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The distress premium puzzle

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  • Ali K. Ozdagli

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.

Suggested Citation

  • Ali K. Ozdagli, 2010. "The distress premium puzzle," Working Papers 10-13, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbwp:10-13
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    References listed on IDEAS

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    1. Joao F. Gomes & Lukas Schmid, 2010. "Levered Returns," Journal of Finance, American Finance Association, vol. 65(2), pages 467-494, April.
    2. 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.
    3. 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.
    4. 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.
    5. Jianjun Miao, 2005. "Optimal Capital Structure and Industry Dynamics," Journal of Finance, American Finance Association, vol. 60(6), pages 2621-2659, December.
    6. 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.
    7. 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.
    8. 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.
    9. 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, February.
    10. repec:oup:rfinst:v:25:y::i:6:p:1799-1843 is not listed on IDEAS
    11. Ball, Ray, 1978. "Anomalies in relationships between securities' yields and yield-surrogates," Journal of Financial Economics, Elsevier, vol. 6(2-3), pages 103-126.
    12. Ilan Cooper, 2006. "Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment," Journal of Finance, American Finance Association, vol. 61(1), pages 139-170, February.
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    Cited by:

    1. Yinxia G. Nielsen , Caren, 2013. "Is Default Risk Priced in Equity Returns?," Knut Wicksell Working Paper Series 2013/2, Lund University, Knut Wicksell Centre for Financial Studies.
    2. Nielsen, Caren Yinxia, 2011. "Hidden in the Factors? The Effect of Credit Risk on the Cross-section of Equity Returns," Working Papers 2011:38, Lund University, Department of Economics, revised 01 Oct 2016.

    More about this item

    Keywords

    Corporations - Finance ; Default (Finance);

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