The distress premium puzzle
AbstractFama and French (1992) suggest that the positive value premium results from risk of financial distress. However, recent empirical research has found that financially distressed firms have lower stock returns, using empirical estimates of default probabilities. This paper reconciles the positive value premium and the negative distress premium in a model that decouples actual and risk-neutral default probabilities. Moreover, in agreement with the data, firms with higher bond yields have higher stock returns in the model. The model also captures the fact that book-to-market value dominates financial leverage in explaining stock returns. Finally, the model predicts that firms with higher risk-neutral default probabilities should have higher stock returns, a hypothesis that can be tested using credit default swap premiums.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Federal Reserve Bank of Boston in its series Working Papers with number 10-13.
Date of creation: 2010
Date of revision:
This paper has been announced in the following NEP Reports:
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Szilagyi, Jan & Hilscher, Jens & Campbell, John, 2008.
"In Search of Distress Risk,"
3199070, Harvard University Department of Economics.
- John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2005. "In Searach of Distress Risk," Harvard Institute of Economic Research Working Papers 2081, Harvard - Institute of Economic Research.
- John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2006. "In Search of Distress Risk," NBER Working Papers 12362, National Bureau of Economic Research, Inc.
- 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.
- Jianjun Miao, 2003.
"Optimal Capital Structure and Industry Dynamics,"
- Fischer, Edwin O & Heinkel, Robert & Zechner, Josef, 1989. " Dynamic Capital Structure Choice: Theory and Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 19-40, March.
- Lorenzo Garlappi & Hong Yan, 2011. "Financial Distress and the Cross‐section of Equity Returns," Journal of Finance, American Finance Association, vol. 66(3), pages 789-822, 06.
- Martin Lettau & Jessica Wachter, 2005.
"Why is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium,"
NBER Working Papers
11144, National Bureau of Economic Research, Inc.
- Martin Lettau & Jessica A. Wachter, 2007. "Why Is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium," Journal of Finance, American Finance Association, vol. 62(1), pages 55-92, 02.
- Jessica Wachter & Martin Lettau, 2005. "Why is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium," 2005 Meeting Papers 302, Society for Economic Dynamics.
- Lettau, Martin & Wachter, Jessica, 2005. "Why is Long-Horizon Equity Less Risky? A Duration-based Explanation of the Value Premium," CEPR Discussion Papers 4921, C.E.P.R. Discussion Papers.
- Hui Chen, 2010.
"Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure,"
NBER Working Papers
16151, National Bureau of Economic Research, Inc.
- Hui Chen, 2010. "Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure," Journal of Finance, American Finance Association, vol. 65(6), pages 2171-2212, December.
- Lorenzo Garlappi & Tao Shu & Hong Yan, 2008. "Default Risk, Shareholder Advantage, and Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2743-2778, November.
- Ball, Ray, 1978. "Anomalies in relationships between securities' yields and yield-surrogates," Journal of Financial Economics, Elsevier, vol. 6(2-3), pages 103-126.
- Lukas Schmid & Joao Gomes, 2007.
2007 Meeting Papers
1007, Society for Economic Dynamics.
- Anginer, Deniz & Yildizhan, Celim, 2010. "Is there a distress risk anomaly ? pricing of systematic default risk in the cross section of equity returns," Policy Research Working Paper Series 5319, The World Bank.
- repec:oup:rfinst:v:25:y::i:6:p:1799-1843 is not listed on IDEAS
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Catherine Spozio).
If references are entirely missing, you can add them using this form.