A Unified Model of Distress Risk Puzzles
93 Pages Posted: 16 Dec 2018 Last revised: 25 Jun 2021
Date Written: January 19, 2019
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 (Campbell, Hilscher, and Szilagyi, CHS, 2008). 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 (CHS, 2008) with the positive distress risk premium-return relation (Friewald, Wagner, and Zechner, 2014).
Keywords: financial distress, distress risk premium, failure probability, structural model
JEL Classification: G12, G32, G33
Suggested Citation: Suggested Citation