Author(s)

Frederick M. Hood III

College of Business, Iowa State University, Ames, USA.

I examine the two components of default risk and how they relate to stock returns, size, and book-to-market. High default risk firms do not necessarily have high levels of systematic asset risk. I show that the two components of default risk, asset volatility and leverage, are negatively related. I provide evidence that leverage differences across firms are not reflected in equity betas. Therefore, I construct firm returns using estimates of firm’s debt returns. The results indicate that a large part of the value premium and some of the size premium can be explained by differences in leverage across firms.

Default Risk, Distress Risk, Beta Estimation, Value Premium

Hood III, F. (2016) Leverage, Default Risk, and the Cross-Section of Equity and Firm Returns. Modern Economy, 7, 1610-1639. doi: 10.4236/me.2016.714143.