Journal of

Risk and
Financial
Management

Article
Default Risk and Cross Section of Returns
Nusret Cakici *, Sris Chatterjee and Ren-Raw Chen
Gabelli School of Business, Fordham University, New York, NY 10023, USA; [email protected] (S.C.);
[email protected] (R.-R.C.)
* Correspondence: [email protected]
check Eor
Received: 7 May 2019; Accepted: 4 June 2019; Published: 6 June 2019 updates

Abstract: Prior research uses the basic one-period European call-option pricing model to compute
default measures for individual firms and concludes that both the size and book-to-market effects
are related to default risk. For example, small firms earn higher return than big firms only if they
have higher default risk and value stocks earn higher returns than growth stocks if their default
risk is high. In this paper we use a more advanced compound option pricing model for the
computation of default risk and provide a more exhaustive test of stock returns using univariate
and double-sorted portfolios. The results show that long/short hedge portfolios based on Geske
measures of default risk produce significantly larger return differentials than Merton’s measure of
default risk. The paper provides new evidence that mediates between the rational and behavioral
explanations of value premium.

Keywords: risk management; default risk; option pricing

1. Introduction
There is widespread evidence that stocks with a high book-to-market ratio (so-called value
stocks) have higher expected returns compared to stocks with a low book-to-market ratio (so-called
growth stocks)1. However, there is disagreement regarding the economic reason behind this
difference in returns. The out-performance of value stocks has been attributed to compensation for
higher risk by Fama and French(1992), an interpretation that is supported by the consistently low
return on high B /M stocks (Fama and French1995andPenman1991), as well as the high correlation
between B /M, leverage, and other measures of financial risk (Fama and French1992;Chen and
Zhang1998andVassalou and Xing2004). However,Santos and Veronesi(2010) show that stocks with a
high book-to-market ratio have similar betas compared to stocks with a low book-to-market ratio
and the difference in expected returns cannot be explained by a difference in beta. In contrast to the
“efficient market” interpretation, the “mispricing” hypothesis holds that high B/M stocks represent
neglected stocks, leading to “pessimistic” expectations about future performance (Lakonishok et
al.1994), as evidenced by positive earnings surprises at subsequent quarterly earnings
announcements (LaPorta et al.1997 ). This explanation is in line with the investment advice ofGraham
and Dodd(1934).
The risk-based explanation of the value premium has been questioned by some authors. Novy-
Marx(2013) shows that gross profitability has roughly the same power as the book-to-market ratio in
predicting the cross section of average returns, and that controlling for profitability dramatically
increases the performance of value strategies, especially among the largest and most liquid stocks.
This result is hard to reconcile with the risk-based explanation of value premium because profitable
firms are less likely to be in financial distress. In another important paper,Piotroski and So(2012)
show that the

1
The list of papers is quite long and includesRosenberg et al.(1985);Fama and French(1992,1995,2006,2008,2011);
Lakonishok et al.(1994);Chen and Zhang(1998);Piotroski(2000);Daniel and Titman(2006) andAsness et al.(2013)
among others.
J. Risk Financial Manag. 2019, 12, 95; doi:10.3390/jrfm12020095www.mdpi.com /journal/jrfm
J. Risk Financial Manag. 2019, 12, 95 2 of

returns to traditional value strategies are concentrated among those firms where expectations
implied by their current value classification are ex ante incongruent with the strength of their
fundamentals. Value stocks with strong fundamentals produce higher returns. These results cast
considerable doubt on the risk-based explanation favored by proponents of efficient rational
markets, and indicate a need to re-examine the link between value stock returns and financial risk.
Vassalou and Xing(2004) provide a direct test of the impact of default risk on equity returns
and their paper motivates our research proposal.Vassalou and Xing(2004) usesMerton’s (1974)
option pricing model to compute default measures for individual firms and conclude that both the
size and book-to-market effects are related to default risk. Small firms earn a higher return than big
firms only if they have higher default risk and value stocks earn higher returns than growth stocks
if their default risk is high. These results contradict the intuition ofNovy-Marx(2013) andPiotroski
and So(2012).
The goal of this paper is to extend the results ofVassalou and Xing(2004) by usingGeske(1979)
instead ofMerton(1974) in computing the likelihood of default. This is the first paper that uses
Geske’s compound option pricing model to compute default probabilities for individual companies
and examines the relationship between cross-sectional returns and default probabilities calculated
from Geske’s model. The advantage of using Geske’s two-period compound option model is that
we can compute three default probabilities: a short-term default probability (which is the
probability that the firm will default at the end of the first period), a forward default probability
(which is the probability that the firm will default in the second period after no default in the first
period), and a total default probability (which is the probability today that the firm will default
either in the first or second period). In contrast to Geske’s model, the Merton model gives a single
default probability because it is a one-period model.
We thoroughly re-examine the link between default risk, size premium, and value premium by
using a more advanced option pricing model for the computation of default risk and a more
exhaustive test of stock returns based on univariate sorts and independent double sorts. Our sample
includes all stocks from July 1963 to December 2013. Our results can be summarized as follows: The
results based on Merton’s default probability are very similar to the results based on Geske’s short-
term default probability and total default probability. A new default measure (short-term minus
forward
default probability provides a much stronger results based on univariate as well as independent
double-sorts. The average return differential between high and low default probability portfolios is
0.81% (the t-statistic is 2.34) for Merton’s model. Whereas the average return differential for total
default probability is 0.63% (t-statistic is 1.90). The average return differential for short-term default
probability is 0.77% per month (t-statistic is 2.27). The return differential for forward default
probability is −0.29%
per month (not significant). However, the results for short-term minus forward default probability
has the highest return differential and statistical significance. The return differential for short-term
minus forward default probabilities is 1.10% per month (t-statistic is 4.56) for equally weighted
portfolios. For value-weighted portfolios, the return differential is 0.52% per month (t-statistic is
2.07).
For double-sorted portfolios based on size and Merton’s default probability, the higher the
default probability, higher the size premium. The default risk premium exists only for small stock.
The results for total and short-term default probability are very similar to the results from Merton’s
default probability. The results from short-term minus forward default probability are also very
similar.
For double-sorted portfolios based on the book-to-market ratio and Merton’s default
probability, the higher the default probability, higher the value premium. The default premium
exists only for two of the highest book-to-market quantiles. The results for short-term and total
default probability from the Geske model are very similar to the results of Merton’s. However, the
results based on short-term minus forward probability are quite interesting. The value premium for
all default quintiles are large and significant. Also, the default premiums are quite large and
significant for every book-to-market quantile.
2. Methodology

