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

Aretz, K and Shackleton, M B (2011) Omitted debt risk, financial distress and the cross-section of expected equity returns. Journal of Banking and Finance, 35 (5). pp. 1213-1227. ISSN 0378-4266

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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.

Item Type: Article
Journal or Publication Title: Journal of Banking and Finance
Subjects: UNSPECIFIED
Departments: Lancaster University Management School > Accounting & Finance
ID Code: 45682
Deposited By: ep_importer_pure
Deposited On: 11 Jul 2011 19:36
Refereed?: Yes
Published?: Published
Last Modified: 09 Apr 2014 22:36
Identification Number:
URI: http://eprints.lancs.ac.uk/id/eprint/45682

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