IDEAS home Printed from https://ideas.repec.org/a/eee/jfinec/v146y2022i2p357-384.html
   My bibliography  Save this article

A unified model of distress risk puzzles

Author

Listed:
  • Chen, Zhiyao
  • Hackbarth, Dirk
  • Strebulaev, Ilya A.

Abstract

We document that (i) debt-to-equity ratios and levered equity betas negatively covary with the market risk premium in distressed firms; (ii) the negative covariance generates negative alphas among those firms. We build a dynamic credit risk model to understand the negative covariance between equity betas and the market risk premium, via endogenous and dynamic debt financing over the business cycles. Because of endogenous debt financing and distress, our model naturally connects the negative failure probability-return relation to the positive distress risk premium-return relation.

Suggested Citation

  • Chen, Zhiyao & Hackbarth, Dirk & Strebulaev, Ilya A., 2022. "A unified model of distress risk puzzles," Journal of Financial Economics, Elsevier, vol. 146(2), pages 357-384.
    • Handle: RePEc:eee:jfinec:v:146:y:2022:i:2:p:357-384
    DOI: 10.1016/j.jfineco.2021.10.001
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0304405X21004402
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jfineco.2021.10.001?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Ivo Welch & Amit Goyal, 2008. "A Comprehensive Look at The Empirical Performance of Equity Premium Prediction," The Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1455-1508, July.
    2. John M. Griffin & Michael L. Lemmon, 2002. "Book‐to‐Market Equity, Distress Risk, and Stock Returns," Journal of Finance, American Finance Association, vol. 57(5), pages 2317-2336, October.
    3. Hackbarth, Dirk & Miao, Jianjun & Morellec, Erwan, 2006. "Capital structure, credit risk, and macroeconomic conditions," Journal of Financial Economics, Elsevier, vol. 82(3), pages 519-550, December.
    4. Goldstein, Robert & Ju, Nengjiu & Leland, Hayne, 2001. "An EBIT-Based Model of Dynamic Capital Structure," The Journal of Business, University of Chicago Press, vol. 74(4), pages 483-512, October.
    5. John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2008. "In Search of Distress Risk," Journal of Finance, American Finance Association, vol. 63(6), pages 2899-2939, December.
    6. 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, June.
    7. Peter M. Demarzo, 2019. "Presidential Address: Collateral and Commitment," Journal of Finance, American Finance Association, vol. 74(4), pages 1587-1619, August.
    8. Strebulaev, Ilya A. & Whited, Toni M., 2012. "Dynamic Models and Structural Estimation in Corporate Finance," Foundations and Trends(R) in Finance, now publishers, vol. 6(1–2), pages 1-163, November.
    9. Koijen, Ralph S.J. & Lustig, Hanno & Van Nieuwerburgh, Stijn, 2017. "The cross-section and time series of stock and bond returns," Journal of Monetary Economics, Elsevier, vol. 88(C), pages 50-69.
    10. 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.
    11. Jaewon Choi, 2013. "What Drives the Value Premium?: The Role of Asset Risk and Leverage," The Review of Financial Studies, Society for Financial Studies, vol. 26(11), pages 2845-2875.
    12. Leland, Hayne E, 1994. "Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-1252, September.
    13. Chaderina, Maria & Weiss, Patrick & Zechner, Josef, 2022. "The maturity premium," Journal of Financial Economics, Elsevier, vol. 144(2), pages 670-694.
    14. Scott Cederburg & Michael S. O'Doherty, 2016. "Does It Pay to Bet Against Beta? On the Conditional Performance of the Beta Anomaly," Journal of Finance, American Finance Association, vol. 71(2), pages 737-774, April.
    15. Ron Giammarino & Murray Carlson & Adlai Fisher, 2004. "Corporate Investment and Asset Price Dynamics: Implications for Post-SEO Performance," 2004 Meeting Papers 812, Society for Economic Dynamics.
    16. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    17. Ilya A. Strebulaev, 2007. "Do Tests of Capital Structure Theory Mean What They Say?," Journal of Finance, American Finance Association, vol. 62(4), pages 1747-1787, August.
    18. Harjoat S. Bhamra & Lars-Alexander Kuehn & Ilya A. Strebulaev, 2010. "The Aggregate Dynamics of Capital Structure and Macroeconomic Risk," The Review of Financial Studies, Society for Financial Studies, vol. 23(12), pages 4187-4241, December.
    19. Peter M. Demarzo & Zhiguo He, 2021. "Leverage Dynamics without Commitment," Journal of Finance, American Finance Association, vol. 76(3), pages 1195-1250, June.
