A Unified Model of Distress Risk Puzzles

93 Pages Posted: 16 Dec 2018 Last revised: 25 Jun 2021

See all articles by Zhiyao Chen

Zhiyao Chen

The Chinese University of Hong Kong (CUHK) - Department of Finance

Dirk Hackbarth

Boston University - Department of Finance & Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Ilya A. Strebulaev

Stanford University - Graduate School of Business; National Bureau of Economic Research

Date Written: January 19, 2019

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 (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

Chen, Zhiyao and Hackbarth, Dirk and Strebulaev, Ilya A., A Unified Model of Distress Risk Puzzles (January 19, 2019). Stanford University Graduate School of Business Research Paper No. 19-9, Available at SSRN: https://ssrn.com/abstract=3270533 or http://dx.doi.org/10.2139/ssrn.3270533

Zhiyao Chen (Contact Author)

The Chinese University of Hong Kong (CUHK) - Department of Finance ( email )

Shatin, N.T.
Hong Kong

Dirk Hackbarth

Boston University - Department of Finance & Economics ( email )

Department of Finance
595 Commonwealth Avenue
Boston, MA 02215
United States
(617) 358-4206 (Phone)
(617) 353-6667 (Fax)

HOME PAGE: http://people.bu.edu/dhackbar/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Ilya A. Strebulaev

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

HOME PAGE: http://faculty-gsb.stanford.edu/strebulaev/

National Bureau of Economic Research ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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