Are the Fama-French Factors really Compensation for Distress Risk?

In this paper, we revisit the question whether the Fama-French factors are manifestation of distress risk premiums. To this end, we develop new tests specifically aimed at dissecting the Fama-French factor returns from a distress risk premium. While we find that value and small-cap exposures are typically associated with distress risk, our results also indicate that distress risk is not priced and that the small-cap and value premiums are priced beyond distress risk. Moreover, the distress risk exposures of common small-cap and value factors do not have explanatory power in asset pricing tests. Our results are robust to international out-of-sample analyses and have important implications for investors engaging in small-cap and value strategies.