2.1. Measuring Default Risk

2.1.1. Merton’s Model

In Merton’s model (1974), the equity of a firm is viewed as a call option on the firm’s assets.
This is because the equity of the firm has a residual claim of the firm’s assets. In a simple example
where the firm has only one zero-coupon bond, the face value of the debt is the exercise price of the
call option. If the asset value at the maturity of the debt is above the face value, the firm will pay o ff
its debt and equity receives the residual value. When the value of the firm’s assets is less than the
strike price, the value of equity is zero.
Our approach to calculating default risk measures using Merton’s model is very simple. We
assume that the capital structure of the firm includes both equity and debt.
Since the market value of equity can be thought of as a call option on the value of the assets (V)
with time to expiration equal to T. The market value of equity, E, will then be given by theBlack and
Scholes(1973) formula for call options:

E = V N(d1) − K e−rT N(d2), (1)

where . √ Σ
ln(V/K) + r + 1 σ2 T √
T, (2)
d1 = √ 2 , d2 = d1 − σ
σ T
where r is the risk-free rate, σ is the volatility of the assets, K is the face value of debt, and N is the
cumulative density function of the standard normal distribution.
In the Merton model, we have another useful relationship (which can be derived from
Ito’s Formula):

σEE = N(d1) σV. (3)

Equations (1) and (3) can be used to calculate V and σ. Note that there is no closed-form
solution.
This can only be done using numerical procedures. Once we solve for V and σ, we can calculate
the risk-neutral default probability as N(−d2). The default probabilities are calculated at the end of
every month.
Note that N(−d2) is the risk-neutral default probability (RNDP), where d2 is known as the risk-
neutral distance to default. As explained in detail byDelianedis and Geske(2003), “RNDPs are the
correct pricing probabilities, and their changes possess the same information as the price changes.
RNDPs are easier to estimate and more accurately estimated than the actual, risk-adjusted default
probabilities (RADPs).” RNDP serves as an upper bound for RADP, and both RNDP and RADP
have the same sensitivities to the variables that affect option value. As a consequence, our results
that are based on risk-neutral probabilities should not be qualitatively different from those that use
actual probabilities.

2.1.2. Compound Option Methodology

The compound option model byGeske(1979) extends Merton’s model to include multiple debts.
Assume that the firm issues two zero-coupon bonds expiring at time T1 and T2 with face values K1
and K2, respectively. Default at T1 is defined byGeske(1977) as the firm value less than the face value
of the first debt plus the market value of the second debt, that is V1 < K1 + D(T1,T2) where D(T1,T2) is
the market value of K2 at time T1. So, if we assume a two period example, the solution to the equity
value and equity volatility can be derived from Geske’s compound call option (call on call) model:

E(t) = V(t) M(h1+, h2+; ρ) − e−r(T2−t) K2 M (h1−, h2−; ρ) − e−r(T1−t) K1 N(h1−) (4)
 σE = σM(h1+, h2+; ρ) V/E, (5)
where N(.) is the univariate standard normal probability and M(.,.;ρ) is the bivariate standard normal
probability, and

ρ = ,(T1 − t)/(T2 − t) (6)

. Σ. Σ
ln V(t) − ln Vj + r ± σ2/2 Tj − t . (7)
hj± = ,
σ Tj − t
Note that V1 can be solved by solving V(T1) − K1 = E(T1) for V(T1), is the critical value of default
at time T1 and V2 = K2 is the critical value for the assets to trigger default at T2, which is just the face
value of the last debt. E(T1) is the Black-Scholes value of the equity at time T1.

