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| Default Risk, Shareholder Advantage and Stock Returns by Lorenzo Garlappi of the University of Texas at Austin, July 2006 Abstract: In this paper, we study the relationship between default probability and stock returns. Using the market-based measure of Expected Default Frequency™ (EDF™) constructed by Moody's KMV, we first demonstrate that higher default probabilities are not necessarily associated with higher expected stock returns, a finding that complements the existing empirical evidence. Adapting the setting of the Fan and Sundaresan (2000) model that explicitly considers the bargaining game between equity-holders and debt-holders of a firm in financial distress, we obtain a theoretical relationship between expected returns and default probability that resembles the empirically observed pattern. Our analysis indicates that the relationship between default probability and equity return tends to be (i) upward sloping for firms where shareholders are not likely to extract significant benefits from renegotiation (low \shareholder advantage") and (ii) humped and downward sloping for firms where shareholder advantage is strong. Moreover, this divergence in the relationship implies that distressed firms in which shareholders have a stronger advantage in renegotiation exhibit lower expected returns. We test these implications using several proxies for shareholder advantage and find results that are consistent with the model's predictions. Keywords: Default Risk, Stock Returns, Debt Renegotiation, Bankruptcy, Liquidation. Published in: Review of Financial Studies, Vol. 21, No. 6, (November 2008), pp. 2743-2778. Previously titled: Default Risk, Shareholders' Advantage and Stock Returns Books Referenced in this paper: (what is this?)
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