1 Discussion: In Search of Distress Risk and Default Risk, Shareholder Advantage, and Stock Returns Kent D. Daniel 1 1 Goldman Sachs Asset Management and Kellogg, Northwestern NYU/Moody s Credit Conference, 9 May, 2006
2 Two Views Two Views The Value Effect Distress Risk These papers address the same question: Can the distress premium can be explained by risk? These two papers provide opposite conclusions: Garlappi, Shu and Yan () argue that it can. Campbell, Hilscher and Szilagyi () argue that it cannot. I want to examine why they reach these conclusions. However, first let s review the history behind this question.
3 Background The Value Effect Two Views The Value Effect Distress Risk An important and controversial issue in the asset pricing field is the origin of the value premium. Historically, value (high book-to-market) stocks have earned higher returns than growth (low BM) stocks. A combination of the Fama-French value portfolio with the market portfolio provides a Sharpe Ratio of 0.80, versus 0.31 for the market alone.
4 The Value Effect Two Views The Value Effect Distress Risk 5 year Value L/S Returns, yr return (%) year
5 Value and Distress Two Views The Value Effect Distress Risk If the value effect is a rational risk premium, then the marginal investor must: have known that value firms would earn higher returns, have chosen not to hold more value because of the pattern of returns Fama and French (1993, 1996) argue that the value premium may result from firms loading on a distress factor. This explanation is consistent with, but not implied by, the lower past returns and lower past fundamental performance of value stocks. For example, the return on distressed stocks may covary with the return to human capital (Fama and French (1996)).
6 A Distress Factor? Two Views The Value Effect Distress Risk However, there are some problems with the FF distress hypothesis: First, Shumway (2001) argues that BM is a poor proxy for distress. Second, Dichev (1998) and others show that, with a better distress proxy, more distressed firms have lower, not higher future returns. Griffin and Lemmon (2002) find that the distress effect is strongest among growth stocks, where it is also most negatively related to default probability. Both Dichev and GL use the Ohlson (1980) model as a proxy for distress.
7 In Search of Distress Risk Campbell, Hilscher and Szilagyi Results Campbell, Hilscher and Szilagyi () use a new set of predictive variables to forecast future bankruptcy They fit this model to the Kamakura risk database of Chapter 7 and 11 events. Their model forecasts bankruptcies considerably better than other models. They also show that there is a strong negative relation between the risk of bankruptcy and abnormal returns (α). This is true even after conditioning on size and book-to-market
8 MKMV Distress Measure Results also examine the Moody s-kmv (Merton) distance-to-default (DD) measure. They find that adds little forecasting power, particularly at short horizons. The DD measure provides a pseudo-r 2 of 15.9% The structural model gives a pseudo-r 2 of 31.2% In multiple regressions, DD adds little to the structural model. This is consistent with the findings of Bharath and Shumway (2005).
14 Summary Model Empirical Findings Additional Implications Default Risk, Shareholder Advantage, and Stock Returns by Garlappi, Shu and Yan The paper proposes both a theoretical model and new empirical tests. The model argues that the low returns of distressed stocks is a result of lower risk. The risk of distressed stocks is dependent on: 1 Shareholder Bargaining Power 2 Liquidation Costs The model is designed to show that, for high SBP and high liquidation cost firms, equity value will be less sensitive to underlying firm value movements. Thus the model predicts that the riskiness of the equity will fall as default risk increases.
15 Empirical Findings Summary Model Empirical Findings Additional Implications Empirically, the authors find that the sign of E(r) EDF is in fact dependent on proxies for SBP and liquidation costs
16 Model Firm Value Summary Model Empirical Findings Additional Implications 1 The value of the (all equity) firm follows GBM with constant E(r) = µ > r f and constant payout rate δ: dv t = (µ δ)v t dt + σv t db t 2 Firms have existing perpetual debt with a coupon of c. Paying this coupon results in a continuous tax shield of τc. 3 The firm value, including tax shields, is v(v t ) > V t.