−
E(T1) = V(T1)N(d+) − e−r(T2 T1 ) K2N(d−) (8)
√ . Σ
(9)
ln V(T1) − ln K
σ 2 +T r ± σ /2 (T2 − T 1 )
2 − T1
2
d± =
Again, V and sigma can be calculated numerically. Once the asset values and volatility are
solved, the default probabilities can be calculated. We calculate the default probabilities at the end
of every month for each company.
The closed-form solution actually relies upon the numerical solution of the default point V1 at
time T1. Using Geske’s model, we calculate the default probabilities at the end of the every month.
With Geske model, we can calculate three different probabilities: (1) short-term default probability;
(2) total default probability; (3) forward default probability. Short-term default probability is the
probability that a company will default in the first year (t = 1). Total default probability is the
probability that a company will default either in the first year or during the second year. Forward
probability is the probability that a company will default during the second period, assuming there
was no default during the first year.
There are two main strands in our methodology. The first strand is that we extendVassalou and
Xing (2004) paper to include more complicated model of Geske. By usingGeske’s (1979) compound-
option model we get a lot more information of the default probability of the firm. In estimating
default probabilities from Geske model, we follow Ren-RawChen(2013). This is a two-period (three
date) model that produces a short-term (end of first period) default probability and a long-term,
forward, default probability (end of second period). Initial tests indicate that the forward default
probability may be interesting information even when the total default probability by the Geske
model is highly correlated to the Merton measure. These early tests indicate that when the total
default probability is decomposed into a short and a forward component, each is more significant
than the total probability and the forward is more significant than the short.
The second strand of our methodology is to follow standard practice in current asset-pricing
literature and to exhaustively analyze stock returns after forming portfolios that are sorted by
default risk, size, book-to-market ratio, etc. We follow the methodology presented
inCakici(2015);Fama and French(2017) andNovy-Marx(2013).
InMerton(1974), the equity of a firm is viewed as a call-option on the firm’s assets. The exercise
price of the call option is the value of the liabilities. Our approach to calculating default probability
in the Merton model is the same as inVassalou and Xing(2004), and we use 50% of the liabilities as
“Debt Due in One Year.” For Geske’s model, we use the current liabilities as “Debt Due in One
Year” and we assume that all long-term liabilities have a maturity of two years.
3. Data
Our sample includes all U.S companies. We use the Compustat annual files to get the firm’s
book value, firm’s debt in one year, and long-term debt series for all companies. As the book value
of debt we use the debt in one year plus half the long-term debt. This is exactly the same as
inVassalou and Xing(2004). Our sample period is from July 1963 to December 2013. We get the daily
and monthly returns and market values from the CRSP daily and monthly files. Firms with
negative book-to-market ratios are excluded from the sample. The average number of firms per
month in our sample is 2900.

4. Results

4.1. Pairwise Correlations between Variables

Table1presents the pairwise correlations between di fferent measures of default probability,
beta, size, and book-to-market ratio for the sample of firms covering July 1963 to December 2013.
From the Merton model we get one measure of default probability. The Geske model provides three
measures:
(1) the total default probability at time t = 0 of incurring default at t = 1 or t = 2; (2) the short-term
default probability of incurring default at t = 1; and (3) the forward default probability of incurring
default at t = 2 if there is no default at t = 1. Therefore, the Geske model gives a term structure of
default probabilities and we examine a fourth measure by computing the difference between the
short-term and the forward default probabilities as a measure of the slope of this term structure of
default probability.

Table 1. This table shows pairwise correlations between different measures of default probability,
beta, size, and book-to-market ratio, for the period July 1963 to December 2013. M-Def. is Merton’s
default probability, T-Def is the total default probability from Geske’s model, S-Def. is the short-term
default probability, F-Def. is the forward default probability, S-F Def. is the short-term minus
forward default probability from Geske’s model. Beta is the CAPM beta, size is the market value of
equity, and bktmkt is the book-to-market ratio.

M-Def. T-Def. S-Def. F-Def. S-F Def. Beta Stdev Size bktmkt
M-Def. 1.00 0.96 1.00 0.58 0.77 −0.05 0.11 0.24 0.68
T-Def. 0.96 1.00 0.97 0.74 0.62 −0.06 0.09 0.25 0.70
S-Def. 1.00 0.97 1.00 0.59 0.77 −0.06 0.11 0.25 0.69
F-Def. 0.58 0.74 0.59 1.00 0.01 −0.03 0.00 0.17 0.49
S-F Def. 0.77 0.62 0.77 0.01 1.00 −0.05 0.13 0.18 0.49
Beta −0.05 −0.06 −0.06 −0.03 −0.05 1.00 −0.07 −0.05 −0.16
Stdev 0.11 0.09 0.11 0.00 0.13 −0.07 1.00 −0.09 −0.01
Size 0.24 0.25 0.25 0.17 0.18 −0.05 −0.09 1.00 0.47
bktmkt 0.68 0.70 0.69 0.49 0.49 −0.16 −0.01 0.47 1.00

The Merton default probability is very highly correlated to Geske’s total default probability
(0.96) and to Geske’s short-term default probability (1.00), but its correlation coefficient with
Geske’s forward default probability is 0.58. It is positively correlated to “short-forward” default
probability (0.77). The average values of all five default probabilities are plotted in Figure1.
 Figure 1. Default probabilities.

4.2. Average Returns from Portfolios Sorted by Default Risk

In Table2, for each month of the sample period, Merton’s default probability is used to sort all
stocks into deciles at the end of each month. We compute the equally weighted and value-weighted
returns over the next month for each decile portfolio. Table2shows the average monthly returns
for the decile portfolios over the sample period. The equally weighted portfolios show that average
returns are monotonically higher with increasing default risk. This is consistent with the results in
Vassalou and Xing(2004). The di fference between the average returns for the highest default risk
portfolio and the lowest default risk portfolio has a Newey-West t-statistic of 2.34. The average
returns from the “high–low” portfolios cannot be completely explained by the standard risk factors;
the ‘alpha’ from the 4-factor model is 0.66 with a t-statistic of 2.13.
Tables3–5replicate the results in Table2by using the three measures of default probability from
Geske’s model. Table3uses Geske’s total default probability, Table4uses Geske’s short-term default
probability, and Table5uses Geske’s forward default probability. The results in Tables3and4are
similar to the results in Table2, i.e., average returns on equally weighted portfolios are higher for
higher total default risk and higher short-term default risk. Table3shows that the “high–low” deciles
of Geske’s total default probability have an average return of 0.63 (Newey-West t-statistic is 1.90),
and the “alpha’ from the four-factor model is 0.48 (t-value is 1.63). Table4shows that the “high–low”
deciles of Geske’s short-term default probability have an average return of 0.77 (Newey-West t-
statistic is 2.27), and the “alpha’ from the four-factor model is 0.63 (t-value is 2.08).
Table 2. Average returns from decile portfolios sorted by Merton’s default probability. From the data for
July 1963 to December 2013, at the end of each month, we used the most recently calculated Merton’s
default probability for each firm to sort all stocks into deciles. We then calculated the equally weighted and
value-weighted returns over the next month. The returns are the average monthly returns over the sample
period. Portfolio 1 is the portfolio with the lowest default risk and Portfolio 10 is the portfolio with the
highest default risk. High-Low is the difference between the high and low default risk portfolios. t-values
are calculated from Newey-West standard errors. Alphas are calculated using the CAPM, the three-factor
Fama-French, and the four-factor model (Fama-French three-factor plus momentum).

