Corporate Failure and the Business Cycle: Measuring Systematic Risk

• In Event: Risk and Risk Management

Abstract

Using firm fundamentals, we develop a forward-looking measure of systematic risk associated with corporate failure. Our measure is consistent with standard asset pricing theory and is equal to the ratio of probabilities of failure in recession to failure in expansion. We validate the measure using two predictions from a stylized model. First, for a given probability of failure, expected returns should increase in our measure. Second, the resulting spread in returns should be larger for more distressed stocks. We find support for both predictions. For stocks in the top quintile of distress, a median hedge portfolio based on our measure generates 10%-12% per annum, suggesting that our approach successfully extracts risk information from accounting data. Our findings have important implications for the literature on distress risk that, despite compelling theoretical arguments, finds little evidence of a distress risk premium. Instead, it documents the distress anomaly—a negative correlation between the probability of failure and future stock returns. Our results suggest that distress risk is priced. However, a firm’s risk exposure depends on the phase of the business cycle in which a firm is more likely to fail.

Authors

• Maria Ogneva, University of Southern California

• Joseph Piotroski, Stanford University

• Anastasia Zakolyukina, University of Chicago