Is Default Risk Negatively Related to Stock Returns?

Posted: 17 May 2010

See all articles by Sudheer Chava

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business

Amiyatosh Purnanandam

University of Michigan, Stephen M. Ross School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: June 2010

Abstract

We find a positive cross-sectional relationship between expected stock returns and default risk, contrary to the negative relationship estimated by prior studies. Whereas prior studies use noisy ex post realized returns to estimate expected returns, we use ex ante estimates based on the implied cost of capital. The results suggest that investors expected higher returns for bearing default risk, but they were negatively surprised by lower-than-expected returns on high default risk stocks in the 1980s. We also extend the sample compared with prior studies and find that the evidence based on realized returns is considerably weaker in the 1952-1980 period.

Keywords: G11, G12, G13, G14, G33

Suggested Citation

Chava, Sudheer and Purnanandam, Amiyatosh, Is Default Risk Negatively Related to Stock Returns? (June 2010). The Review of Financial Studies, Vol. 23, Issue 6, pp. 2523-2559, 2010. Available at SSRN: https://ssrn.com/abstract=1607509 or http://dx.doi.org/10.1093/rfs/hhp107

Sudheer Chava (Contact Author)

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

HOME PAGE: http://www.prism.gatech.edu/~schava6/

Amiyatosh Purnanandam

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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