An Option-Pricing Explanation for a Negative Impact of Default Risk on Stock Returns

Abstract

This study provides an option-theory explanation for a negative overall relation between default risk and stock returns. The analysis sheds light on the debate of whether default risk commands a positive or a negative risk premium, depending on firm-specific characteristics. Unlike most previous studies which rely mainly on accounting variables and provide different explanations, such as mispricing (Dichev 1998, Griffin and Lemmon 2002), our measure and new explanation for default risk are based on option theory. We show that default option variables are significantly related to subsequent stock returns, beyond the Fama and French (1992, 1993) factors. Our documented negative relation between default risk and stock returns may be explained by the option value held by shareholders of levered firms to default embedded in the current price. The impact of default risk on stock returns decreases with firm size and depends on value-growth characteristics.. While healthy firms on main exchanges show a positive (traditional) return impact, distressed firms exhibit a negative (default-option) impact. For the aggregation of firms on main exchanges the net relationship is weaker (due to the opposing effects). Nasdaq (growth) firms exhibit a negative (default-option) impact, which is strongest for distressed firms. Our findings, illuminating in which situations default risk might lead to a positive distress risk premium or to a negative (insurance-type) discount, help understand better the size-value anomalies.