Abstract
The main objective of the paper is to find out whether bankruptcy risk is a systematic risk. In particular, we investigate the contribution of size, bookto-market, excess market returns and bankruptcy probability in explaining returns. We allocate stocks into portfolios according to the probability of bankruptcy from the hazard model. Results show that bankruptcy risk is not a systematic risk. The results consistently show that excess market returns and size have strong power to explain returns in the UK for the period from 1988 to 1997. Book-to-market and bankruptcy risk only matt er in portfolios with higher probability of bankruptcy. Keyword: Bankruptcy risk, bankruptcy probability, hazard model. JEL Classification: G12, G33
Highlights
A good deal of empirical research has revealed that size and book-tomarket have strong roles in explaining average returns
small minus big (SMB) is negatively correlated with high minus low (HML) and excess market returns, and HML is positively correlated with excess market returns
The correlation between distress minus undistress (DMU) and HML is consistent with the distress hypothesis, that confirms that high-book-to-market has a higher risk of bankruptcy
Summary
A good deal of empirical research has revealed that size and book-tomarket have strong roles in explaining average returns. Fama and French (1993) showed that portfolios constructed to mimic risk factors related to size and bookto-market add substantially to the variation in stock returns. The three-factor asset pricing model, which includes a market factor and risk factors related to size and book-to-market, seems to capture the cross-section of average returns on US stocks. Studies in the UK found a book-to-market effect in explaining average returns (Chan & Chui, 1996; Strong & Xu, 1997); but the size effect played no significant role in explaining such returns. The ability of these factors to explain the variation in average returns has challenged the Capital Asset Pricing Model’s (CAPM) proposition that beta is the only variable that explains returns
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