Investing on the risk of company bankruptcy

Sammanfattning: We investigate the risk-return relationship between bankruptcy risk, measured by Skogsvik (1990)'s probability of firm failure ("pfail"), and stock returns on a refined stock sample on Stockholmsbörsen between 2002 and 2017. Using portfolio analysis and cross sectional regressions inspired by Fama-MacBeth (1973), we find lacking evidence to support a distress risk premium. While investors are better off investing in portfolios with low risk of bankruptcy "over time", i.e. when investors are persistently dedicated to the investment strategy for the entire time horizon, we do not find sufficient support for a combined long-short strategy. When instead splitting the time horizon into Pre/during and Post the Global Financial Crisis, we argue that investors have become increasingly risk-averse Post crisis. As a result, the combined long-short strategy can be successfully executed 5 out of 8 years Post crisis, in contrast to 1 out of 7 years Pre/during crisis.