default risk resulted in unexpected findings, i.e. firms with higher default risk seem to underperform firms with lower default risk in the next period. But then why would investors expose themselves to this type of risk if they do not get any compensation in return? We are the first paper in this literature to point out that traditional measures of default risk are not necessarily good measures of exposure to the systematic component of default risk. Think about CAPM beta vs. the firm’s return volatility: For which of these measures do you expect to get compensation? Theoretically you would expect a premium due to your co-variation with the market , i.e. you’d get a premium based on your CAPM-beta not based on your return volatility, i.e. a firm can have very volatile returns but these returns may co-vary very little with the market returns. Similarly a firm may have a high expected default probability but this default probability may not be correlated with the default likelihoods of other firms in the market. And if that is the case (a high default probability with little correlation with other defaults in the market) then the investor wouldn’t necessarily be compensated for this firm-specific risk. In this paper we devise a method to better understand a firm’s covariation with the common default risk factor rather than blindly using a firm’s real world probability of default.
Is there a distress risk anomaly? Pricing of default risk in the cross-section of equity returns
Çelim Yıldızhan, Research & Ideas