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In Search of Distress Risk

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In this article, the authors study the pricing of distress risk in equity returns. They use a set of firm characteristics such as leverage, profitability, market cap, stock returns and volatility, cash holdings, market-to-book ratio and stock price to predict default. 

They use a logit model to estimate the probability of bankruptcy or failure. They use data from Kamakura Risk Information Services, Compustat and CRSP from January 1963 to December 2003.

They find that all the variables are significant with the correct sign. As they extend the horizon of the default forecast, they find that market capitalization and equity volatility become the most important variables. Their reduced form model seems to be more accurate than a structured credit model. 

They proceed to look at the risk and returns on distressed stocks (high likelihood of failure). Previous research has documented that returns are high (Vassalou and Xing 2004, using Merton style distance to default) or low (for instance Dichev 1998 using accounting information). Since they have a better model to predict default they hope to get more robust findings on the effect on equity returns.

Specifically, they look at 12-month equity returns of value-weighted portfolios ranked on their 12-month conditional default probabilities. Stocks with high default risk have lower returns but positively skewed returns. Interestingly, the stocks in the high default risk portfolio are volatile and small.    

The factor loadings on the equity market, the Fama and French (FF) HML and SMB factors are high and positive especially on the SMB factor. Even after controlling for the FF factors, they find the alphas of the portfolios are decreasing with distress risk. Their results do not change when results are first sorted on firm characteristics such as book-to-market, size or distance-to-default.

In their conclusions, they discuss several explanations:

-  Underreaction to negative news

-  Private benefits of shareholders that compensate for the low returns

Preference for positively skewed stocks

- Transition in this sample of asset holdings from individual investors to institutional investors (who prefer “safe’” stocks and probably large stocks)

We think  the institutional explanation is reasonable (large institutional investors cannot load small cap stocks). The preference for lottery stocks (positively skewed distribution) is also a strong contender. The payoff of holding these stocks is similar to holding cheap call options with limited downside and potentially large returns when the stock recovers. 

Campbell, John Y., Hilscher, Jens and Szilagyi, Jan, "In Search of Distress Risk" . Harvard Institute of Economic Research Discussion Paper No. 2081 Available at SSRN:

Dichev , Ilia,  “Is the Risk of Bankruptcy a Systematic Risk?”, The Journal of Finance, Vol. 53, No. 3 (Jun., 1998), pp. 1131-1147

Vassalou, Maria and Yuhang Xing, 2004, “Default risk in equity returns”, Journal of Finance 59:831-868.




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