How Does a Firm's Default Risk Affect its Expected Equity Return?

Abstract

In an equilibrium Black and Scholes (1973) economy, a firm’s default risk and its expected equity return are non-monotonically related. This may explain the surprising relation found between these two variables in recent empirical research. Although changes in default risk induced by expected profitability and leverage effects correlate positively with changes in the expected equity return, an increase in default risk induced by changing asset volatility can have a negative impact on the expected equity return if default risk is high. My empirical evidence based on time-series regressions supports the main testable implications of the theoretical model.