The Distress Premium Puzzle

43 Pages Posted: 23 Nov 2010  

Ali K. Ozdagli

Federal Reserve Banks - Federal Reserve Bank of Boston

Date Written: November 16, 2010

Abstract

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: https://ssrn.com/abstract=1713449 or http://dx.doi.org/10.2139/ssrn.1713449

Ali K. Ozdagli (Contact Author)

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

600 Atlantic Avenue
Boston, MA 02210
United States

HOME PAGE: http://sites.google.com/site/ozdagli/

Paper statistics

Downloads
155
Rank
155,798
Abstract Views
875