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Tracking down distress risk

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  • Kapadia, Nishad

Abstract

This paper shows that exposure to aggregate distress risk is the underlying source of the premiums for the Fama-French size (SMB) and value (HML) factors. Using a unique data set of aggregate business failures of both private and public firms from 1926 to 1997, I build portfolios that track news about future firm failures. These tracking portfolios optimally hedge aggregate distress risk and earn a Capital Asset Pricing Model (CAPM) alpha of approximately -4% a year. Both HML and SMB predict changes in future failure rates. Small stocks have lower returns than large stocks and value stocks have lower returns than growth stocks when the market expects an increase in future failure rates. Finally, a two-factor model with the market and the tracking portfolio for aggregate distress as factors does as well as the Fama-French three-factor model in pricing the 25 size and book-to-market sorted portfolios.

Suggested Citation

  • Kapadia, Nishad, 2011. "Tracking down distress risk," Journal of Financial Economics, Elsevier, vol. 102(1), pages 167-182, October.
    • Handle: RePEc:eee:jfinec:v:102:y:2011:i:1:p:167-182
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