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Default Risk, Shareholder Advantage, and Stock Returns

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Author Info

  • Lorenzo Garlappi
  • Tao Shu
  • Hong Yan
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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 benefit 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. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org., Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rfs/hhl044
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Bibliographic Info

Article provided by Oxford University Press for Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 21 (2008)
Issue (Month): 6 (November)
Pages: 2743-2778
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Handle: RePEc:oup:rfinst:v:21:y:2008:i:6:p:2743-2778

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Cited by:
  1. Campbell, John Y. & Hilscher, Jens & Szilagyi, Jan, 2005. "In search of distress risk," Discussion Paper Series 1: Economic Studies 2005,27, Deutsche Bundesbank, Research Centre.
  2. Ali K. Ozdagli, 2010. "The distress premium puzzle," Working Papers 10-13, Federal Reserve Bank of Boston.
  3. Kara, A. & Marques-Ibanez, D. & Ongena, S., 2011. "Securitization and Lending Standards: Evidence from the Wholesale Loan Market," Discussion Paper 2011-081, Tilburg University, Center for Economic Research.

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