Investigating the Effect of Default Risk on Individual Stocks Returns using Stocks listed in Tehran Stock Exchange

Document Type : Original Article

Authors

1 MA in Financial Management, University of Isfahan, Isfahan, Iran.

2 Assistant Professor, University of Isfahan, Isfahan, Iran.

Abstract

The main purpose of this study is to investigate the effect of default risk on the individual stocks' expected returns using stocks listed in Tehran Stock Exchange. To this end, we use a sample of 376 non-financial companies listed in Tehran Stock Exchange during September 2008 to November 2018 and compute distance to default (DD) as a measure of default risk following KMV-Merton model in a monthly frequency. In this way, market value of assets and its deviation are estimated by simultaneously solving nonlinear equations induced form Black-Scholes-Merton option pricing model. To do a comprehensive study, dependent variable of this study, expected return, is estimated using realized returns in different time periods (one month, six months, one year and two years). Then the relationship between distance to default as a firm characteristic and expected return was assessed in univariate and multivariate cross sectional regressions using Fama-Macbeth (1973) procedure and with the beta of CAPM model, size, book to market and momentum as control variables. The results show that, in both univariate and multivariate regressions, the effect of DD on expected return depends on the time period realized return is measured as expected return and we observe a more significant relationship in longer periods. Particularly if we estimate expected returns using two-year realized return, we observe a significant and negative relationship between DD and expected returns of equity holders, confirming that firms with lower DDs, or firms that are closer to default, have higher expected returns. Furthermore if we estimate stock volatility using more recent information, the effect of DD on returns become stronger

Keywords

References

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Financial Management Perspective
Volume 9, Issue 27 - Serial Number 27
October 2019
Pages 133-168

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