Monotonicity in Distress Risk Portfolios

Abstract: Is Default Risk Priced? Empirical Evidence in the Presence of Fat Tails Originality: It is common to study and measure risk premiums, such as that associated with the risk of financial distress, in terms of the differential between mean returns of the extreme portfolios (i.e. high and low distress risk). Not only are such approaches sensitive to model specification, distributional assumptions and the measurement error, they do not address directly the question of whether risk exposures and measured risk premiums are monotonically related - as would be expected if distress is viewed as a systematic source of risk. The current study applies the recent methodology of Patton and Timmerman (2010) as a direct test of the monotonicity hypothesis. Findings: Using a formal test of monotonicity this paper finds little evidence of a systematic relationship between expected return and distress risk premiums. Statistically significant distress-related equity premiums appear observable at the extremes of exposure only.