A Unified Model of Distress Risk Puzzles

80 Pages Posted: 16 Dec 2018 Last revised: 27 Feb 2020

See all articles by Zhiyao Chen

Zhiyao Chen

The Chinese University of Hong Kong (CUHK) - Department of Finance

Dirk Hackbarth

Boston University - Department of Finance & Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Ilya A. Strebulaev

Stanford University - Graduate School of Business; National Bureau of Economic Research

Date Written: January 19, 2019

Abstract

We build a dynamic model to link two empirical patterns:\ the negative failure probability-return relation (Campbell, Hilscher, and Szilagyi, 2008) and the positive distress risk premium-return relation (Friewald, Wagner, and Zechner, 2014). We show analytically and quantitatively that (i) equity-to-debt ratios and levered equity betas negatively covary with the market risk premium in distressed firms; (ii) negative covariance generates low stock returns and negative alphas among those firms; and (iii) firms with a lower distress risk premium endogenously choose higher leverage, so they are more likely to become distressed and earn negative returns. Finally, empirical evidence supports our model predictions.

Keywords: financial distress, distress risk premium, failure probability, structural model

JEL Classification: G12, G32, G33

Suggested Citation

Chen, Zhiyao and Hackbarth, Dirk and Strebulaev, Ilya A., A Unified Model of Distress Risk Puzzles (January 19, 2019). Stanford University Graduate School of Business Research Paper No. 19-9. Available at SSRN: https://ssrn.com/abstract=3270533 or http://dx.doi.org/10.2139/ssrn.3270533

Zhiyao Chen (Contact Author)

The Chinese University of Hong Kong (CUHK) - Department of Finance ( email )

Shatin, N.T.
Hong Kong

Dirk Hackbarth

Boston University - Department of Finance & Economics ( email )

Department of Finance
595 Commonwealth Avenue
Boston, MA 02215
United States
(617) 358-4206 (Phone)
(617) 353-6667 (Fax)

HOME PAGE: http://people.bu.edu/dhackbar/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Ilya A. Strebulaev

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

HOME PAGE: http://faculty-gsb.stanford.edu/strebulaev/

National Bureau of Economic Research ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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