Default Risk and Cross Section of Returns

J. Risk Financial Manag. 2019, 12, 95; doi:10.3390/jrfm12020095

15 Pages Posted: 17 Jun 2019

See all articles by Nusret Cakici

Nusret Cakici

Fordham University

Sris Chatterjee

Fordham University - Gabelli School of Business

Ren-Raw Chen

affiliation not provided to SSRN

Date Written: June 6, 2019

Abstract

Prior research uses the basic one-period European call-option pricing model to compute default measures for individual firms and concludes that both the size and book-to-market effects are related to default risk. For example, small firms earn higher return than big firms only if they have higher default risk and value stocks earn higher returns than growth stocks if their default risk is high. In this paper we use a more advanced compound option pricing model for the computation of default risk and provide a more exhaustive test of stock returns using univariate and double-sorted portfolios. The results show that long/short hedge portfolios based on Geske measures of default risk produce significantly larger return differentials than Merton’s measure of default risk. The paper provides new evidence that mediates between the rational and behavioral explanations of value premium.

Keywords: risk management; default risk; option pricing

JEL Classification: G12, G13, G15

Suggested Citation

Cakici, Nusret and Chatterjee, Sris and Chen, Ren-Raw, Default Risk and Cross Section of Returns (June 6, 2019). J. Risk Financial Manag. 2019, 12, 95; doi:10.3390/jrfm12020095. Available at SSRN: https://ssrn.com/abstract=3400074

Nusret Cakici (Contact Author)

Fordham University ( email )

Fordham University
Graduate School of Business
New York, NY 10023
United States
2126366776 (Phone)

Sris Chatterjee

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
New York, NY 10023
United States

Ren-Raw Chen

affiliation not provided to SSRN

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