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Value premium and default risk

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Abstract

This article investigates the relationship between value premium and financial distress using a long US data set over 1927–2011. The measures of leverage and default are used as proxies for financial distress when applying a time-varying volatility methodology. The article examines the potential risk-based explanation for the source of the value premium. The empirical analysis shows that both the default premium and its volatility have positive explanatory power for the value premium and its volatility. The findings suggest a negative association between the lagged values of the default premium and the current small stocks value premium. Investigating the reasons behind this association uniquely uncovers an asymmetric correlation between returns on both value and growth stocks and default risk before and post July 1954 after a change in the monetary regime in the United States.

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Notes

  1. Black (2006) investigates the relationship between default risk and value premium volatilities using quarterly data. Our analysis expands to investigate the association between the variables themselves in addition to their volatilities using longer and higher frequent set of data.

  2. Elgammal and Al-Najjar (2013) report leverage effects in the monthly value premium in the US, Canada, Denmark, Finland, New Zealand, Sweden, the UK and Poland stock markets during the period of December 1991 to December 2006. The leverage effect is well documented in the literature (for more details and evidence, see Christie, 1982; Ivaschenko, 2003; Bollerslev et al, 2006; Penman et al, 2007).

  3. Campbell et al (2008) argue that the previous researchers’ results for the returns on financial distressed stocks depend on the used measure of financial distress. For example, the low returns of distressed stocks are also documented by Dichev (1998), who uses Altman’s Z-score and Ohlson’s O-score to measure financial distress; Garlappi and Yan (2011), who obtain default risk measures from Moody’s KMV; and Avramov et al (2009), who use credit ratings to measure firms’ financial status. On the other hand, Vassalou and Xing (2004) find evidence that distressed stocks with a low distance to default have higher returns, but this evidence comes entirely from small value stocks.

  4. As Penman et al (2007) mention, the Black-Scholes-Merton measure potentially uses more information compared with the O-score and Z-score measures, which are limited to accounting information. However, it is based on equity prices, introducing some concern as to whether inefficient prices are conjectured.

  5. I thank Kenneth French for making the data available on his website: http://mba.tuk.dratmouth.edu/pages/ken.french/.

  6. The Structural break tests of both Chow’ Breakpoint Test and The CUSUM Test, the cumulative sum of the recursive residuals (Brown et al, 1975); results are available on request.

  7. Penman et al (2007) argue that this association is consistent with inverse relationship founded between future returns and wide variety of financial distress measures in different context. They introduce an extensive discussion for the work in this area (for example, they have interesting discussion for the work of Dichev, 1998; Griffin and Lemmon, 2002, and Campbell et al, 2008).

  8. This period is described by NBER as the last expansion period in the US economy (NBER, 11 December 2008, http://www.nber.org/cycles/dec2008.pdf). The last liquidity period of July 2007 to June 2009 is included in the analysis but the results are not significant for this period. The results are available on request.

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Acknowledgements

The authors thank Angela Black, Ercan Balaban, Ken Peasnell, David Shepherd, Alison Rieple, Linda Clarke, Petia Petrova, the participants at the 2008 ICAS/BAA Accounting & Finance Scot-doc Conference in Glasgow and the 2013 BAFA conference in Newcastle as well as Panagiotis Dontis-Charitos, Ben Nowman, Sheeja Sivaprasad, Stefan Van Dellen and all other participants at a 2011 research seminar of Westminster Business School in London for their useful comments and advice on earlier versions of this article. Furthermore, we are grateful to the anonymous referees from the World Finance Conference, Rhodes (Greece), June (2011) for accepting the article in the conference and for their helpful comments. The authors alone are responsible for all limitations and errors that may relate to the article.

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Authors and Affiliations

  1. College of Business and Economics, Qatar University, Doha, Qatar

    Mohammed M Elgammal

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  1. Mohammed M Elgammal
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  2. David G McMillan
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Correspondence to Mohammed M Elgammal.

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1has worked for the past 18 years in Egypt, the United Kingdom and Qatar Academia. He has worked in International Commercial Bank, Menoufia University, Aberdeen University, Westminster University and Qatar University. He has many publications in different areas of finance, including Financial Predictors of Credit Ratings, Liquidity Crisis, Financial Distress, market anomalies, corporate governance, bank performance and macroeconomic risk factors. He has been awarded research grant from different internationally respected organizations, including Qatar University, Egyptian Government, Suez Canal University, Economic and Social Research Council and Qatar National Research Foundation.

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Elgammal, M., McMillan, D. Value premium and default risk. J Asset Manag 15, 48–61 (2014). https://doi.org/10.1057/jam.2014.10

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