Why some Distressed Firms Have Low Expected Returns. ( Revised in September. 2007 )

Abstract

In recent years, empirical researchers show that firms with higher credit risk have much smaller average stock returns. This finding is opposite to the risk-reward principle and is often attributed to mispricing and market anomalies. We investigate how credit risk and expected stock return are determined in a model with production, capital structure and aggregate uncertainty. We show that, contrary to the conventional wisdom, a firm with higher credit risk can have less risky stock than the one with lower credit risk.