Default Risk, Shareholder Advantage and Stock Returns
59 Pages Posted: 21 Mar 2006
Date Written: November 2006
This paper examines the relationship between default probability and stock returns. Using the Expected Default Frequency (EDF) of Moody's KMV, we document that higher default probabilities are not associated with higher expected stock returns. Within a model of bargaining between equity-holders and debt-holders in default, we show that the relationship between default probability and equity return is (i) upward sloping for firms where shareholders can extract little benefits from renegotiation (low shareholder advantage) and (ii) humped and downward sloping for firms with high shareholder advantage. This dichotomy implies that distressed firms with stronger shareholder advantage should exhibit lower expected returns in the cross-section. Our empirical evidence, based on several proxies for shareholder advantage, is consistent with the model's predictions.
Keywords: Default Risk, Stock Returns, Debt Renegotiation, Bankruptcy, Liquidation
JEL Classification: G12, G14
Suggested Citation: Suggested Citation