Tracking Down Distress Risk

44 Pages Posted: 15 Aug 2009 Last revised: 15 Jun 2010

See all articles by Nishad Kapadia

Nishad Kapadia

Tulane University - Finance & Economics

Date Written: June 14, 2010


This paper shows that exposure to aggregate distress risk is the underlying source of the premiums for the Fama-French size (SMB) and value (HML) factors. Using a unique dataset of aggregate business failures of both private and public firms from 1926 to 1997, I build portfolios that track news about future firm failures. These tracking portfolios optimally hedge aggregate distress risk and earn a CAPM alpha of approximately -4% a year. Both HML and SMB predict changes in future failure rates. Small stocks have lower returns than large stocks and value stocks have lower returns than growth stocks when the market expects an increase in future failure rates. Finally, a two-factor model with the market and the tracking portfolio for aggregate distress as factors does as well as the Fama-French three-factor model in pricing the 25 size and book-to-market sorted portfolios and 30 industry sorted portfolios.

Keywords: distress risk, value, growth, bankruptcy

JEL Classification: G11, G12, G32, G33

Suggested Citation

Kapadia, Nishad, Tracking Down Distress Risk (June 14, 2010). Available at SSRN: or

Nishad Kapadia (Contact Author)

Tulane University - Finance & Economics ( email )

A.B. Freeman School of Business
7 McAlister Drive
New Orleans, LA 70118
United States
504-314-7454 (Phone)

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