Deciles ew_ret vw_ret Beta Std Size bktmkt MD GTD GSD GF GS-M Nfirms
low 1.05 0.89 0.58 6.16 6.43 0.51 0.00 0.00 0.00 0.00 0.00 290
2 1.11 0.99 0.79 7.67 6.01 0.59 0.00 0.00 0.00 0.00 0.00 290
3 1.20 0.99 0.93 8.80 5.59 0.63 0.00 0.00 0.00 0.00 0.00 290
4 1.20 1.07 1.03 9.88 5.19 0.67 0.00 0.01 0.01 0.00 0.00 290
5 1.27 0.99 1.13 10.99 4.83 0.71 0.02 0.04 0.03 0.00 −0.08
−0.02 290
76 1.30
1.38 1.05
1.03 1.22
1.31 12.13
13.43 4.50
4.18 0.74
0.79 0.08
0.26 0.13
0.40 0.11
0.36 0.00 −0.27 290
8 1.41 0.98 1.41 15.08 3.79 0.83 0.82 1.15 1.03 0.02 −0.81 290
9 1.53 1.02 1.53 17.61 3.35 0.88 2.53 3.33 2.93 0.06 −2.40 290
high 1.86 0.97 1.84 24.51 2.71 0.92 9.95 12.46 10.62 0.49 −8.21 290
dif 0.81 0.08
t-stat 2.34 0.23
Capm_alpha 0.42
t-stat 1.46
FF3-alpha 0.16
t-stat 0.73
FF4-alpha 0.66
t-stat 2.13

Table 3. Average returns from ddecile portfolios sorted by Geske’s total default probability. From the data
for July 1963 to December 2013, at the end of each month, we used the most recently calculated Geske’s
total default probability for each firm to sort all stocks into deciles. We then calculated the equally
weighted and value-weighted returns over the next month. The returns are the average monthly returns
over the sample period. Portfolio 1 is the portfolio with the lowest default risk and Portfolio 10 is the
portfolio with the highest default risk. High-Low is the difference between the high and low default risk
portfolios. t-values are calculated from Newey-West standard errors. Alphas are calculated using the
CAPM, the three-factor Fama-French, and the four-factor model (Fama-French three-factor plus
momentum).

Deciles ew_ret vw_ret Beta Std Size bktmkt MD GTD GSD GF GS-M Nfirms
low 1.09 0.94 0.63 6.35 6.37 0.53 0.00 0.00 0.00 0.00 0.00 290
2 1.16 0.91 0.79 7.80 5.84 0.58 0.00 0.00 0.00 0.00 0.00 290
3 1.19 0.98 0.91 8.71 5.50 0.65 0.00 0.00 0.00 0.00 0.00 290
4 1.20 0.97 1.01 9.70 5.16 0.68 0.00 0.01 0.01 0.00 −0.01 290
5 1.27 0.97 1.10 10.73 4.81 0.71 0.02 0.04 0.03 0.00 290
−0.03
6 1.28 0.99 1.21 11.87 4.53 0.74 0.09 0.16 0.13 0.00 −0.12 290
7 1.42 1.08 1.29 13.21 4.19 0.78 0.31 0.47 0.39 0.01 −0.37 290
8 1.41 0.97 1.42 14.96 3.84 0.81 0.91 1.31 1.09 0.04 −1.00 290
9 1.55 0.91 1.55 17.67 3.41 0.85 2.65 3.60 3.02 0.15 −2.74 290
high 1.72 0.74 1.88 24.77 2.84 0.86 9.92 12.77 10.63 1.38 −8.08 290
dif 0.63 −0.20
t-stat 1.90 −0.64
Capm_alpha 0.25
t-stat 0.90
FF3-alpha 0.03
t-stat 0.13
FF4-alpha 0.48
t-stat 1.63
 J. Risk Financial Manag. 2019, 12, 95 8 of 15

Table 4. Average returns from decile portfolios sorted by Geske’s short-term default probability. From the
data for July 1963 to December 2013, at the end of each month, we used the most recently calculated
Geske’s short-term default probability for each firm to sort all stocks into deciles. We then calculated the
equally weighted and value-weighted returns over the next month. The returns are the average monthly
returns over the sample period. Portfolio 1 is the portfolio with the lowest default risk and Portfolio 10 is
the portfolio with the highest default risk. High-Low is the difference between the high and low default
risk portfolios. t-values are calculated from Newey-West standard errors. Alphas are calculated using the
CAPM, the three-factor Fama-French, and the four-factor model (Fama-French three-factor plus
momentum).

