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How Does A Firm’s Default Risk Affect Its Expected

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In a Black and Scholes (1973) economy, a firm’s default risk and its expected equity return are non-monotonically related. This result may explain the surprising relation found between these two variables in recent empirical research. Although changes in default risk induced by expected profitability and leverage effects correlate positively with changes in the expected equity return, an increase in default risk induced by changing asset volatility can have a negative impact on the expected equity return if default risk is high. Empirical evidence based on cross-sectional and time-series tests supports the main testable implications of the theoretical model. Keywords Default risk premium, asset pricing, macroeconomic conditions JEL Classification G11 , G12, G15 This version October 22, 2011
  • The author is at Lancaster University Management School. Address for correspondence: Kevin Aretz, Department of Accounting & Finance, Lancaster University Management School, Bailrigg, Lancaster LA1 4YX , UK, tel.: +44(0)1524-593 402, fax.: +44(0)1524-847 321, e-mail: . Thanks are due to Michael Brennan, Tom George, Chris Florackis, Massimo Guidolin, Alex Kostakis, Aneel Keswani, Dick Stapleton, MartinWiddicks and seminar participants at Cass Business School (CBS), Liverpool University, Manchester Business School (MBS) and the 2010 Annual Meeting of the Financial Management Association in New York for very helpful comments and suggestions. I am especially indebted to Michael Brennan who helped me to prepare the manuscript for submission. I very gratefully acknowledge research funding from the Lancaster University Small Grant Scheme.

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