Research output: Contribution to Journal/Magazine › Journal article › peer-review
Research output: Contribution to Journal/Magazine › Journal article › peer-review
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TY - JOUR
T1 - Omitted debt risk, financial distress and the cross-section of expected equity returns
AU - Aretz, K
AU - Shackleton, M B
PY - 2011
Y1 - 2011
N2 - 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.
AB - 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.
U2 - 10.1016/j.jbankfin.2010.10.018
DO - 10.1016/j.jbankfin.2010.10.018
M3 - Journal article
VL - 35
SP - 1213
EP - 1227
JO - Journal of Banking and Finance
JF - Journal of Banking and Finance
SN - 0378-4266
IS - 5
ER -