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.
Highlights
There is widespread evidence that stocks with a high book-to-market ratio have higher expected returns compared to stocks with a low book-to-market ratio1
Santos and Veronesi (2010) show that stocks with a high book-to-market ratio have similar betas compared to stocks with a low book-to-market ratio and the difference in expected returns cannot be explained by a difference in beta
A new default measure
Summary
There is widespread evidence that stocks with a high book-to-market ratio (so-called value stocks) have higher expected returns compared to stocks with a low book-to-market ratio (so-called growth stocks). In contrast to the “efficient market” interpretation, the “mispricing” hypothesis holds that high B/M stocks represent neglected stocks, leading to “pessimistic” expectations about future performance (Lakonishok et al 1994), as evidenced by positive earnings surprises at subsequent quarterly earnings announcements (LaPorta et al 1997). This explanation is in line with the investment advice of Graham and Dodd (1934)
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