Equity Returns, Bankruptcy Risk and Asset Pricing Models

Abstract

Empirical tests of the capital asset pricing model (CAPM) have shown that movements in a single factor market index poorly explain returns on individual securities. Assuming that a possible reason is the existence of pricing anomalies, more recent research has extended the model by adding new factors to explain systematic variations in stock returns and achieved significant results. In particular, securities with high book to market ratios (book equity divided by market equity, BE/ME) appear to command a value premium. Notwithstanding considerable empirical evidence, there is no definitive theoretical explanation for what remains an anomaly. One suggestion is that the BE/ME premium compensates for the systematic risk associated with financial distress. To explore this proposition, this paper examines the behaviour of CAPM and three-factor models when tested using portfolios that face bankruptcy risk. To define bankruptcy risk, measures in the UK that parallel the work of Altman (1968) z-score model such as Lis (1972) are used and the period under consideration is 1981-1999. An additional factor is then created, defined as a value weighted portfolio of returns of firms likely to go bankrupt minus firms predicted not to go bankrupt. The significance of this variable is also assessed. The results show that the three-factor model provides a better explanation of equity returns than other models. The additional independent variable is significant for the CAPM model but becomes insignificant under the three-factor model. Monthly returns in excess of the one month t-bill tend to be lower for firms facing bankruptcy risk than other portfolios. The portfolio of firms facing high risk of bankruptcy has lower market value and book-to-market value than other portfolios although it still loads relatively high on the BE/ME variable implying that the BE/ME variable is a proxy for relative distress.