Omitted debt risk, financial distress and the cross-section of expected equity returns

Kevin Aretz, Mark B. Shackleton

Research output: Contribution to journalArticlepeer-review

Abstract

The study of Ferguson and Shockley (2003) shows that, if the Merton (1974) model can reflect reality, the omission of debt claims from the market portfolio proxy may explain the poor pricing ability of the CAPM in empirical tests. We critically re-assess this argument by first reviewing existing, but also new avenues through which the Merton (1974) model can point to a systematic bias in market beta estimates. However, we also show that some avenues are diversifiable, and that they all rely on excessive economy-wide default risk to create a non-negligible bias. We then use the Merton (1974) model to proxy for the total debt portfolio, but find that its application in empirical tests cannot improve pricing performance. We conclude that there are (so far) no valid theoretical reasons to believe that omitted debt claims undermine CAPM tests. © 2010 Elsevier B.V.
Original languageEnglish
Pages (from-to)1213-1227
Number of pages14
JournalJournal of Banking and Finance
Volume35
Issue number5
DOIs
Publication statusPublished - May 2011

Keywords

  • Calibration
  • CAPM
  • Characteristic 'anomalies'
  • Equity and debt market portfolio

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