Does fear spur default risk?

While a large body of research documents various firm characteristics and market conditions that drive corporate default, whether risk aversion matters for default risk remains largely under-investigated. A challenge for prior studies that aim to examine the impact of fear on default risk is that investor risk aversion is not an exogenous variable or the presence of omitted variables that drive both risk aversion and default risk. To address endogeneity concerns, we use the 9/11 terrorist attacks, the largest mega-terrorist event, as an exogenous shock to the investor's risk aversion. Our findings show the significantly increased default risks at both market and firm levels following the 9/11 attacks. Terrorism causes an increase in market-wide default risk for firms located in the attacked states and other states. Our findings are consistent with the notion that terrorist attacks increase investors' risk aversion, which triggers an increase in asset volatility, leading to increased default risk.