Value Premium And Distress Risk

While there are many studies demonstrating a link between the value premium and risk, the empirical evidence draws inconsistent conclusions on whether distress risk is a systematic risk factor that is priced in the cross section of stock returns.

There are studies that conclude that default risk is positively priced in the stock market, and that a large portion of the book-to-price effect can be attributed to default risk. For example, the 2010 study “Anomalies and Financial Distress” found that value strategies derive their profitability from taking long positions in high-credit-risk firms that are prone to distress risk, survive it and subsequently go on to earn high returns.

On the other hand, there are also papers that find a negative relation between distress risk and equity returns; stocks with higher levels of distress risk as measured by models earn low returns.

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