The Relationship between Risk of Default and Return on Equity: An Empirical Investigation

Avner Arbel, Richard Kolodny and Josef Lakonishok

Journal of Financial and Quantitative Analysis, 1977, vol. 12, issue 4, 615-625

Abstract: The focus of this study is the role of default risk in capital market theory. The impact of default risk on the value of securities has been a major concern of investors and academics alike. Several authors have examined the relationship between bond ratings, the probability of default, and security value [5, 12]. In this context, the ability to avoid or reduce expected bankruptcy costs and thereby increase value has been suggested as a reason for mergers and consolidations [16, 18]. In other studies, models have been developed for predicting ratings [17, 20, 21, 28], for predicting bankruptcy using accounting and other financial variables [1, 6, 7], and for approximating default premiums in the credit markets [22]. Finally a question which has received considerable attention is the effect of bankruptcy on a company's cost of capital. When bankruptcy is possible and there exists a positive bankruptcy transaction cost, it has been argued that there is an optimal capital structure [24, 26].

Date: 1977
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