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Is the Risk of Bankruptcy a Systematic Risk? Is the Risk of Bankruptcy a Systematic Risk? ILIA D. DICHEV* ABSTRACT Several studies suggest that a firm distress risk
of a costly bankruptcy, the value of the firm was assumed to depend solely on the level and risk of a firm's operating cash flows. And operating profitability in
and Northwest following the 9/11 attacks. We then analyze how the 9/11 events impacted the risk, that is, the systematic and unsystematic volatility of the airlines'
especially if a firm's risk changes over time and if the firm's operations are opaque to outsiders. Outside investors can estimate the systematic risk of the firm
risk is variations in total market returns affecting all assets; systematic risk is measured by an asset's beta coefficient (reflecting the asset's correlation with
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Is the Risk of Bankruptcy a Systematic Risk?
ILIA D. DICHEV*
ABSTRACT
Several studies suggest that a firm distress risk factor could be behind the size
and the book-to-market effects. A natural proxy for firm distress is bankruptcy
risk. If bankruptcy risk is systematic, one would expect a positive association between
bankruptcy risk and subsequent realized returns. However, results demonstrate
that bankruptcy risk is not rewarded by higher returns. Thus, a distress
factor is unlikely to account for the size and book-to-market effects. Surprisingly,
firms with high bankruptcy risk earn lower than average returns since 1980. A
risk-based explanation cannot fully explain the anomalous evidence.
SEVERAL STUDIES SUGGEST that the effects of firm size and book-to-market,
probably the two most powerful predictors of stock returns, could be related
to some sort of a firm distress risk factor. For example, Chan and Chen
~1991! find that "marginal" firms, or inefficient firms with high leverage
and cash flow problems, seem to drive the small firm effect. Fama and French
~1992! conjecture that the book-to-market effect might be due to the risk of
distress. Chan, Chen, and Hsieh ~1985! show that much of the size effect is
explained by a default factor, computed as the difference between high-grade
and low-grade bond returns. Fama and French ~1993! and Chen, Roll, and
Ross ~1986! find that a similarly defined default factor is significant in explaining
stock returns.
This study investigates the importance of the firm distress risk factor and
its relation to size and book-to-market effects. Probability of bankruptcy is a
natural proxy for firm distress, and there is a well-developed literature on
bankruptcy prediction that provides powerful measures of ex ante bankruptcy
risk ~see Altman ~1993! for...
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