Deciles ew_ret vw_ret Beta Std Size bktmkt MD GTD GSD GF GS-M Nfirms
low 1.07 0.92 0.62 6.32 6.44 0.53 0.00 0.00 0.00 0.00 0.00 290
2 1.13 0.90 0.79 7.79 5.89 0.57 0.00 0.00 0.00 0.00 0.00 290
3 1.20 1.04 0.91 8.74 5.54 0.63 0.00 0.00 0.00 0.00 0.00 290
4 1.16 1.02 1.01 9.71 5.20 0.67 0.00 0.01 0.01 0.00 0.00 290
5 1.27 0.95 1.11 10.82 4.83 0.71 0.02 0.04 0.03 0.00 −0.02 290
6 1.30 1.02 1.21 11.95 4.52 0.74 0.08 0.14 0.12 0.00 290
−0.09
7 1.38 1.07 1.30 13.28 4.20 0.78 0.26 0.43 0.36 0.01 −0.29 290
8 1.40 0.99 1.41 14.95 3.82 0.83 0.82 1.22 1.03 0.03 −0.84 290
9 1.53 1.00 1.54 17.55 3.39 0.87 2.52 3.43 2.93 0.09 −2.43 290
high 1.84 0.93 1.85 24.51 2.74 0.91 9.93 12.59 10.63 0.57 −8.22 290
dif 0.77 0.01
t-stat 2.27 0.02
Capm_alpha 0.38
t-stat 1.36
FF3-alpha 0.14
t-stat 0.63
FF4-alpha 0.63
t-stat 2.08

Table 5. Average returns from decile portfolios sorted by Geske’s forward default probability. From the
data for July 1963 to December 2013, at the end of each month, we used the most recently calculated
Geske’s forward default probability for each firm to sort all stocks into deciles. We then calculated the
equally weighted and value-weighted returns over the next month. The returns are the average monthly
returns over the sample period. Portfolio 1 is the portfolio with the lowest default risk and Portfolio 10 is
the portfolio with the highest default risk. High-Low is the difference between the high and low default
risk portfolios. t-values are calculated from Newey-West standard errors. Alphas are calculated using the
CAPM, the three-factor Fama-French, and the four-factor model (Fama-French three-factor plus
momentum).

Deciles ew_ret vw_ret Beta Std Size bktmkt MD GTD GSD GF GS-M Nfirms
low 1.41 0.97 0.75 8.03 5.44 0.75 0.00 0.00 0.00 0.00 0.00 290
2 1.54 1.16 0.88 9.80 4.56 0.74 0.06 0.07 0.07 0.00 −0.07 290
3 1.37 0.98 0.93 10.65 4.37 0.70 0.01 0.01 0.01 0.00 290
−0.01
4 1.31 0.88 0.94 10.03 4.90 0.72 0.00 0.00 0.00 0.00 0.00 290
5 1.30 0.92 1.02 10.29 5.01 0.71 0.00 0.01 0.01 0.00 −0.01 290
6 1.33 0.94 1.10 11.15 4.83 0.71 0.01 0.02 0.02 0.00 −0.02 290
7 1.29 0.85 1.21 12.16 4.68 0.71 0.03 0.05 0.05 0.00 −0.04 290
8 1.30 0.95 1.32 13.49 4.52 0.69 0.09 0.21 0.16 0.04 −0.12 290
9 1.29 0.91 1.49 15.67 4.24 0.67 0.41 0.97 0.63 0.26 −0.33 290
high 1.13 0.70 1.81 21.72 3.72 0.63 3.39 7.15 4.26 2.42 −0.75 290
dif −0.29 −0.27
t-stat −1.29 −1.07
Capm_alpha −0.56
t-stat −2.90
FF3-alpha −0.59
t-stat −3.94
FF4-alpha −0.55
t-stat −3.65
 In contrast to these results, the forward default probability produces a completely different
picture. Table5shows that the average returns on decile portfolios formed on the basis of Geske’s
forward default probability do not increase with increasing risk. In fact, the average return from
“high–low” portfolios is −1.29 (Newey-West t-statistic is −1.07), and the “alpha” from the four-
factor model is
−0.55 (t-value is −3.65). Table6shows the average returns for decile portfolios formed on the basis
of the slope of the default risk term structure (i.e., the difference between the short-term default
probability and the forward default probability). The return differential for equally weighted high
and low portfolios is 1.10 (Newey-West t-statistic is 4.56) and the return differential for value-
weighted portfolios is 0.52 (Newey-West t-statistic is 2.07) and the four-factor alpha for equally
weighted
portfolios is 1.24 (Newey-west t-statistic is 4.61). So, using Geske model creates a much larger return
differential than Merton’s model. Not only did the Geske model create a larger return differential,
but the value-weighted return differential is significant. These are new results that have not been
reported in previous research.

Table 6. Average returns from decile portfolios sorted by Geske’s short-term minus forward default
probability. From the data for July 1963 to December 2013, at the end of each month, we used the most
recently calculated Geske’s short-term minus forward default probability for each firm to sort all stocks
into deciles. We then calculated the equally weighted and value-weighted returns over the next month. The
returns are the average monthly returns over the sample period. Portfolio 1 is the portfolio with the lowest
default risk and Portfolio 10 is the portfolio with the highest default risk. High-Low is the difference
between the high and low default risk portfolios. t-values are calculated from Newey-West standard errors.
Alphas are calculated using the CAPM, the three-factor Fama-French and the four-factor model (Fama-
French three-factor plus momentum).

