Investigating the Effect of Default Risk on Individual Stocks Returns using Stocks listed in Tehran Stock Exchange

The main purpose of this study is analyzing the effect of default risk on the individual stocks' expected returns, in the other words pricing the default risk, in Iran’s capital market. To this end we use a sample of 376 non-financial companies listed in Tehran Stock Exchange during September 2008 to November 2018 and compute distance to default (DD) as a measure of default risk following KMV-Merton model in a monthly frequency. In this way, market value of assets and its volatility are estimated by simultaneously solving nonlinear equations induced form Black-Scholes-Merton option pricing model. Following the literature, dependent variable of this study, expected return, is estimated using realized returns in different time periods (one month, six months, one year and two years). Then the relationship between distance to default as a firm characteristic and expected return was assessed in univariate and multivariate cross sectional regressions using Fama-Macbeth (1973) procedure and with the beta of CAPM model, size, book to market and momentum as control variables. The results show that, generally DD affects the expected return inversely, namely the smaller is the distance to default of a company (or the closer is the company to default) the higher is the company investors’ expected return. Nevertheless the effect is not completely robust and depends on the time period realized return is measured as expected return and becomes weaker in subsamples. Furthermore, if we estimate stock volatility (as an input to estimate asset DD) conditionally using exponentially weighted moving average method, the effect of DD on returns becomes stronger. The presence of explanatory variables such as size and B/M also reduces the significance of the coefficient.