Do Stock Returns Really Decrease with Default Risk? New International Evidence

This study constructs a novel dataset of bankruptcy filings for a large sample of non-US firms in 14 developed markets and sheds new light on the cross-sectional relation between default risk and stock returns. Using the reduced-form approach of Campbell et al. (2008) to estimate default probabilities, we offer conclusive evidence supporting the existence of a significant positive default risk premium in international markets. This finding is robust to different portfolio weighting schemes, data filters, risk-adjusting approaches and holding period definitions. Decomposing the default risk measure into its systematic and idiosyncratic components, we find that the former drives this positive relation. We also show that the default risk premium is more pronounced in countries where creditor protection is stronger and shareholder bargaining power is lower