Abstract
Fama and French (1996) conjectured that their HML factor represents financial distress risk. In contrast, Vassalou and Xing (2004) find that the return on a portfolio of stocks with high default risk is too high to be explained by the HML factor loading. We reconcile the Vassalou and Xing finding with the Fama and French conjecture. We show that the HML factor does represent financial distress risk; the large positive return on the high default risk portfolio in Vassalou and Xing is related to the first month reversal phenomenon documented in the momentum literature and liquidity risk.
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