17 Model Liquidation Summary Model Empirical Findings Additional Implications 4 At liquidation, firm value drops by the fraction α i.e., V t (1 α)v t Absolute priority is followed on liquidation. In this model, the firm is never liquidated. 5 Upon entry to Chapter 11, the debt and equity holders enter a Nash bargaining game and renegotiate the value of their claimn (debt/equity). The gains to renegotiation (v(v ) (1 α)v ) are divided between the equity and debt holders. The equity-holders get fraction η of these gains 6 The equity holders choose to enter Chapter 11 when it is optimal for them to do so.
18 Summary Model Empirical Findings Additional Implications Expected Returns and Default Risk An implication of this model is that, in some cases, r/ EDF < 0:
19 Empirical Work Summary Model Empirical Findings Additional Implications To test their model, use the Moody s-kmv measure of Expected Default Frequency (EDF), in combination with CRSP/COMPUSTAT. They show that, among firms with high SBP and high liquidation costs, r/ EDF < 0 However, among low SBP/low liquidation cost firms, r/ EDF > 0. use multiple proxies for both SBP and liquidation costs: Asset Size, BM, R&D, Herfindahl Index, Asset Tangibility
20 Empirical Work Summary Model Empirical Findings Additional Implications For example, s Table 7 examines returns to portfolios sorted on BM and EDF: Only the low BM, high EDF, portfolio has low returns, consistent with the model predictions.
21 Summary Model Empirical Findings Additional Implications Model Additional Implication However, there are actually two key implications of the HSY model: 1 The return of high EDF, high SBP, low LC firms should be low. 2 The risk of high EDF, high SBP, low LC firms should also be low. The second implication of HSY is not tested, at least here.
22 Risk Implications Summary Model Empirical Findings Additional Implications Recall that the cum-dividend value of the firm, net of tax-shields, follows: ( ) dv V rdt = (µ r)dt + σ V db t This means that the cum-dividend value of equity follows: ( ) de E rdt = σ E (µ r)dt + σ E db t σ V This is just a complicated way of saying that the only way that a firm can earn a high return is if it is risky!
23 Other Empirical Work Summary Model Empirical Findings Additional Implications Griffin and Lemmon (2002) do examine both the risk and return of these portfolios. Mean returns look like those obtained in : Book-to-Market Equity O-score L M H Ret(H)-(L) (p-value) Size-Adjusted L (0.068) (0.022) (0.000) (0.000) H (0.000) Ret(H-L) (p-value) (0.001) (0.963) (0.088)
24 Other Empirical Work Summary Model Empirical Findings Additional Implications However, Griffin and Lemmon find that the low BM, high Ohlson measure firms are actually slightly higher risk. This is true for both small firms: Small Firms α t(α) LBM M HBM LBM M HBM LO HO
25 Other Empirical Work Summary Model Empirical Findings Additional Implications However, Griffin and Lemmon find that the low BM, high Ohlson measure firms are actually slightly higher risk. This is true for both small firms and large: Large Firms α t(α) LBM M HBM LBM M HBM LO HO
26 1 It is possible that some other risk measure might explain the returns of the growth, high EDF stocks. 2 If it is not risk, what is responsible for these return patterns? The market fails to fully incorporate the info in the distress measure (?) size, BM, etc., are potentially proxies for the costs of arbitrage or for information uncertainty. 3 Which of the variables that forecast distress forecast equity returns? Why?
27 Value-Distress Interaction From, Table 8: Using the distress measure, the high BM, high distress portfolio has low returns.
