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.
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