Default Risk and Expected Equity Returns: Theory and Evidence

Abstract

In a rational, representative agent model, a firm's default risk can relate to its expected equity return in a non-linear fashion, with higher default risk firms possibly having lower expected equity returns than lower default risk firms. This might explain the often unintuitive pattern between these two variables in recent empirical studies. Although default risk changes induced through the expected asset payment and debt associate positively with expected equity return changes, for highly distressed firms higher default risk induced through lower volatility has an ambiguous impact on the expected equity return. When default risk is extremely high, higher volatility benefits equity-holders through a higher chance of obtaining a positive payment, but can also hurt them through probability mass being shifted from highly desirable to less desirable states of nature. In this setup, the default risk premium also depends on macroeconomic conditions. Preliminary empirical evidence is consistent with these conjectures.