THE JOURNAL OF FINANCE VOL. LVII, NO. 5 OCTOBER 2002 Book-to-Market Equity, Distress Risk, and Stock Returns JOHN M. GRIFFIN and MICHAEL L. LEMMON* ABSTRACT This paper examines the relationship between
KM Model Expected default frequency Expected default frequency (EDF) is a forward-looking measure of actual probability of default. EDF is firm specific. KM model is based on the structural approach to
Cost of Capital Presentation for ERRA Tariff Committee Dr. Konstantin Petrov / Waisum Cheng / Dr. Daniel Grote April 2009 Experience you can trust. Agenda 1.Definition of Cost of Capital a) Concept and
Use the table for the questions 18 and 19 below. The following table summarizes prices of various default-free zero-coupon bonds (expressed as a percentage of face value): Maturity (years) 1 3 4 5 Price
BOOK-TO-MARKET RATIO, DEFAULT RISK AND RETURN IMPLICATIONS: From a negative perspective BOB LI, Lecturer, Deakin University PAUL LAJBCYGIER, Associate Professor, Monash University CINDY CHEN, Associate
Principles of Corporate Finance Chapter 18. Does debt policy matter? Ciclo Profissional 2 o Semestre / 2009 Graduaccão em Ciências Econômicas V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance
In Search of Distress Risk John Y. Campbell, Jens Hilscher, and Jan Szilagyi 1 First draft: October 2004 This version: May 15, 2005 1 Corresponding author: John Y. Campbell, Department of Economics, Littauer
~~FN3023 ZA d0 This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON FN3023 ZA BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences,
1 The present value of the exercise price does not change in one hour if the risk-free rate does not change, so the change in call put is the change in the stock price. The change in call put is $4, so
Put-Call Parity chris bemis May 22, 2006 Recall that a replicating portfolio of a contingent claim determines the claim s price. This was justified by the no arbitrage principle. Using this idea, we obtain
Discussion of: Does Shareholder Composition Affect Stock Returns? Evidence from Corporate Earnings Announcements by Edith S. Hotchkiss and Deon Strickland NBER Corporate Finance Meetings August 8, 2000
Journal of Modern Accounting and Auditing, ISSN 1548-6583 November 2013, Vol. 9, No. 11, 1519-1525 D DAVID PUBLISHING A Panel Data Analysis of Corporate Attributes and Stock Prices for Indian Manufacturing
CHAPTER 18 Capital Budgeting and Valuation with everage Chapter Synopsis 18.1 Overview of Key Concepts There are three discounted cash flow valuation methods: the weighted average cost of capital (WACC)
Stock Valuation: Gordon Growth Model Week 2 Approaches to Valuation 1. Discounted Cash Flow Valuation The value of an asset is the sum of the discounted cash flows. 2. Contingent Claim Valuation A contingent
Equity returns following changes in default risk: New insights into the informational content of credit ratings. Maria Vassalou and Yuhang Xing First Draft: October 30, 2002 This Draft: July 18, 2003 The
Economic Feasibility Studies ١ Introduction Every long term decision the firm makes is a capital budgeting decision whenever it changes the company s cash flows. The difficulty with making these decisions
Deep into Negative Territory: Who Negative Book Equity Stocks Are and Their Risk-Return Implications Abstract The common practice in asset pricing modeling is to omit negative book equity stocks from the
The Equity Risk, the, and Other Market s Roger G. Ibbotson Professor, Yale School of Management Canadian Investment Review Investment Innovation Conference Bermuda November 2011 1 What is the Equity Risk?
