TITLE:
Leverage, Default Risk, and the Cross-Section of Equity and Firm Returns
AUTHORS:
Frederick M. Hood III
KEYWORDS:
Default Risk, Distress Risk, Beta Estimation, Value Premium
JOURNAL NAME:
Modern Economy,
Vol.7 No.14,
December
14,
2016
ABSTRACT: 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.