Talk by Kevin Aretz*
How Does A Firm’s Default Risk Affect Its Expected
Equity Return?
Abstract:
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