Essay About Risk Of Bankruptcy A Systematic Risk And Firm Distress Risk Factor

Is The Risk Of Bankruptcy A Systematic Risk?
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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 prediction that provides powerful measures of ex ante bankruptcy
risk ~see Altman ~1993! for a review!. Evidence that bankruptcy risk
is systematic would support a distress factor explanation for the size and the
book-to-market effects.
Existing evidence on the relation of bankruptcy risk to systematic risk is
mostly circumstantial and often contradictory. Lang and Stulz ~1992! and
Denis and Denis ~1995! demonstrate that bankruptcy risk is related to aggregate
factors, which implies that bankruptcy risk could be positively related to systematic risk. Shumway ~1996! finds that NYSE and AMEX firms with
high risk of exchange delisting for performance reasons earn higher than
average returns, suggesting that the risk of default is systematic. However,
Opler and Titman ~1994! and Asquith, Gertner, and Sharfstein ~1994! find
that bankruptcy is mostly due to idiosyncratic factors, which suggests that
bankruptcy risk is unrelated to systematic risk. Interestingly, Altman ~1993!
finds that the bonds of the most distressed firms ~defined as high-yielding
bonds! earn lower than average subsequent returns, consistent with bankruptcy
risk being negatively related to systematic risk.
This study presents more direct and comprehensive evidence about the
relation between bankruptcy risk and systematic risk. Measures of bankruptcy
risk are derived from existing models of bankruptcy prediction ~Altman
~1968! and Ohlson ~1980!! which have been widely used in other research
and in practice. Systematic risk is proxied by subsequent realized returns.
As hypothesized in other studies, simple correlations reveal that bankruptcy
risk is negatively related to firm size and positively related to book-to-market.
Thus, bankruptcy risk could potentially account for the size and the book-tomarket
effects if bankruptcy risk is a systematic risk priced into returns.
However, a further investigation reveals several findings that are inconsistent
with a distress explanation for the size and the book-to-market effects.
First, the main result of this study is that bankruptcy risk is not
rewarded by higher returns. Surprisingly, firms with high bankruptcy risk
earn significantly lower than average returns since 1980.1 Second, the relation
between bankruptcy risk and book-to-market is not monotonic: distressed
firms generally have high book-to-market but the most distressed
firms have lower book-to-market. Thus, a return premium related to bankruptcy
risk cannot fully explain the book-to-market effect even if distress
were rewarded by higher returns. Third, this study finds that the size effect,
strong in the 1960s and 1970s, has virtually disappeared since 1980 ~see
also Fama and French ~1992! and Roll ~1995!!. Although the disappearance
of the size effect is somewhat of a puzzle, pre-1980 evidence suggests that
there is no reliable relation between bankruptcy risk and returns that could