Pricing Default Risk: The Good, The Bad, and The Anomaly

Posted: 3 Feb 2014 Last revised: 16 Oct 2016

See all articles by Sara Ferreira Filipe

Sara Ferreira Filipe

Luxembourg School of Finance

Theoharry Grammatikos

Luxembourg School of Finance

Dimitra Michala

Luxembourg School of Finance

Date Written: October 1, 2016

Abstract

While empirical literature has documented a negative relation between default risk and stock returns, theory suggests that default risk should be positively priced. In this paper, we calculate monthly probabilities of default (PDs) for a large sample of European firms and break them down into systematic and idiosyncratic components. The approach that we follow does not require data on credit spreads, thus it can also be applied to small firms that do not have such data available. In accordance with theory, we find that the systematic part, measured as the PD sensitivity to aggregate default risk, is positively related to stock returns. We show that stocks with higher PDs underperform because they have, on average, higher idiosyncratic risk. Finally, small and value stocks are quite heterogeneous with respect to their exposure to aggregate default risk.

Keywords: default risk; Merton model; default anomaly; idiosyncratic risk

JEL Classification: G11, G12, G15, G33

Suggested Citation

Ferreira Filipe, Sara and Grammatikos, Theoharry and Michala, Dimitra, Pricing Default Risk: The Good, The Bad, and The Anomaly (October 1, 2016). Journal of Financial Stability, Vol. 26, No. 1, 2016, Available at SSRN: https://ssrn.com/abstract=2389717 or http://dx.doi.org/10.2139/ssrn.2389717

Sara Ferreira Filipe

Luxembourg School of Finance ( email )

4 Rue Albert Borschette
Luxembourg, L-1246
Luxembourg
(+352) 46 66 44 5838 (Phone)
(+352) 46 66 44 6835 (Fax)

HOME PAGE: http://www.lsf.lu/

Theoharry Grammatikos

Luxembourg School of Finance ( email )

4 Rue Albert Borschette
Luxembourg, L-1246
Luxembourg

Dimitra Michala (Contact Author)

Luxembourg School of Finance ( email )

2b, Rue Albert Borschette
Luxembourg, L-1246
Luxembourg
+352 4666446805 (Phone)

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