Relation between distress risk, book-to-market ratio and return premium

Purpose -Earlier research found that firms with the highest distress risk have low book-to-market (B/M) ratios and low returns. This paper aims to examine the robustness of those's results and provide further evidence that high distress-risk firms do not enjoy the same high returns earned by high B/M firms and that distress risk is unlikely to explain the Fama and French high-minus-low (HML) B/M factor. Design/methodology/approach -A distress-risk measure, distressed-minus-solvent (DMS), is calculated and a range of zero investment distress-risk trading strategies is investigated. Value- and equal-weighted portfolios are examined both with negative book-equity firms and without. These most distressed firms have low or negative B/M values and would either not be included in the Fama and French sample or included in the low B/M portfolio. Findings - The paper finds that the DMS factor is negative and significant, and none of the zero investment strategies earns significantly positive returns. Research limitations/implications - The findings suggest that exposure to distress risk does not earns investors a positive risk premium. It appears that over the period examined, market inefficiencies drive the market value and returns of high distress-risk firms. Originality/value -The distress-risk premium is shown to be negative and, therefore, cannot be driven by bankruptcy risk alone. The negative premium is not consistent with a financial distress explanation for the Fama and French HML factor.