Fama and French (1992, 1993, 1995 and 1996) declare that size and book-to-market equity (BM) have strong explanatory power for the cross-section of stock returns, and the risk captured by size and BM is the relative distress of small stocks and value stocks. Firstly, this study examines the pricing power of the default risk, measured by the market revealed credit default swap premiums for individual U.S. firms from 2004 to 2010, in average returns across stocks; secondly, it explores whether the size and BM effects are due to that they proxy for the default risk effect. The tests demonstrate that size effect dominates the joint effect of size and default risk, while both BM and default risk co-work for the joint effect of BM and default risk. Therefore, part of the size and BM effects can be interpreted as default risk effect. As expected, size is priced with a negative risk premium, and BM is priced with a positive risk premium. However, higher default risk is priced with higher expected stock returns only when BM is below a certain level and BM is not priced. Additionally, size indeed proxies for the sensitivity to the default risk factor. Furthermore, the Fama-French factors SMB (small-minus-big) and HML (high-minus-low), mimicking the risks related to size and BM, share some common information with the default risk factor in the asset pricing tests.
