RFS Advance Access originally published online on October 31, 2006
Review of Financial Studies 2008 21(6):2743-2778; doi:10.1093/rfs/hhl044
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Default Risk, Shareholder Advantage, and Stock Returns
University of Texas at Austin
University of Georgia
University of South Carolina
Send correspondence to Lorenzo Garlappi, McCombs School of Business, B6600, University of Texas at Austin, Austin, TX, 78712, or e-mail: lorenzo.garlappi{at}mccombs.utexas.edu
JEL Classification: G12, G14, G33
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Abstract |
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This paper examines the relationship between default probability and stock returns. Using the Expected Default Frequency (EDF) of Moody's KMV, we document that higher default probabilities are not associated with higher expected stock returns. Within a model of bargaining between equity holders and debt holders in default, we show that the relationship between default probability and equity return is (i) upward sloping for firms where shareholders can extract little benefit from renegotiation (low "shareholder advantage") and (ii) humped and downward sloping for firms with high shareholder advantage. This dichotomy implies that distressed firms with stronger shareholder advantage should exhibit lower expected returns in the cross section. Our empirical evidence, based on several proxies for shareholder advantage, is consistent with the model's predictions.
We are grateful to Moody's KMV for providing us with the data on Expected Default Frequency
(EDF
) and to Jeff Bohn and Shisheng Qu of Moody's KMV for help with the data and for insightful suggestions. We appreciate useful comments and suggestions from Jonathan Berk, Jason Chen, Kent Daniel, Sanjiv Das, Sergei Davydenko, Mara Faccio, Andras Fulop, Raymond Kan, Hayne Leland, Mahendrarajah Nimalendran, Burton Hollifield, George Oldfield, Hernan Ortiz-Molina, Ramesh Rao, Jacob Sagi, Matthew Spiegel (the editor), Sheridan Titman, Stathis Tompaidis, Raman Uppal, two anonymous referees, and seminar participants at George Washington University, Hong Kong University of Science and Technology, University of California at Berkeley, University of Hong Kong, University of Lausanne, University of South Carolina, University of Texas at Austin, University of Toronto, University of Vienna, the Eighth Texas Finance Festival, the Third UBC Summer Conference, the Third Moody's NYU Credit Risk Conference, and the 2006 "Festkolloquium" in honor of Phelim Boyle. We are responsible for all errors in the paper. Part of this work was done while Yan was a visiting scholar in the Office of Economic Analysis at the U.S. Security and Exchange Commission. The SEC disclaims responsibility for any private publication or statement of any SEC employee.