Probability Weighting and Default Risk: A Possible Explanation for Distressed Stock Puzzles

Abstract

This paper suggests incorporating investor probability weighting and the default risk of individual firms into a consumption-based asset pricing model. The extended model provides a unified solution for several anomalous patterns observed on financial markets. The analysis addresses not only widely-recognized asset pricing puzzles, such as the equity premium puzzle, but also less studied anomalies on financially distressed stocks. The simulation, under which the model is calibrated according to U.S. historical data, shows the combination of mild overweighting of probability on tail events and nonlinearity of equity values caused by default risk has the potential to resolve these patterns.

Keywords: asset pricing puzzles; consumption-based asset pricing; distressed stock; probability weighting function; default risk; business time

JEL Classification: G12