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Recovery Risk in Stock Returns

The authors provide evidence that the power of book–to–market and size attributes in explaining the cross–section of stock returns may, in part, lie in the fact that these concepts subsume useful information regarding both the probability of bankruptcy and recovery rates. Other research that focuses primarily on the probability of default concludes that investors do not care about financial distress risk. The authors argue, however, that this conclusion may be premature, as the evidence suggests that investors are concerned, ex ante, about recovery rate risk as well. The findings here have important portfolio management implications.