Default Risk, Shareholder Advantage and Stock Returns

59 Pages Posted: 21 Mar 2006

See all articles by Lorenzo Garlappi

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business

Tao Shu

The Chinese University of Hong Kong, Shenzhen; Shenzhen Finance Institute

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Multiple version iconThere are 2 versions of this paper

Date Written: November 2006

Abstract

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

Garlappi, Lorenzo and Shu, Tao and Yan, Hong, Default Risk, Shareholder Advantage and Stock Returns (November 2006). McCombs Research Paper Series No. FIN-05-06, Available at SSRN: https://ssrn.com/abstract=890348 or http://dx.doi.org/10.2139/ssrn.890348

Lorenzo Garlappi (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Tao Shu

The Chinese University of Hong Kong, Shenzhen ( email )

Shenzhen Finance Institute ( email )

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

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