    20. Hayne Leland & Dirk Hackbarth, 2019. "Debt Maturity and the Leverage Ratcheting Effect," Finance, Presses universitaires de Grenoble, vol. 40(3), pages 13-44.
    21. Harjoat S. Bhamra & Lars-Alexander Kuehn & Ilya A. Strebulaev, 2010. "The Levered Equity Risk Premium and Credit Spreads: A Unified Framework," The Review of Financial Studies, Society for Financial Studies, vol. 23(2), pages 645-703, February.
    22. Heitor Almeida & Thomas Philippon, 2007. "The Risk‐Adjusted Cost of Financial Distress," Journal of Finance, American Finance Association, vol. 62(6), pages 2557-2586, December.
    23. repec:bla:jfinan:v:59:y:2004:i:6:p:2577-2603 is not listed on IDEAS
    24. Stambaugh, Robert F., 1999. "Predictive regressions," Journal of Financial Economics, Elsevier, vol. 54(3), pages 375-421, December.
    25. Andrea Gamba & Alessio Saretto, 2020. "Growth Options and Credit Risk," Management Science, INFORMS, vol. 66(9), pages 4269-4291, September.
    26. Glover, Brent, 2016. "The expected cost of default," Journal of Financial Economics, Elsevier, vol. 119(2), pages 284-299.
    27. Elkamhi, Redouane & Ericsson, Jan & Parsons, Christopher A., 2012. "The cost and timing of financial distress," Journal of Financial Economics, Elsevier, vol. 105(1), pages 62-81.
    28. Ali K. Ozdagli, 2012. "Financial Leverage, Corporate Investment, and Stock Returns," The Review of Financial Studies, Society for Financial Studies, vol. 25(4), pages 1033-1069.
    29. Lewellen, Jonathan & Nagel, Stefan, 2006. "The conditional CAPM does not explain asset-pricing anomalies," Journal of Financial Economics, Elsevier, vol. 82(2), pages 289-314, November.
    30. Halling, Michael & Yu, Jin & Zechner, Josef, 2016. "Leverage dynamics over the business cycle," Journal of Financial Economics, Elsevier, vol. 122(1), pages 21-41.
    31. George, Thomas J. & Hwang, Chuan-Yang, 2010. "A resolution of the distress risk and leverage puzzles in the cross section of stock returns," Journal of Financial Economics, Elsevier, vol. 96(1), pages 56-79, April.
    32. repec:bla:jfinan:v:53:y:1998:i:5:p:1443-1493 is not listed on IDEAS
    33. Long Chen & Pierre Collin-Dufresne & Robert S. Goldstein, 2009. "On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle," The Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3367-3409, September.
    34. Mikhail Simutin, 2010. "Excess Cash and Stock Returns," Financial Management, Financial Management Association International, vol. 39(3), pages 1197-1222, September.
    35. Sergei A. Davydenko & Ilya A. Strebulaev & Xiaofei Zhao, 2012. "A Market-Based Study of the Cost of Default," The Review of Financial Studies, Society for Financial Studies, vol. 25(10), pages 2959-2999.
    36. Pierre Collin‐Dufresne & Robert S. Goldstein, 2001. "Do Credit Spreads Reflect Stationary Leverage Ratios?," Journal of Finance, American Finance Association, vol. 56(5), pages 1929-1957, October.
    37. Boguth, Oliver & Carlson, Murray & Fisher, Adlai & Simutin, Mikhail, 2011. "Conditional risk and performance evaluation: Volatility timing, overconditioning, and new estimates of momentum alphas," Journal of Financial Economics, Elsevier, vol. 102(2), pages 363-389.
    38. Johnson, T.C. & Chebonenko, T. & Cunha, I. & D'Almeida, F. & Spencer, X., 2011. "Endogenous leverage and expected stock returns," Finance Research Letters, Elsevier, vol. 8(3), pages 132-145, September.
    39. Petkova, Ralitsa & Zhang, Lu, 2005. "Is value riskier than growth?," Journal of Financial Economics, Elsevier, vol. 78(1), pages 187-202, October.
    40. repec:bla:jfinan:v:59:y:2004:i:2:p:831-868 is not listed on IDEAS
    41. Hayne E. Leland., 1998. "Agency Costs, Risk Management, and Capital Structure," Research Program in Finance Working Papers RPF-278, University of California at Berkeley.
    42. Luca Benzoni & Lorenzo Garlappi & Robert S. Goldstein & Julien Hugonnier & Chao Ying, 2020. "Optimal Debt Dynamics, Issuance Costs, and Commitment," Working Paper Series WP-2020-20, Federal Reserve Bank of Chicago.
    43. Francisco Covas & Wouter J. Den Haan, 2011. "The Cyclical Behavior of Debt and Equity Finance," American Economic Review, American Economic Association, vol. 101(2), pages 877-899, April.
    44. Arnold, Marc & Wagner, Alexander F. & Westermann, Ramona, 2013. "Growth options, macroeconomic conditions, and the cross section of credit risk," Journal of Financial Economics, Elsevier, vol. 107(2), pages 350-385.
    45. Nils Friewald & Christian Wagner & Josef Zechner, 2014. "The Cross-Section of Credit Risk Premia and Equity Returns," Journal of Finance, American Finance Association, vol. 69(6), pages 2419-2469, December.
