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A unified model of distress risk puzzles

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  • 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
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    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

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