The Connection between Equity Returns and Default Risk

Studies into the connection between returns on equity and default risk have shown that the two variables have a negative correlation (Gharghori, Chan, & Faff, 2009). Small firms with high book-to-market values are expected to have high equity returns if their default risks are high. However, the firms will only realize high returns on their equity if their BM is also high. Big firms with high default risks are expected to realize lower returns on their equity if their BM is low. Companies’ credit rating ranges between 300 and 850. Most companies’ credit rating ranges between 670 and 739.