Beyond Distress Risk

This paper explores the role of credit cycles in supporting a risk-based view of equity distress risk premium. I identify a slope factor in CDS returns, which also drives and co-moves with the equity returns of financially constrained firms. The strong sensitivity of cash flows to credit cycles accounts for the observed co-movement among equity and credit returns. An affine dynamic asset pricing model with credit cycle risk parsimoniously replicates the high and volatile risk premium in the data. Differential exposure to credit cycles largely explains the returns for distressed firms beyond firm-specific distress premium. ∗I thank Tobias Berg, Matthijs Breugem, Emirhan Ilhan, Yigitcan Karabulut, Francesco Sangiorgi, Paul Schneider, Grigory Vilkov and participants at the American Finance Association Ph.D. Poster Session 2019 (Atlanta), as well as seminar participants at Frankfurt School of Finance & Management for helpful comments. †Frankfurt School of Finance & Management; E-mail: a.pazarbasi@fs.de