    46. repec:bla:jfinan:v:53:y:1998:i:3:p:1131-1147 is not listed on IDEAS
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Jiao, Feng & Zhang, Chuanqian, 2022. "Lumpy investment and credit risk," Journal of Corporate Finance, Elsevier, vol. 77(C).
    2. Dainelli, Francesco & Bet, Gianmarco & Fabrizi, Eugenio, 2024. "The financial health of a company and the risk of its default: Back to the future," International Review of Financial Analysis, Elsevier, vol. 95(PB).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Haque, Sharjil & Varghese, Richard, 2023. "Firms’ rollover risk, capital structure and unequal exposure to aggregate shocks," Journal of Corporate Finance, Elsevier, vol. 80(C).
    2. François Gourio, 2013. "Credit Risk and Disaster Risk," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 1-34, July.
    3. Glover, Brent, 2016. "The expected cost of default," Journal of Financial Economics, Elsevier, vol. 119(2), pages 284-299.
    4. Nils Friewald & Florian Nagler & Christian Wagner, 2022. "Debt Refinancing and Equity Returns," Journal of Finance, American Finance Association, vol. 77(4), pages 2287-2329, August.
    5. Arnold, Marc & Wagner, Alexander F. & Westermann, Ramona, 2013. "Growth options, macroeconomic conditions, and the cross section of credit risk," Journal of Financial Economics, Elsevier, vol. 107(2), pages 350-385.
    6. Lotfaliei, Babak, 2018. "The variance risk premium and capital structure," ESRB Working Paper Series 70, European Systemic Risk Board.
    7. Chen, Hui & Xu, Yu & Yang, Jun, 2021. "Systematic risk, debt maturity, and the term structure of credit spreads," Journal of Financial Economics, Elsevier, vol. 139(3), pages 770-799.
    8. Shi, Zhan, 2019. "Time-varying ambiguity, credit spreads, and the levered equity premium," Journal of Financial Economics, Elsevier, vol. 134(3), pages 617-646.
    9. Chen, Chang-Chih & Ho, Kung-Cheng & Yan, Cheng & Yeh, Chung-Ying & Yu, Min-Teh, 2023. "Does ambiguity matter for corporate debt financing? Theory and evidence," Journal of Corporate Finance, Elsevier, vol. 80(C).
    10. Hui Chen & Yu Xu & Jun Yang, 2012. "Systematic Risk, Debt Maturity and the Term Structure of Credit Spreads," Staff Working Papers 12-27, Bank of Canada.
    11. Assaf Eisdorfer & Efdal Ulas Misirli, 2020. "Distressed Stocks in Distressed Times," Management Science, INFORMS, vol. 66(6), pages 2452-2473, June.
    12. Chaderina, Maria & Weiss, Patrick & Zechner, Josef, 2022. "The maturity premium," Journal of Financial Economics, Elsevier, vol. 144(2), pages 670-694.
    13. Luca Benzoni & Lorenzo Garlappi & Robert Goldstein, 2023. "Incomplete Information, Debt Issuance, and the Term Structure of Credit Spreads," Management Science, INFORMS, vol. 69(7), pages 4331-4352, July.
    14. Jianjun Miao & PENGFEI WANG, 2010. "Credit Risk and Business Cycles," Boston University - Department of Economics - Working Papers Series WP2010-033, Boston University - Department of Economics.
    15. João F. Gomes & Lukas Schmid, 2021. "Equilibrium Asset Pricing with Leverage and Default," Journal of Finance, American Finance Association, vol. 76(2), pages 977-1018, April.
    16. Shilin Li & Jinqiang Yang & Siqi Zhao, 2022. "Robust leverage dynamics without commitment," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 74(2), pages 643-679, September.
    17. Kapadia, Nikunj & Pu, Xiaoling, 2012. "Limited arbitrage between equity and credit markets," Journal of Financial Economics, Elsevier, vol. 105(3), pages 542-564.
    18. Ban, Mingyuan & Chen, Chang-Chih, 2019. "Ambiguity and capital structure adjustments," International Review of Economics & Finance, Elsevier, vol. 64(C), pages 242-270.
    19. Giesecke, Kay & Longstaff, Francis A. & Schaefer, Stephen & Strebulaev, Ilya, 2011. "Corporate bond default risk: A 150-year perspective," Journal of Financial Economics, Elsevier, vol. 102(2), pages 233-250.
    20. Marc Arnold & Dirk Hackbarth & Tatjana Xenia Puhan, 2018. "Financing Asset Sales and Business Cycles [Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries]," Review of Finance, European Finance Association, vol. 22(1), pages 243-277.

    More about this item

    Keywords

    Distress risk premium; Failure probability; Endogenous debt financing; Endogenous distress; Financial leverage;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jfinec:v:146:y:2022:i:2:p:357-384. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/505576 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.