A Unified Model of Distress Risk Puzzles
72 Pages Posted: 16 Dec 2018 Last revised: 28 Jan 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, 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: Suggested Citation