Abstract
Fama and French (1992) suggest that the positive value premium results from financial distress risk. However, recent empirical research finds that financially distressed firms have lower stock returns, by using empirical estimates of default probabilities. This paper reconciles the positive value premium and the negative distress premium in a model that decouples actual and risk-neutral default probabilities. Moreover, in agreement with the data, firms with higher bond yields have higher stock returns in the model. The model also captures the fact that book-to-market dominates financial leverage in explaining stock returns. Finally, the model makes the prediction that the firms with higher risk-neutral default probabilities should have higher stock returns, which can be tested using credit-default-swap premiums.
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