Is the risk of failure a systematic risk? Several studies suggest that a firm distress risk factor may underlie size and book-to-market effects. A natural indicator of corporate failure is the risk of bankruptcy. If failure risk is systematic, one would expect a positive association between failure risk and subsequent realized returns. However, the results demonstrate that the risk of failure is not rewarded by higher returns. Therefore, a distress factor is unlikely to account for size and book-to-market effects. Surprisingly, companies with a high risk of failure have achieved lower-than-average returns since 1980. A risk-based explanation cannot fully explain the anomalous evidence. SEVERAL STUDIES SUGGEST that the effects of firm size and book-to-market, arguably the two most powerful predictors of stock returns, could be related to some sort of firm distress risk factor. For example, Chan and Chen ~1991! find that “marginal” firms, or inefficient firms with high leverage and cash flow problems, appear to drive the small firm effect. Fame and French ~1992! conjecture that the book-to-market effect could be due to distress risk. Chan, Chen and Hsieh ~1985! show that much of the size effect is explained by a default factor, calculated as the difference between high-quality and lower-quality bond yields. Fame and French ~1993! and Chen, Roll and Ross ~1986! find that a similarly defined default factor is significant in explaining stock returns. This study investigates the importance of the firm's distress risk factor and its relationship with size and book-to-market effects. The probability of failure is a natural indicator of corporate failure, and there is a well-developed literature on bankruptcy prediction that provides powerful measures of ex ante failure risk ~see Altman ~1993! for a review!. Evidence that failure risk is systematic would support a stressor explanation for size and book-to-market effects. Existing evidence on the relationship between failure risk and systematic risk is mostly circumstantial and often contradictory. Lang and Stulz ~1992! and Denis and Denis ~1995! demonstrate that failure risk is related to aggregate factors, implying that failure risk could be positively related to systematic risk. Shumway ~1996! finds that NYSE and AMEX firms at high risk of delisting for performance reasons earn above-average returns, suggesting that default risk is systematic. However, Opler and Titman ~1994! and Asquith, Gertner and Sharfstein ~1994! find that failure is mainly due to idiosyncratic factors, which suggests that failure risk is unrelated to systematic risk.