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Essay / Is the risk of bankruptcy a systematic risk? - 1488
Is the risk of bankruptcy a systematic risk? Several studies suggest that a risk factor for corporate distress could be at the origin of size and book-to-market effects. Bankruptcy risk is a natural indicator of business distress. If bankruptcy risk is systematic, one would expect a positive association between bankruptcy risk and subsequent realized returns. However, the results demonstrate that bankruptcy risk is not rewarded with higher returns. It is therefore unlikely that a distress factor explains the size and market value effects. Surprisingly, companies with high bankruptcy risk have had below-average returns since 1980. A risk-based explanation cannot fully explain these anomalies. SEVERAL STUDIES SUGGEST that the effects of firm size and book-to-market, probably the two most powerful indicators of stock returns, may be linked to some sort of risk factor for firm distress. For example, Chan and Chen ~1991! find that “marginal” firms, or inefficient firms with high debt and cash flow problems, appear to be driving the small firm effect. Fama and French ~1992! We can assume that the book-to-market effect could be due to the risk of difficulties. Chan, Chen and Hsieh ~1985! show that a large part of the size effect is explained by a default factor, calculated as the difference between the yields of higher and lower quality bonds. Fama and French ~1993! and Chen, Roll and Ross ~1986! find that a similarly defined default factor is important in explaining stock returns. This study examines the importance of the risk factor of firm distress and its relationship with size and book-to-market effects. The probability of bankruptcy is a natural indicator of a firm's distress, and there is a well-developed literature on bankruptcy forecasting that provides powerful measures of ex ante bankruptcy risk ~ see Altman ~ 1993! for a review!. Evidence that bankruptcy risk is systematic would support the hypothesis of a distress factor explaining size and book value effects in the market. Existing evidence on the relationship between bankruptcy risk and systematic risk is mostly circumstantial and often contradictory. Lang and Stulz ~1992! and Denis and Denis ~1995! demonstrate that bankruptcy risk is linked to global factors, implying that bankruptcy risk could be positively related to systematic risk. Shumway ~ 1996! finds that NYSE and AMEX companies at high risk of delisting for performance reasons achieve above-average returns, suggesting that default risk is systematic. However, Opler and Titman ~1994! and Asquith, Gertner and Sharfstein ~1994! find that bankruptcy is mainly due to idiosyncratic factors, suggesting that bankruptcy risk is not related to systematic risk.