Prof. Lorenzo Garlappi from the University of Texas at Austin is giving a
VGSF research seminar on "Default Risk, Shareholder Advantage, and Stock
Returns" on FRIDAY, May 19th, from 15:30 to 17:00 at the Institute for
Advanced Studies (Institut für Höhere Studien, Stumpergasse 56, 1060 Wien),
Lecture Room (HS) 2. Please find the paper's abstract below.
Coffee and snacks are going to be available in the cafeteria of IHS, which
is located next to the lecture room, before and after the seminar.
Information regarding the further schedule of the VGSF research seminar can
be found at
www.vgsf.ac.at! Lorenzo is going to be available for discussions
on Friday before and after the seminar, and on the following Monday (22.5.)
and Tuesday (23.5.). If you would like to meet him, please let me know.
Best,
Michael Halling
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. We then show that the
puzzling and complex relationship between stock returns and default
probability is consistent with the implications of existing
structural models that account for possible negotiated benefits for
equity-holders upon default. Adapting the setting of the Fan and
Sundaresan (2000) model that explicitly considers the bargaining
game between equity-holders and debt-holders in financial distress,
we are able to obtain a theoretical relationship between expected
returns and default probability that resembles the empirically
observed pattern. Our analysis indicates that, depending on the
level of shareholder advantage, the relationship between default
probability and equity return may be either upward sloping (low
shareholder advantage) or humped and downward sloping (high
shareholder advantage). Moreover, we show that distressed firms in
which shareholders have a stronger advantage in renegotiation
exhibit lower expected returns, and that their default probabilities
do not adequately represent the risk of default born by equity. We
test these implications using several proxies for shareholder
advantage and find strong support in the data.