Deciles ew_ret vw_ret Beta Std Size bktmkt MD GTD GSD GF GS-M Nfirms
low 0.88 0.72 1.41 14.81 4.91 0.50 0.07 0.64 0.17 0.46 −0.21 290
2 0.93 0.76 0.87 8.42 6.06 0.55 0.00 0.00 0.00 0.00 290
0.00
3 1.15 0.98 0.71 6.94 6.12 0.58 0.00 0.00 0.00 0.00 0.00 290
4 1.24 1.10 0.84 8.15 5.59 0.63 0.00 0.00 0.00 0.00 0.00 290
5 1.30 1.18 0.96 9.50 5.09 0.70 0.01 0.01 0.01 0.00 0.01 290
6 1.33 1.07 1.09 10.89 4.61 0.76 0.04 0.06 0.06 0.00 0.05 290
7 1.45 1.15 1.22 12.34 4.25 0.81 0.17 0.23 0.22 0.00 0.19 290
8 1.44 1.03 1.33 14.08 3.84 0.86 0.61 0.77 0.74 0.00 0.66 290
9 1.57 1.13 1.47 16.71 3.37 0.91 2.09 2.48 2.38 0.02 2.10 290
high 1.98 1.25 1.75 23.05 2.66 0.96 8.78 9.87 9.38 0.05 8.22 290
dif 1.10 0.52
t-stat 4.56 2.07
Capm_alpha 0.98
t-stat 4.51
FF3-alpha 0.73
t-stat 3.39
FF4-alpha 1.24
t-stat 4.61

4.3. Average Returns from Portfolios Double Sorted by Size and Default Risk
Table7shows the average returns on quintile portfolios double-sorted on size and Merton’s
default probability. There are 25 such portfolios. The portfolios that are constructed at the end of
each month are the combination of five portfolios formed on size and five portfolios formed on the
default probability. The results based on Merton’s model are consistent withVassalou and
Xing(2004). We see that the monotonically increasing effect of default risk on average returns is
most pronounced for the smallest size firms. The average return on “high–low” for the smallest size
quintile is 1.02 (Newey-West t-statistic is 3.27). The average return differential for the other size
quintiles is not statistically significant. On the other hand, the size effect is statistically significant
for all default risk quintile portfolios. The size effect is most pronounced for the quintile portfolio
with the highest default risk (average return for “small–big” is 1.31, with the Newey-West t-statistic
being 4.29).
Table 7. Average returns from double-sorted quantile portfolios (sorted by size and Merton’s default
probability). From the data for July 1963 to December 2013, at the end of each month, stocks are
independently sorted into 5 × 5 portfolios based on size and Merton’s default probability. The table shows
average returns for each of 25 portfolios. Small-big is the return differential between the small and big firm
portfolios within each default quantile. High-low is the return differential between the high and low
default probability firms within each size quantile. t-statistics are calculated using Newey-West standard
errors.

Size Low 2 3 4 High High-Low t-Stat

small 1.36 1.53 1.59 1.91 2.37 1.02 3.27
2 1.23 1.26 1.31 1.28 1.09 −0.15 −0.52
3 1.08 1.23 1.25 1.26 1.07
− 0.01 − 0.03
4 1.18 1.20 1.24 1.20 0.99 −0.19 − 0.73
big 0.97 1.05 1.08 0.98 1.07 0.09 0.34
small-big 0.38 0.48 0.51 0.93 1.31
t-stat 2.23 2.67 2.62 4.20 4.29

Tables8–10replicate Table7by using Geske’s total default probability, Geske’s short-term default
probability, and Geske’s forward default probability. The results in Tables8and9are similar to the
results reported in Table7, i.e., default risk is most pronounced for the smallest quintile and average
returns for the smallest size quintile increase monotonically with default risk. However, Table10
produces a different picture. The average returns on portfolios sorted by forward default risk are
negatively related to this measure of risk; in addition, the effect is seen in all size quintiles (with
varying t-values). However, the size effect is statistically significant in all forward default quintiles
and is similar to what is reported in Tables8and9.

Table 8. Average returns from double-sorted quantile portfolios (sorted by size and Geske’s total default
probability). From the data for July 1963 to December 2013, at the end of each month, stocks are
independently sorted into 5 × 5 portfolios based on size and Geske’s total default probability. The table
shows average returns for each of 25 portfolios. Small-big is the return differential between the small and
big firm portfolios within each default quantile. High-low is the return differential between the high and
low default probability firms within each size quantile. t-statistics are calculated using Newey-West
standard errors.

Size Low 2 3 4 High High-Low t-Stat

small 1.42 1.51 1.61 2.00 2.35 0.93 3.18
2 1.28 1.28 1.30 1.26 1.07 −0.20 −0.76
3 1.16 1.27 1.26 1.25 1.05
−0.11 −0.45
4 1.20 1.23 1.20 1.21 0.98 −0.22 −0.89
big 1.00 1.06 1.06 1.03 0.81 −0.19 −0.73
small-big 0.42 0.46 0.56 0.98 1.55
t-stat 2.59 2.42 2.82 4.41 5.21

Table11shows the average returns on double-sorted portfolios when we use the short-term
minus forward default probability to sort on the risk dimension. The results in Table11show that
default risk is significant not only among small stocks, but also for big firms. This implies that
Geske’s model provides more information that Merton’s model.
 J. Risk Financial Manag. 2019, 12, 95 11 of

Table 9. Average returns from double-sorted quantile portfolios (sorted by size and Geske’s short-term
default probability). From the data for July 1963 to December 2013, at the end of each month, stocks are
independently sorted into 5 × 5 portfolios based on size and Geske’s short-term default probability. The
table shows average returns for each of 25 portfolios. Small–big is the return differential between the small
and big firm portfolios within each default quantile. High–low is the return differential between the high
and low default probability firms within each size quantile. t-statistics are calculated using Newey-West
standard errors.

