Aggregate Distress Risk and Equity Returns
44 Pages Posted: 1 Aug 2015
Date Written: July 30, 2015
We show in two ways that, ceteris paribus, investors require a positive return premium for taking aggregate distress risk. First, aggregate distress risk correlates positively with future excess stock market returns. Second, stocks that provide a poor hedge against aggregate distress risk have high expected returns. To reconcile our results with previous evidence of a negative default probability-return relation, we find that default probabilities are an inadequate measure of exposure to systematic distress risk. Consistent with George and Hwang’s (2010) tradeoff theory of capital structure, firms that are more susceptible to aggregate distress risk have a lower level of leverage.
Keywords: financial distress risk; default probability; conditional equity premium; stock market return predictability; idiosyncratic risk; and financial leverage
JEL Classification: G1
Suggested Citation: Suggested Citation