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. 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.
| Original language | English |
|---|---|
| Pages (from-to) | 357-384 |
| Number of pages | 28 |
| Journal | Journal of Financial Economics |
| Volume | 146 |
| Issue number | 2 |
| Early online date | 4 Aug 2022 |
| DOIs | |
| Publication status | Published - Nov 2022 |
Bibliographical note
Publisher Copyright:© 2021
Funding
Zhiyao Chen acknowledges financial support from the General Research Fund by the Hong Kong Research Grants Council [grant number 14519816].
Keywords
- Distress risk premium
- Failure probability
- Endogenous debt financing
- Endogenous distress
- Financial leverage