Default Risk and Cross Section of Returns

摘要

Prior research uses the basic one-period European call-option pricing model to computedefault measures for individual firms and concludes that both the size and book-to-market effects arerelated to default risk. For example, small firms earn higher return than big firms only if they havehigher 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 defaultrisk 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 producesignificantly larger return differentials than Merton’s measure of default risk. The paper providesnew evidence that mediates between the rational and behavioral explanations of value premium.