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The distress premium puzzle

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  • Ali K. Ozdagli
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    Abstract

    Fama 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.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 10-13.

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    Date of creation: 2010
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    Handle: RePEc:fip:fedbwp:10-13

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    Keywords: Corporations - Finance ; Default (Finance);

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    1. 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.
    2. Ball, Ray, 1978. "Anomalies in relationships between securities' yields and yield-surrogates," Journal of Financial Economics, Elsevier, vol. 6(2-3), pages 103-126.
    3. 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.
    4. 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.
    5. Jianjun Miao, 2003. "Optimal Capital Structure and Industry Dynamics," Industrial Organization 0310001, EconWPA.
    6. John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2006. "In Search of Distress Risk," NBER Working Papers 12362, National Bureau of Economic Research, Inc.
    7. Joao F. Gomes & Lukas Schmid, 2010. "Levered Returns," Journal of Finance, American Finance Association, vol. 65(2), pages 467-494, 04.
    8. 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.
    9. repec:oup:rfinst:v:25:y::i:6:p:1799-1843 is not listed on IDEAS
    10. Anginer, Deniz & Yildizhan, Celim, 2009. "Is there a Distress Risk Anomaly? Pricing of Systematic Default Risk in the Cross Section of Equity Returns," MPRA Paper 53885, University Library of Munich, Germany, revised 23 Apr 2013.
    11. 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.
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