Are the Fama-French Factors Really Compensations for Distress Risk?

Abstract

In this paper, we revisit the question whether the Fama-French factors are manifestations of distress risk premiums. To this end, we develop new tests specifically aimed at dissecting the Fama-French factor returns from a distress risk premium. While we find that small-cap and value exposures are typically associated with distress risk, our results also indicate that distress risk is not priced and that the small-cap and value premiums are priced beyond distress risk. Moreover, the distress risk exposures of common small-cap and value factors do not have explanatory power in asset pricing tests. Our results have important implications for investors engaging in small-cap and value strategies.

Keywords: book-to-market effect, value anomaly, market efficiency, default risk, bankruptcy, credit spread, bond spread, distress risk, credit rating, size effect

JEL Classification: G11, G12, G14