risk premium. In expectation, HDR firms take longer than LDR firms to generate cash-flows for shareholders because HDR firms may use most of their short-term cash-flows to ensure their survival. Consequently, equity duration for HDR firms is 4.03 years longer than that for LDR firms. An arbitrage portfolio that buys the top decile and sells the bottom decile of firms differing in equity duration based on the new technique (chapter 1) reduces the default risk puzzle by 57% on the value-weighted arbitrage portfolio that buys the top quintile and sells the bottom quintile of default risk firms. This chapter suggests that equity duration has implications for the cross-section of returns.
- Business administration