First draft: June 2013 This draft: November 2013 A Five-Factor Asset Pricing Model Eugene F. Fama and Kenneth R. French * Abstract A five-factor model directed at capturing the size, value, profitability,
Models of Risk and Return Aswath Damodaran Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for
Risk and return in Þxed income arbitrage Université d Evry June 2005 1 Risk and return in Þxed income arbitrage: Nickels in front of a steamroller? Jefferson Duarte University of Washington Francis Longstaff
Class #4 Using Accounting Earnings for Valuation aka EBO Valuation or Abnormal Earnings Valuation or Residual Income Valuation 15.535 - Class #4 1 Where have we been & where are we going? Where have we
2. Capital Asset pricing Model Dr. Youchang Wu WS 2007 Asset Management Youchang Wu 1 Efficient frontier in the presence of a risk-free asset Asset Management Youchang Wu 2 Capital market line When a risk-free
RELATIONSHIP OF LIQUIDITY AND PROFITABILITY WITH MARKET VALUE OF LIFE INSURANCE COMPANIES IN PAKISTAN Aaliya Noreen International Islamic University, Islamabad (Pakistan) Email: email@example.com
LECTURES ON REAL OPTIONS: PART II TECHNICAL ANALYSIS Robert S. Pindyck Massachusetts Institute of Technology Cambridge, MA 02142 Robert Pindyck (MIT) LECTURES ON REAL OPTIONS PART II August, 2008 1 / 50
Journal Of Financial And Strategic Decisions Volume 9 Number 2 Summer 1996 THE USE OF FINANCIAL RATIOS AS MEASURES OF RISK IN THE DETERMINATION OF THE BID-ASK SPREAD Huldah A. Ryan * Abstract The effect
Financial Management, 2008, Volume 37, Number 3, Pages 461-484 Does Financial Distress Risk Drive the Momentum Anomaly? This paper brings together the evidence on two asset pricing anomalies continuation
Value-Based Management Lecture 5: Calculating the Cost of Capital Prof. Dr. Gunther Friedl Lehrstuhl für Controlling Technische Universität München Email: firstname.lastname@example.org Overview 1. Value Maximization
Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors BRAD M. BARBER TERRANCE ODEAN Presenter: Hsuan-Chi Chen ABSTRACT Individual investors who hold common
Cost of Capital and Project Valuation 1 Background Firm organization There are four types: sole proprietorships partnerships limited liability companies corporations Each organizational form has different
LIQUIDITY AND ASSET PRICING Evidence for the London Stock Exchange Timo Hubers (358022) Bachelor thesis Bachelor Bedrijfseconomie Tilburg University May 2012 Supervisor: M. Nie MSc Table of Contents Chapter
Value Premium in the Chinese Stock Market: free lunch or paid lunch? VALUE PREMIUM IN THE CHINESE STOCK MARKET:FREE LUNCH OR PAID LUNCH? Yujia Huang Renmin University of China Jiawen Yang The George Washington
University of Iowa Iowa Research Online Theses and Dissertations Spring 2011 Essays in asset pricing: on testing asset-pricing anomalies and modeling stock returns using model pools Michael Shane O'Doherty
Illiquidity frictions and asset pricing anomalies Björn Hagströmer a, Björn Hansson b, Birger Nilsson,b a Stockholm University, School of Business, S-10691 Stockholm, Sweden b Department of Economics and
Taxes, Leverage, and the Cost of Equity Capital Dan Dhaliwal Department of Accounting University of Arizona Shane Heitzman Department of Accounting University of Arizona Oliver Zhen Li Department of Accountancy
Chapter 7 Portfolio Theory and Other sset Pricing Models NSWERS TO END-OF-CHPTER QUESTIONS 7-1 a. portfolio is made up of a group of individual assets held in combination. n asset that would be relatively
How Does A Firm s Default Risk Affect Its Expected Equity Return? Kevin Aretz Abstract In a standard representative agent economy, a firm s default probability and its expected equity return are non-monotonically
Finance 2 for IBA (30J201) F.Feriozzi Regular exam December 15 th, 2010 Question 1 Part One: Multiple-hoice Questions (45 points) Which of the following statements regarding the capital structure decision
