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Pricing default risk: The good, the bad, and the anomaly

Sara Ferreira Filipe, Theoharry Grammatikos and Dimitra Michala

Journal of Financial Stability, 2016, vol. 26, issue C, 190-213

Abstract: While empirical literature has documented a negative relation between default risk and stock returns, theory suggests that default risk should be positively priced. In this paper, we calculate monthly probabilities of default (PDs) for a large sample of European firms and break them down into systematic and idiosyncratic components. The approach that we follow does not require data on credit spreads, thus it can also be applied to small firms that do not have such data available. In accordance with theory, we find that the systematic part, measured as the PD sensitivity to aggregate default risk, is positively related to stock returns. We show that stocks with higher PDs underperform because they have, on average, higher idiosyncratic risk. Finally, small and value stocks are quite heterogeneous with respect to their exposure to aggregate default risk.

Keywords: Default risk; Merton model; Default anomaly; Idiosyncratic risk (search for similar items in EconPapers)
JEL-codes: G11 G12 G15 G33 (search for similar items in EconPapers)
Date: 2016
References: Add references at CitEc
Citations: View citations in EconPapers (7)

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Related works:
Working Paper: Pricing Default Risk: The Good, The Bad, and The Anomaly (2014) Downloads
Working Paper: Pricing Default Risk: The good, the bad, and the anomaly (2014) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:26:y:2016:i:c:p:190-213

DOI: 10.1016/j.jfs.2016.07.001

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