A Unified Model of Distress Risk Puzzles

72 Pages Posted: 16 Dec 2018 Last revised: 28 Jan 2019

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, JF, 2008) and the positive distress risk premium-return relation (Friewald, Wagner, and Zechner, JF, 2014). We show analytically and quantitatively that (i) procyclical debt financing in highly distressed firms results in a negative covariance between levered equity beta with countercyclical market risk premium; (ii) the negative covariance generates low or negative stock returns and alphas among those highly distressed firms; 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

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 ECARES ULB CP 114
B-1050 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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