Default Risk in Equity Returns


  • Maria Vassalou,

  • Yuhang Xing

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    • Vassalou is at Columbia University and Xing is at Rice University. This paper was presented at the 2002 Western Finance Association Meetings in Park City, Utah; at London School of Economics; Norwegian School of Management; Copenhagen Business School; Ohio State University; Dartmouth College; Harvard University (Economics Department); the 2003 NBER Asset Pricing Meeting in Chicago; and the Federal Reserve Bank of New York. We would like to thank John Campbell, John Cochrane, Long Chen (WFA discussant), Ken French, David Hirshleifer, Ravi Jagannathan (NBER discussant), David Lando, Lars Tyge Nielsen, Lubos Pastor, Jay Ritter, Jay Shanken, and Jeremy Stein for useful comments. Special thanks are due to Rick Green and an anonymous referee for insightful comments and suggestions that greatly improved the quality and presentation of our paper. We are responsible for any errors.


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.