Default Risk, Shareholder Advantage, and Stock Returns∗

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.