A Unified Model of Distress Risk Puzzles
77 Pages Posted: 16 Dec 2018 Last revised: 22 Aug 2019
Date Written: January 19, 2019
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) levered equity betas negatively covary with countercyclical market risk premium in highly distressed firms because of the substantial decline in their debt value and their procyclical debt financing; (ii) the negative covariance generates low or negative stock returns and alphas among those highly distressed firms in the conditional CAPM; and (iii) firms with lower distress risk premiums endogenously choose higher leverage, so they are more likely to become distressed and earn negative returns. We provide empirical evidence to support our model predictions.
Keywords: financial distress, distress risk premium, failure probability, structural model
JEL Classification: G12, G32, G33
Suggested Citation: Suggested Citation