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Leverage, Default Risk, and the Cross-Section of Equity and Firm Returns

DOI: 10.4236/me.2016.714143, PP. 1610-1639

Keywords: Default Risk, Distress Risk, Beta Estimation, Value Premium

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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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