Default Risk and Cross Section of Returns

Nusret Cakici, Sris Chatterjee and Ren-Raw Chen
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Nusret Cakici: Gabelli School of Business, Fordham University, New York, NY 10023, USA
Sris Chatterjee: Gabelli School of Business, Fordham University, New York, NY 10023, USA
Ren-Raw Chen: Gabelli School of Business, Fordham University, New York, NY 10023, USA

JRFM, 2019, vol. 12, issue 2, 1-15

Abstract: Prior research uses the basic one-period European call-option pricing model to compute default measures for individual firms and concludes that both the size and book-to-market effects are related to default risk. For example, small firms earn higher return than big firms only if they have higher default risk and value stocks earn higher returns than growth stocks if their default risk is high. In this paper we use a more advanced compound option pricing model for the computation of default risk and provide a more exhaustive test of stock returns using univariate and double-sorted portfolios. The results show that long/short hedge portfolios based on Geske measures of default risk produce significantly larger return differentials than Merton’s measure of default risk. The paper provides new evidence that mediates between the rational and behavioral explanations of value premium.

Keywords: risk management; default risk; option pricing (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2019
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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