Learning, Optimal Default, and the Pricing of Distress Risk
47 Pages Posted: 27 Nov 2012 Last revised: 27 Mar 2017
Date Written: March 1, 2017
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
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