Recovery risk in stock returns

The authors provide evidence that the power of book-to-market and size attr ibutes in explaining the cross-section of stock returns may, in part, lie i n the fact that these concepts subsume useful information regarding both th e probability of bankruptcy and recovery rates. Other research that focuses primarily on the probability of default concludes that investors do not ca re about financial distress risk. The authors argue, however, that this con clusion may be premature, as the evidence suggests that investors are conce rned, ex ante, about recovery rate risk as well. The findings here have imp ortant portfolio management implications.