Bankruptcy Risk Prediction and Pricing: Unravelling the Negative Distress Risk Premium

Abstract

In sharp contrast to the basic risk-return assumption of theoretical finance, the empirical evidence shows that distressed firms underperform non-distressed firms (e.g. Dichev, 1998; Agarwal and Taffler, 2008b). Existing literature argues that a shareholder advantage effect (Garlappi and Yan, 2011), limits of arbitrage (Shleifer and Vishny, 1997) or gambling retail investor (Kumar, 2009) could drive the underperformance. Herein, I test these potential explanations and explore the drivers of distress risk. In order to do so, I require a clean measure of distress risk. Measures of distress risk have usually been accounting-based, market-based or hybrids using both information sources. I provide the first comprehensive study that employs a variety of performance tests on different prediction models. Cont/d.