Relation between distress risk, book‐to‐market ratio and return premium

Abstract

Purpose

Earlier research found that firms with the highest distress risk have low book‐to‐market (B/M) ratios and low returns. This paper aims to examine the robustness of those's results and provide further evidence that high distress‐risk firms do not enjoy the same high returns earned by high B/M firms and that distress risk is unlikely to explain the Fama and French high‐minus‐low (HML) B/M factor.

Design/methodology/approach

A distress‐risk measure, distressed‐minus‐solvent (DMS), is calculated and a range of zero investment distress‐risk trading strategies is investigated. Value‐ and equal‐weighted portfolios are examined both with negative book‐equity firms and without. These most distressed firms have low or negative B/M values and would either not be included in the Fama and French sample or included in the low B/M portfolio.

Findings

The paper finds that the DMS factor is negative and significant, and none of the zero investment strategies earns significantly positive returns.

Research limitations/implications

The findings suggest that exposure to distress risk does not earns investors a positive risk premium. It appears that over the period examined, market inefficiencies drive the market value and returns of high distress‐risk firms.

Originality/value

The distress‐risk premium is shown to be negative and, therefore, cannot be driven by bankruptcy risk alone. The negative premium is not consistent with a financial distress explanation for the Fama and French HML factor.

Citation

Zaretzky, K. and Kenton Zumwalt, J. (2007), "Relation between distress risk, book‐to‐market ratio and return premium", Managerial Finance, Vol. 33 No. 10, pp. 788-797. https://doi.org/10.1108/03074350710779232