A unified model of distress risk puzzles

We build a dynamic model to link two empirical patterns:\ the negative failure probability-return relation (Campbell, Hilscher, and Szilagyi, 2008) and the positive distress risk premium-return relation (Friewald, Wagner, and Zechner, 2014). We show analytically and quantitatively that (i) equity-to-debt ratios and levered equity betas negatively covary with the market risk premium in distressed firms; (ii) negative covariance generates low stock returns and negative alphas among those firms; and (iii) firms with a lower distress risk premium endogenously choose higher leverage, so they are more likely to become distressed and earn negative returns. Finally, empirical evidence supports our model predictions