Credit Rating Anomaly in the Taiwan Stock Market


  • Acknowledgments: The authors acknowledge helpful comments and suggestions from Rosita P. Chang, F.Y. Eric C. Lam, Jungwon Suh, and seminar participants at the 6th International Conference on Asian Financial Markets, the 2012 Asian Finance Association Annual Meeting, and 2012 KFA–TFA Joint Conference in Finance. They are especially grateful to two anonymous referees and Chang-Soo Kim (the editor) for constructive comments that have improved the paper. Ko acknowledges financial support from the National Science Council of Taiwan (grant number: NSC 98-2410-H-260-068).

Corresponding author: Kuan-Cheng Ko, Department of Banking and Finance, National Chi Nan University, 1, University Road, Puli 54561, Taiwan. Tel: +886-49-2910960 ext 4695, Fax: +886-49-2914511, email:


Rational asset-pricing theory asserts that higher risk should be accompanied by higher expected return. The credit risk puzzle, however, states a negative cross-sectional relationship between credit risk and future stock returns (Journal of Finance, 53, 1998, 1131; Journal of Finance, 57, 2002, 2317; Journal of Finance, 63, 2008, 2899; Journal of Financial Markets, 12, 2009, 469). This paper examines the credit risk puzzle using an independent dataset from Taiwan's stock market. We document a significantly positive premium between highest- and lowest-rated stocks in both portfolios and individual stocks, and demonstrate that it cannot be explained by well-known asset-pricing models, including the CAPM, Journal of Financial Economics, 33, 1993, 3 three-factor model, and Journal of Financial Economics 82, 2006, 631 liquidity-augmented CAPM. Unlike the evidence collected from the US market, rating downgrades only have limited impact on the cross-sectional variation of stock returns in Taiwan. Further analysis indicates that credit rating serves as a better proxy for distress risk, and is thus priced in Taiwan's stock market.