• Asset-pricing anomalies;
  • Rationality-based asset-pricing models;
  • Credit ratings;
  • Credit risk puzzle;
  • Distress risk


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.