“Financial Distress and the Cross Section of Equity Returns” by Lorenzo Garlappi
University of Texas at Austin
In this paper, we provide a new perspective for understanding cross-sectional properties of equity returns. We explicitly introduce financial leverage in a simple equity valuation model and consider potential shareholder recovery upon the resolution of financial distress. Our model demonstrates the amplifying effect of leverage on the book-to-market effect and generates two novel predictions about the cross section of equity returns: (i) the value premium is hump- shaped with respect to default probability, and (ii) momentum profits are concentrated among high credit-risk firms with significant expected shareholder recovery upon financial distress. These results are robust in a more general model with endogenous dynamic investment and financing decisions and are supported by our empirical analysis. Using data simulated from a calibrated version of the general model in which a conditional CAPM holds, we illustrate how our framework can accommodate the appearance of significant alphas in the cross section of stock returns.