Size Low 2 3 4 High High-Low t-Stat

small 1.38 1.49 1.63 1.92 2.38 1.00 3.35
2 1.26 1.26 1.32 1.27 1.08 −0.17 −0.65
3 1.11 1.24 1.28 1.26 1.08
− 0.04 − 0.14
4 1.19 1.23 1.23 1.20 0.99 −0.20 − 0.78
big 0.98 1.10 1.06 0.98 0.98 0.00 0.01
small-big 0.40 0.39 0.57 0.95 1.40
t-stat 2.52 2.02 2.91 4.30 4.69

Table 10. Average returns from double-sorted quantile portfolios (sorted by size and Geske’s forward
default probability). From the data for July 1963 to December 2013, at the end of each month, stocks are
independently sorted into 5 × 5 portfolios based on size and Geske’s forward default probability. The table
shows average returns for each of 25 portfolios. Small-big is the return differential between the small and
big firm portfolios within each default quantile. High-low is the return differential between the high and
low default probability firms within each size quantile. t-statistics are calculated using Newey-West
standard errors.

Size Low 2 3 4 High High-Low t-Stat

small 2.15 2.31 2.05 1.96 1.88 −0.27 −2.13
1.36 1.36 1.32 1.19 0.97
2 −0.39 −2.61
3 1.27 1.29 1.25 1.29 1.00 −0.27 −1.90
4 1.22 1.37 1.20 1.16 1.05 −0.17 −1.07
big 1.10 1.01 1.01 1.01 0.82 −0.28 −1.43
small-big 1.05 1.30 1.05 0.94 1.06
t-stat 3.90 4.19 4.13 3.97 4.19

Table 11. Average returns from double-sorted quantile portfolios (sorted by size and Geske’s short-
term minus forward default probability). From the data for July 1963 to December 2013, at the end of
each month, stocks are independently sorted into 5 × 5 portfolios based on size and Geske’s short-
term minus forward default probability. The table shows average returns for each of 25 portfolios.
Small-big is the return differential between the small and big firm portfolios within each default
quantile. High-low is the return differential between the high and low default probability firms
within each size quantile. t-statistics are calculated using Newey-West standard errors.

Size Low 2 3 4 High High-Low t-Stat

small 1.20 1.55 1.52 1.91 2.44 1.24 5.20
2 0.86 1.41 1.38 1.34 1.15 0.29 1.47
3 0.91 1.22 1.35 1.36 1.11 0.19 0.97
4 1.04 1.23 1.30 1.27 1.11 0.07 0.33
big 0.82 1.11 1.19 1.05 1.39 0.57 2.04
small-big 0.38 0.44 0.33 0.86 1.06
t-stat 1.56 2.68 1.79 4.03 3.55

4.4. Returns from Portfolios Double-Sorted by Book-to-Market Ratio and Default Risk
In this section we present the returns from portfolios independently double-sorted by book-to-
market ratio and default probability. The portfolios that are constructed at the end of
each month, are a combination of five portfolios formed on the book-to-market ratio and five
portfolios formed on the default probability.
Table12shows the average returns on quintile portfolios double-sorted by book-to-market ratio
and Merton’s default probability. The average return for every book-to-market quintile is increasing
in default risk, but the effect is most pronounced for the highest book-to-market quintile (so-called
value
stocks), with the average “high–low” return being 0.81 (Newey-West t-statistic = 2.77). Value stocks
earn a significantly higher average return for every default risk quintile.

Table 12. Average returns from double-sorted quantile portfolios (sorted by book-to-market ratio
and Merton’s default probability). From the data for July 1963 to December 2013, at the end of each
month, stocks are independently sorted into 5 × 5 portfolios based on the book-to-market ratio and
Merton’s default probability. The table shows average returns for each of 25 portfolios. Small-big is
the return differential between the small and big firm portfolios within each default quantile. High-
low is the return differential between the high and low default probability firms within each size
quantile. t-statistics are calculated using Newey-West standard errors.

Low 2 3 4 High High-Low t-Stat

Low BM 0.94 0.92 0.65 0.63 1.09 0.15 0.47
2 1.12 1.14 1.25 1.22 1.40 0.28 0.92
3 1.15 1.26 1.34 1.48 1.66 0.51 1.54
4 1.11 1.34 1.45 1.65 1.77 0.66 2.06
High BM 1.29 1.44 1.61 1.74 2.10 0.81 2.77
High-low
BM 0.36 0.52 0.96 1.11 1.02
t-stat 2.06 2.58 4.93 5.64 4.64

Tables13–15replicate Table12by using the three default measures from the Geske model. As
we have seen previously, the results in Tables13and14are similar to those reported in Table12, but
Table15produces a contrary picture. Table16uses the short-term minus forward default probability
as the risk measure and the results in Table16gives much stronger results than Merton’s model. In
Table12, default risk is significant only for the fourth and fifth book-to-market quintiles, whereas in
Table16all book-to-market quintiles are significant. This casts doubt on the risk explanation of the
book-to-market anomaly. This result is in contrast to the results of Vassalou and Xing.

Table 13. Average returns from double-sorted quantile portfolios (sorted by book-to-market ratio
and Geske’s total default probability). From the data for July 1963 to December 2013, at the end of
each month, stocks are independently sorted into 5 × 5 portfolios based on the book-to-market ratio
and Geske’s total default probability. The table shows average returns for each of 25 portfolios.
Small-big is the return differential between the small and big firm portfolios within each default
quantile. High-low is the return differential between the high and low default probability firms
within each size quantile. t-statistics are calculated using Newey-West standard errors.

