Abstract

https://ssrn.com/abstract=895729
 
 

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Default Risk, Shareholder Advantage, and Stock Returns*


Lorenzo Garlappi


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

Tao Shu


University of Georgia - Department of Finance

Hong Yan


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

March 2006

8th Annual Texas Finance Festival

Abstract:     
In this paper, we study the relationship between default probability and stock returns. Using the market-based measure of Expected Default Frequency* (EDF) constructed by Moody's KVM, we first demonstrate that higher default probabilities are not necessarily associated with higher expected stock returns, a finding that complements the existing empirical evidence. We then show that the puzzling and complex relationship between stock returns and default probability is consistent with the implications of existing structural models that account for possible negotiated benefits for equity-holders upon default. Adapting the setting of the Fan and Sundarasan (2000) model that explicitly considers the bargaining game between equity-holders and debt-holders in default probability that resembles the empirically observed pattern. Our analysis indicated that, depending on the level of shareholder advantage, the relationship advantage, the relationship between default probability and equity return may be either upward sloping (low shareholder advantage) or humped and downward sloping (high shareholder advantage). Moreover, we show that distressed firms in which shareholders have a stronger advantage in renegotiation exhibit lower expected returns, and that their default probabilities do not adequately represent the risk of default born by equity. We test these implications using several proxies for shareholder advantage and find strong support in the data.

Number of Pages in PDF File: 56

Keywords: Default Risk, Stock Returns, Debt Renegotiatin, Bankruptcy, Liquidation

JEL Classification: G12, G14


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Date posted: April 7, 2006  

Suggested Citation

Garlappi, Lorenzo and Shu, Tao and Yan, Hong, Default Risk, Shareholder Advantage, and Stock Returns* (March 2006). 8th Annual Texas Finance Festival . Available at SSRN: https://ssrn.com/abstract=895729 or http://dx.doi.org/10.2139/ssrn.895729

Contact Information

Lorenzo Garlappi (Contact Author)
University of British Columbia (UBC) - Sauder School of Business ( email )
2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
Tao Shu
University of Georgia - Department of Finance ( email )
Department of Finance
Terry College of Business, University of Georgia
Athens, GA 30602
United States

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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