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Default Risk and Cross Section of Returns

Gabelli School of Business, Fordham University, New York, NY 10023, USA
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J. Risk Financial Manag. 2019, 12(2), 95; https://doi.org/10.3390/jrfm12020095
Received: 7 May 2019 / Revised: 24 May 2019 / Accepted: 4 June 2019 / Published: 6 June 2019
(This article belongs to the Special Issue Quantitative Finance)
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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. View Full-Text
Keywords: risk management; default risk; option pricing risk management; default risk; option pricing
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Cakici, N.; Chatterjee, S.; Chen, R.-R. Default Risk and Cross Section of Returns. J. Risk Financial Manag. 2019, 12, 95.

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