University of Science and Technology Beijing Dongling School of Economics and management Chapter 17 Capital Structure Limits to the Use of Debt Dec. 2012 Dr. Xiao Ming USTB 1 Key Concepts and Skills Define
Chapter 5 Conditional CAPM 5.1 Conditional CAPM: Theory 5.1.1 Risk According to the CAPM The CAPM is not a perfect model of expected returns. In the 40+ years of its history, many systematic deviations
Capital Structure-1 Capital Structure Prof. Ian Giddy New York University Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT MGT PORTFOLIO CAPITAL M&A DEBT EQUITY MEASUREMENT TOOLS
598 PART SIX Cost of Capital and Long-Term Financial Policy CONCEPT QUESTIONS 17.9a What is the APR? 17.9b What is the difference between liquidation and reorganization? 17.10 SUMMARY AND CONCLUSIONS The
ON THE RISK ADJUSTED DISCOUNT RATE FOR DETERMINING LIFE OFFICE APPRAISAL VALUES BY M. SHERRIS B.A., M.B.A., F.I.A., F.I.A.A. 1. INTRODUCTION 1.1 A number of papers have been written in recent years that
Returning Cash to the Owners: Dividend Policy Aswath Damodaran Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate
Utah State University DigitalCommons@USU All Graduate Plan B and other Reports Graduate Studies 3-2014 Optimal Debt-to-Equity Ratios and Stock Returns Courtney D. Winn Utah State University Follow this
Volume 4 Number 2 2013 pp. 11-22 ISSN: 1309-2448 www.berjournal.com Fama and French Three-Factor Model: Evidence from Istanbul Stock Exchange Veysel Eraslan a Abstract: This study tests the validity of
Performance Evaluation on Mutual Funds Dr.G.Brindha Associate Professor, Bharath School of Business, Bharath University, Chennai 600073, India Abstract: Mutual fund investment has lot of changes in the
DOES IT PAY TO HAVE FAT TAILS? EXAMINING KURTOSIS AND THE CROSS-SECTION OF STOCK RETURNS By Benjamin M. Blau 1, Abdullah Masud 2, and Ryan J. Whitby 3 Abstract: Xiong and Idzorek (2011) show that extremely
Levered Returns João F. Gomes, and Lukas Schmid November 2008 Abstract In this paper we revisit the theoretical relation between financial leverage and stock returns in a dynamic world where both the corporate
Tutorial: Structural Models of the Firm Peter Ritchken Case Western Reserve University February 16, 2015 Peter Ritchken, Case Western Reserve University Tutorial: Structural Models of the Firm 1/61 Tutorial:
1 LECTURE 07 Cost of Capital Berk, De Marzo Chapter 14 and 15 2 Equity Versus Debt Financing Capital Structure: The relative proportions of debt, equity, and other securities that a firm has outstanding.
NATIONAL UNIVERSITY OF SCIENCE AND TECHNOLOGY FACULTY OF COMMERCE DEPARTMENT OF FINANCE BACHELOR OF COMMERCE HONOURS DEGREE IN FINANCE PART II 2 ND SEMESTER FINAL EXAMINATION MAY 2005 CORPORATE FINANCE
Asset Pricing Models and Industry Sorted Portfolios Author: Marijn de Vries ANR: 264141 Faculty: Faculty of Economics and Business studies Programme: Bedrijfseconomie Supervisor: Jiehui Hu MSc Date: 7/6/2012
Appendices with Supplementary Materials for CAPM for Estimating Cost of Equity Capital: Interpreting the Empirical Evidence This document contains supplementary material to the paper titled CAPM for estimating
Investment Management and Financial Innovations, Issue 1, 2013 Christopher Gan (New Zealand), Baiding Hu (New Zealand), Yaoguang Liu (New Zealand), Zhaohua Li (New Zealand) An empirical cross-section analysis
In Search of Distress Risk John Y. Campbell, Jens Hilscher, and Jan Szilagyi 1 First draft: October 2004 Preliminary and incomplete 1 Corresponding author: John Y. Campbell, Department of Economics, Littauer
Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2011 Answers 1 (a) Net present value evaluation of new confectionery investment Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales
Distressed Debt Prices and Recovery Rate Estimation Robert Jarrow Joint Work with Xin Guo and Haizhi Lin May 2008 Introduction Recent market events highlight the importance of understanding credit risk.
