This is the first study that uses Merton's (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the book-to-market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama–French (FF) factors SMB and HML contain some default-related information, but this is not the main reason that the FF model can explain the cross section of equity returns.