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Financial distress and equity returns: A leverage-augmented three-factor model

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  • Boubaker, Sabri
  • Hamza, Taher
  • Vidal-García, Javier

Abstract

Our study examines whether financial distress risk is systematic risk using twelve portfolios sorted by size, book-to-market, and leverage and a portfolio of distressed firms covering an 18-year period. It also tests the explanatory power of the risk factors that best capture default risk. The empirical findings show that: (i) equity portfolio investment requires systematically both size and value premiums and that SMB and HML capture additional risk missed by the market portfolio; (ii) the leverage risk premium is positive for highly leveraged firms; and (iii) the risk premium for the relative distress factor is significant only for the distressed firm portfolio. Overall, our results have practical implications for portfolio managers since they advocate a leverage-augmented three-factor model to accurately price assets and to implement efficient portfolio strategies.

Suggested Citation

  • Boubaker, Sabri & Hamza, Taher & Vidal-García, Javier, 2018. "Financial distress and equity returns: A leverage-augmented three-factor model," Research in International Business and Finance, Elsevier, vol. 46(C), pages 1-15.
    • Handle: RePEc:eee:riibaf:v:46:y:2018:i:c:p:1-15
    DOI: 10.1016/j.ribaf.2016.09.003
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    More about this item

    Keywords

    Financial distress; Equity returns; Fama-French three-factor model;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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