THE EFFECT OF THE DEFAULT RISK OF DEBT ON THE EARNINGS RESPONSE COEFFICIENT

The objective of this study is to examine the effect of the default ri sk of debt on the relation between accounting earnings and stock retur ns. Recent research suggests that measurements of equity beta do not c apture all dimensions of riskiness of equity. The default risk of debt may help explain how accounting earnings are linked to stock returns because the default risk of debt may capture some elements of riskines s of equity that are not captured by equity beta. We document empirica lly that the coefficient relating unexpected changes in earnings to ab normal stock returns (the earnings response coefficient or ERC) is neg atively related to the default risk of debt as measured by bond rating s.