The Distress Premium Puzzle

43 Pages Posted: 23 Nov 2010

See all articles by Ali K. Ozdagli

Ali K. Ozdagli

Federal Reserve Banks - Federal Reserve Bank of Dallas

Date Written: November 16, 2010


Fama and French (1992) suggest that the positive value premium results from financial distress risk. However, recent empirical research finds that financially distressed firms have lower stock returns, by using empirical estimates of default probabilities. This paper reconciles the positive value premium and the negative distress premium in a model that decouples actual and risk-neutral default probabilities. Moreover, in agreement with the data, firms with higher bond yields have higher stock returns in the model. The model also captures the fact that book-to-market dominates financial leverage in explaining stock returns. Finally, the model makes the prediction that the firms with higher risk-neutral default probabilities should have higher stock returns, which can be tested using credit-default-swap premiums.

Keywords: Distress premium, value premium

JEL Classification: JEL Codes: G12, G32, G33

Suggested Citation

Ozdagli, Ali K., The Distress Premium Puzzle (November 16, 2010). Available at SSRN: or

Ali K. Ozdagli (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

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