Is the Risk of Bankruptcy a Systematic Risk?
ILIA D. DICHEV*
ABSTRACT
Several studies suggest that a firm distress risk factor could be behind the size
and the book-to-market effects. A natural proxy for firm distress is bankruptcy
risk. If bankruptcy risk is systematic, one would expect a positive association between
bankruptcy risk and subsequent realized returns. However, results demonstrate
that bankruptcy risk is not rewarded by higher returns. Thus, a distress
factor is unlikely to account for the size and book-to-market effects. Surprisingly,
firms with high bankruptcy risk earn lower than average returns since 1980. A
risk-based explanation cannot fully explain the anomalous evidence.
SEVERAL STUDIES SUGGEST that the effects of firm size and book-to-market,
probably the two most powerful predictors of stock returns, could be related
to some sort of a firm distress risk factor. For example, Chan and Chen
~1991! find that "marginal" firms, or inefficient firms with high leverage
and cash flow problems, seem to drive the small firm effect. Fama and French
~1992! conjecture that the book-to-market effect might be due to the risk of
distress. Chan, Chen, and Hsieh ~1985! show that much of the size effect is
explained by a default factor, computed as the difference between high-grade
and low-grade bond returns. Fama and French ~1993! and Chen, Roll, and
Ross ~1986! find that a similarly defined default factor is significant in explaining
stock returns.
This study investigates the importance of the firm distress risk factor and
its relation to size and book-to-market effects. Probability of bankruptcy is a
natural proxy for firm distress, and there is a well-developed literature on
bankruptcy pr ...