Low 2 3 4 High High-Low t-Stat

Low BM 0.95 0.93 0.69 0.73 0.96 0.01 0.03
2 1.19 1.09 1.20 1.22 1.41 0.22 0.78
3 1.22 1.28 1.30 1.48 1.61 0.39 1.26
4 1.18 1.37 1.43 1.67 1.74 0.56 1.86
High BM 1.31 1.49 1.65 1.75 2.10 0.79 2.75
High-low
BM 0.36 0.56 0.96 1.02 1.14
t-stat 2.16 2.78 5.15 5.04 5.42
 Table 14. Average returns from double-sorted quantile portfolios (sorted by book-to-market ratio
and Geske’s short-term default probability). From the data for July 1963 to December 2013, at the
end of each month, stocks are independently sorted into 5 × 5 portfolios based on the book-to-
market ratio and Geske’s short-term default probability. The table shows average returns for each of
25 portfolios. Small-big is the return differential between the small and big firm portfolios within
each default quantile. High-low is the return differential between the high and low default
probability firms within each size quantile. t-statistics are calculated using Newey-West standard

errors.
Low 2 3 4 High High-Low t-Stat
Low BM 0.94 0.92 0.69 0.63 1.06 0.12 0.37
2 1.16 1.10 1.24 1.21 1.41 0.24 0.81
3 1.18 1.29 1.35 1.49 1.65 0.47 1.46
4 1.17 1.35 1.47 1.65 1.76 0.59 1.89
High BM 1.29 1.48 1.61 1.72 2.11 0.82 2.85
High-low
BM 0.35 0.57 0.93 1.10 1.05
t-stat 2.05 2.75 4.65 5.50 4.86

Table 15. Average returns from double-sorted quantile portfolios (sorted by book-to-market ratio and
Geske’s forward default probability). From the data for July 1963 to December 2013, at the end of each
month, stocks are independently sorted into 5 × 5 portfolios based on the book-to-market ratio and Geske’s
forward default probability. The table shows average returns for each of 25 portfolios. Small-big is the
return differential between the small and big firm portfolios within each default quantile. High-low is the
return differential between the high and low default probability firms within each size quantile. t-statistics
are calculated using Newey-West standard errors.

Low 2 3 4 High High-Low t-Stat

Low BM 1.01 1.08 0.85 0.83 0.62 −0.39 −2.11
2 1.38 1.24 1.19 1.15 1.09 −0.30 −1.94
3 1.51 1.53 1.27 1.32 1.25 −0.26 −1.52
4 1.54 1.39 1.46 1.43 1.53 −0.01 −0.05
High BM 1.92 1.73 1.73 1.76 1.72 −0.20 −1.37
High-low
0.91 0.65 0.87 0.92 1.10
BM
t-stat 4.70 3.06 4.90 4.89 5.45

Table 16. Average returns from double-sorted quantile portfolios (sorted by book-to-market ratio
and Geske’s short-term minus forward default probability). From the data for July 1963 to December
2013, at the end of each month, stocks are independently sorted into 5 × 5 portfolios based on book-
to-market and Geske’s short-term minus forward default probability. The table shows average
returns for each of 25 portfolios. Small-big is the return differential between the small and big firm
portfolios within each default quantile. High-low is the return differential between the high and low
default probability firms within each size quantile. t-statistics are calculated using Newey-West

standard errors.
Low 2 3 4 High High-Low t-Stat
Low BM 0.57 0.95 0.87 0.67 1.28 0.71 2.68
2 0.95 1.22 1.21 1.32 1.50 0.55 2.14
3 1.00 1.35 1.41 1.49 1.73 0.73 2.55
4 1.14 1.29 1.50 1.61 1.81 0.68 2.63
High BM 1.38 1.42 1.57 1.73 2.10 0.72 2.87
High-low
BM 0.82 0.47 0.71 1.06 0.82
t-stat 4.15 2.42 3.53 5.33 3.65
5. Conclusions
In this paper we report a detailed comparison between the Merton model (Merton1974) and
Geske’s compound option model (Geske1979) regarding the e ffect of default risk on average
stock returns. This is the first paper that uses Geske’s compound option pricing model to
investigate the effect of default risk on average stock returns. We report several interesting
results, including the importance of the forward default probability (which is a proxy for the term
structure of default risk).
Our results can be summarized as follows. The results based on Merton’s default probability
are very similar to the results based on Geske’s short-term default probability and total default
probability. A new default measure (short-term minus forward default probability) provides much
stronger results
based on univariate as well as independent double-sorts. The average return differential between the
high and low default probability portfolios is 0.81% (t-statistic is 2.34) for Merton’s model. Whereas
the average return differential for total default probability is 0.63% (t-statistic is 1.90). The average
return differential for short-term default probability is 0.77% per month (t-statistic is 2.27). The
return differential for forward default probability is −0.29% per month (not significant). However,
the results for short-term minus forward default probability show the highest return differential
and statistical significance. The return differential for short-term minus forward default
probabilities is 1.10% per
month (t-statistic is 4.56) for equally weighted portfolios. For value-weighted portfolios the return
differential is 0.52% per month (t-statistic is 2.07).
For double-sorted portfolios based on size and Merton’s default probability, the higher the
default probability, the higher the size premium. The default risk premium exists only for small
stock. The results for total and short-term default probability are very similar to the results from
Merton’s default probability. The results from short-term minus forward default probability are also
very similar.
For double-sorted portfolios based on the book-to-market ratio and Merton’s default
probability, the higher the default probability, the higher the value premium. The default premium
exists only for two of the highest book-to-market quantiles. The results for short-term and total
default probability from the Geske model are very similar to the results of Merton’s. However, the
results based on short-term minus forward probability are quite interesting. The value premium for
all default quintiles are large and significant. The default premiums are also quite large and
significant for every book-to-market quantile.

Author Contributions: All three authors have contributed to the motivation, research methodology, data
analysis, and the writing of the paper.
Funding: The authors gratefully acknowledge research funding from the Gabelli School of Business at
Fordham University.
Conflicts of Interest: The authors declare no conflict of interest.

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