Yield Spreads as Alternative Risk Factors for Size and Book-to-Market

This paper investigates whether the size and book-to-market factors of Fama and French (1993) proxy for the risks associated with business cycle fluctuations. We find that changes in default spread (Δ<italic>def</italic>) and changes in term spread (Δ<italic>term</italic>) capture the systematic differences in average returns along the size and book-to-market dimensions in the way that the Fama-French factors do: small stock portfolios have higher loadings on Δ<italic>def</italic> than large stock portfolios, while high book-to-market portfolios have higher loadings on Δ<italic>term</italic> than low book-to-market portfolios. Furthermore, in the presence of Δ<italic>def</italic> and Δ<italic>term</italic>, the Fama-French factors are superfluous in explaining the size and book-to-market effects. The results suggest that the size and value premiums are compensation for higher exposure to the risks related to changing credit market conditions and interest rates proxied by Δ<italic>def</italic> and Δ<italic>term</italic>.