A Bankruptcy Risk Factor

Abstract

This paper introduces a factor based on an estimated probability of bankruptcy — a measure of the risk a typical investor will lose their investment, or the cost of insuring that investment. Using an underlying model of firm bankruptcy built as a sequence of two random forests, I demonstrate my bankruptcy risk factor has predictive power in equity, bond, option and credit default swap markets earning statistically significant monthly returns of 0.23%, 0.15%, 1.97% and 1.04%, respectively, in all four markets. In markets with existing common factors I find statistically significant alpha with respect to these factors.

Keywords: Anomaly Factor, Random Forest, Bankruptcy Risk, Cross-Section, Asset Pricing, Bonds, Options, Credit Default Swaps

JEL Classification: G11, G12, G32