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. 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 to the positive distress risk premium-return relation.
Bibliographical noteFunding Information:
Bill Schwert was the editor for this article. We thank him and an anonymous referee for constructive suggestions. We also thank Philip Bond, Yasser Boualam, John Y. Campbell, Jaewon Choi, Pierre Collin-Dufresne, Hui Chen, Kent Daniel, Andrea Gamba, Amit Goyal, Yan Hong, Ron Kaniel, Hayne Leland, Jun Li, Thomas A. Mauer, Redouane Elkamhi, Lukas Schmid, and Sheridan Titman as well as conference and seminar participants at the American Finance Association annual conference (San Diego), the SFS Cavalcade meetings (Carnegie Mellon), the European Finance Association meetings (Lisbon), the Cambridge corporate finance theory symposium, the 2nd World Symposium on Investment Research (New York), the COAP conference (CASS and Inquire UK), CAFIN Workshop in Finance, the Greater Bay Area Finance Conference, the CUHK internal research workshop, Shanghai University of Finance and Economics for investment research for valuable comments. Zhiyao Chen acknowledges financial support from the General Research Fund by the Hong Kong Research Grants Council [grant number 14519816].
- Distress risk premium
- Failure probability
- Endogenous debt financing
- Endogenous distress
- Financial leverage