Abstract
We construct an asset pricing model with explicit default to develop a risk-based source of the distress anomaly. We show that distress produces sharply countercyclical betas leading to biased estimates of risk premia and alphas. This effect is amplified when earnings growth is mean-reverting, so that distressed stocks also have high expected future earnings. This bias can account for between 39 and 76 percent of the distress anomaly in a calibrated economy that replicates the key characteristics of these stocks.
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