Abstract
I examine the two components of default risk and how they relate to stock returns, size, and book-to-market. High default risk firms do not necessarily have high levels of systematic asset risk. I show that the two components of default risk, asset volatility and leverage, are negatively related. I provide evidence that leverage differences across firms are not reflected in equity betas. Therefore, I construct firm returns using estimates of firm’s debt returns. The results indicate that a large part of the value premium and some of the size premium can be explained by differences in leverage across firms.
Highlights
In this paper, I examine the relationship between the components of default risk and how they relate to the size and value factors in stock returns
The results indicate that a large part of the value premium and some of the size premium can be explained by differences in leverage across firms
The results in this paper establish that the separation of the components of default risk is an important step in understanding the relationship between stock returns, book-tomarket, and size
Summary
I examine the relationship between the components of default risk and how they relate to the size and value factors in stock returns. I show that the value premium in the cross-section of firm returns is no longer significant as a pricing factor This is strong empirical evidence that leverage is driving the value premium and since leverage is directly related to default risk, this mechanically connects the two measures and their relationship to stock returns. I examine the relationship between beta, leverage, asset volatility, default risk, size, book-to-market, and stock returns. I examine the differences in the cross-section of equity and firm returns and how they relate to default risk, size, and book-to-market. I use this estimate of asset return volatility to control for asset risk when examining leverage and beta in the cross-section. The short-term government bond index and the equal-weighted CRSP stock index are negatively related in the recent sub-sample
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