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Learning, Optimal Default, and the Pricing of Distress Risk

47 Pages Posted: 27 Nov 2012 Last revised: 27 Mar 2017

Christian C. Opp

University of Pennsylvania - The Wharton School

Date Written: March 1, 2017

Abstract

I propose a tractable asset pricing model to study distressed firms' returns when agents dynamically learn about firm solvency and make optimal default decisions. As distressed firms' access to finance depends on investors' information quality, the future speed of learning critically affects prices and risk premia. Through this feedback channel, the cost of equity can decrease with leverage and become negative, contrary to typical interpretations of Modigliani and Miller (1958). The model yields closed-form solutions and sheds light on key asset pricing puzzles related to financial distress, including the momentum anomaly and abnormal returns following private placements of public equity.

Keywords: Expected Returns, Financial Distress, Learning, Momentum, Anomalies, PIPE, Activist Investors

Suggested Citation

Opp, Christian C., Learning, Optimal Default, and the Pricing of Distress Risk (March 1, 2017). Available at SSRN: https://ssrn.com/abstract=2181441 or http://dx.doi.org/10.2139/ssrn.2181441

Christian C. Opp (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-573-3186 (Phone)

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