Is Bankruptcy Risk a Systematic Risk? Evidence from Pakistan Stock Exchange

This study empirically investigates the relationship between default risk and crosssection of stock returns in the Pakistan Stock Exchange (PSX). Stock price data from all listed and delisted companies use to calculate monthly return sftom 2001-2016. Ohlson's O-score is employed to measure exposure of firm to systematic deviation within bankruptcy risk. Besides, asset-pricing models like the Capital Asset Pricing Model (CAPM) and Fama French (FF) models are employed. Portfolios are sorted in deciles by default probability. This result finds that stocks of firms significantly exposed to not diversified Default Risk yield higher returns. Besides that, the FF models explain cross-sectional stock returns since factors incorporate information on financial distress and default. After that, the book-to-market equity factor is not significant in elucidating returns of distressed firms because of market inefficiency. Results have practical implications for portfolio managers and investors of an emerging economy in developing diversified portfolios during periods of uncertainty and market volatility.