Abstract

This is the first study that computes default measures for individual firms using Merton’s (1974) option pricing model, to assess the effect that default risk has on equity returns. We find that equally-weighted portfolios of stocks with high default probability earn significantly higher returns than equally-weighted portfolio of stocks with low default probability. In addition, both the size and book-to-market effects are present only within the portfolio of stocks with the highest default probabilities. Once stocks with the 30 % highest default probabilities are excluded from the sample, both size and B/M effects disappear. We also find that default risk is priced and can explain part of the cross-sectional variation in returns. The Fama-French factors SMB and HML, and particularly SMB, contain some default-related information, although it appears that this information is not the driving force behind the success of the Fama-French model. Keywords: default risk, equity returns, Merton’s (1974) model, size and book-to-market. JEL classification: G33, G12 1

Citations