Default Risk in Equity Returns
by Maria Vassalou of Columbia University, and
Abstract: This is the first study that computes default measures for individual firms using Merton's (1974) option pricing model, to assess the effect that default risk has on equity returns. We find that both size and book-to-market (BM) exhibit a strong link with default risk. There is a very strong size effect (45.84% per annum), which is however present only within the segment (one-fifth) of the market that contains the stocks with the highest default risk. There is no size effect in the remaining of the market. A similar result is obtained for the BM effect (30.5% p.a.) which is however present in the two-fifths of the stocks in the market with the highest default risk. Again, no BM effect exists in the remaining stocks of the market. High default stocks earn significantly higher returns than low default stocks, but only if they are small in size or high BM. Default risk in systematic risk. The Fama-French (FF) factors SMB and HML contain some default-related information, but this is not the main reason why the FF model can explain the cross-section of equity returns.
Keywords: default risk, equities, Merton's (1974) model, size and book-to-market effects.
Published in: Journal of Finance, Vol. 59, No. 2, (April 2004), pp. 831-868.
Previously titled: Equity Returns Following Changes in Default Risk: New insights into the informational content of credit ratings