CHAPTER 17 B- 1 CHAPTER 17 CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT Answers to Concepts Review and Critical Thinking Questions 1. Direct costs are potential legal and administrative costs. These are
Foundations of Asset Management Goal-based Investing the Next Trend Robert C. Merton Distinguished Professor of Finance MIT Finance Forum May 16, 2014 #MITSloanFinance 1 Agenda Goal-based approach to investment
15.433 INVESTMENTS Classes 8 & 9: The Equity Market Cross Sectional Variation in Stock Returns Spring 2003 Introduction Equities are common stocks, representing ownership shares of a corporation. Two important
Asian Economic and Financial Review journal homepage: http://www.aessweb.com/journals/5002 THE CAPITAL INVESTMENT INCREASES AND STOCK RETURNS Jung Fang Liu 1 --- Nicholas Rueilin Lee 2 * --- Yih-Bey Lin
Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) The primary focus of the next two chapters will be to examine the debt/equity choice by firms. In particular,
V. Conclusion One of the MM theorem assumptions, trading frictionless, is the starting point in this study. In the U.S., Banerjee, Gatchev, and Spindt (2007) provide evidence that the NYSE commission rate
Prof. Alex Shapiro Lecture Notes 9 The Capital Asset Pricing Model (CAPM) I. Readings and Suggested Practice Problems II. III. IV. Introduction: from Assumptions to Implications The Market Portfolio Assumptions
Cash Holdings and Mutual Fund Performance Online Appendix Mikhail Simutin Abstract This online appendix shows robustness to alternative definitions of abnormal cash holdings, studies the relation between
leadership series market research Payout Ratio: The Most Influential Management Decision a Company Can Make? January 2013 In today s equity market, payout ratios have a meaningful impact on both equity
Fama-French and Small Company Cost of Equity Calculations This article appeared in the March 1997 issue of Business Valuation Review. Michael Annin, CFA Senior Consultant Ibbotson Associates 225 N. Michigan
Product Market Competition, Insider Trading And Stock Market Efficiency Joel Peress INSEAD J. Peress Product Market Competition, Insider Trading and Stock Market Efficiency 1 Evidence Share turnover Insider
380.760: Corporate Finance Lecture 9: Advanced Valuation with Capital Structure Professor Gordon M. Bodnar 2008 Gordon Bodnar, 2008 Valuation and Capital Structure In the real world with market imperfections,
Special Comment December 2004 Contact Phone New York Praveen Varma 1.212.553.1653 Richard Cantor Determinants of Recovery Rates on Defaulted Bonds and Loans for North American Corporate Issuers: 1983-2003
Market Efficiency and Behavioral Finance Chapter 12 Market Efficiency if stock prices reflect firm performance, should we be able to predict them? if prices were to be predictable, that would create the
Discussion of: The Stock Market Valuation of Research and Development Expenditures by Louis K.C. Chan, Josef Lakonishok and Theodore Sougiannis American Finance Association Meetings January 7, 2000 Discussant:
DESCRIPTION OF FINANCIAL INSTRUMENTS AND INVESTMENT RISKS A. General The services offered by Prochoice Stockbrokers cover a wide range of Financial Instruments. Every type of financial instrument carries
FUNDING INVESTMENTS FINANCE 238/738, Spring 2008, Prof. Musto Class 6 Introduction to Corporate Bonds Today: I. Equity is a call on firm value II. Senior Debt III. Junior Debt IV. Convertible Debt V. Variance
5Capital Structure II: Stockholder & Bondholder Conflicts Modigliani-Miller (MM I) theorem If There are no taxes There are no bankruptcy costs The firm s investment policy is fixed Then The value of the
Swaps: Debt-equity swap INTRODUCTION Debt-equity (respectively equity-debt) swap allows a company, government, or municipality to swap debt for equity (respectively equity for debt). Debt and equity are
The performance of the S&P Global Luxury Index compared to the MSCI World Index, during the financial crisis. An analysis of 80 luxury goods companies around the world Name: Laura van Ballegooijen Student
Lecture 10 Empirical issues in valuation: cost of capital, terminal value, growth rates Learning objectives for today How to get the cost of capital right: what potential choices there are and how they
Capital Structure [CHAP. 15 & 16] -1 CAPITAL STRUCTURE [Chapter 15 and Chapter 16] CONTENTS I. Introduction II. Capital Structure & Firm Value WITHOUT Taxes III. Capital Structure & Firm Value WITH Corporate
The Other Side of Value: The Gross Profitability Premium Robert Novy-Marx June, 2012 Abstract Profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market predicting
Schonbucher Chapter 9: Firm alue and Share Priced-Based Models Updated 07-30-2007 (References sited are listed in the book s bibliography, except Miller 1988) For Intensity and spread-based models of default