Financial Distress, Shareholder Advantage And Equity Returns

Our paper is the first to systematically study the relationship between default riskand equity returns in China. Employing a newly constructed default risk measure thatcombines KMV-Merton model and selected financial ratios, we find that default riskhas a positive relationship with stock return. This pattern could be explained fromboth a risk-based perspective (i.e. premium for the financial distress cost andliquidation risk) and a behavior-based perspective (i.e. investors speculate in thedefault stock which may undergo back-door listing). In addition, we find that defaultrisk will increase the magnitude of Size and Reversal effect, and decrease themagnitude of Value effect. On the other hand, we find that shareholder advantagedoesn’t play an important role in the pricing of default risk in China, whether beforeor after controlling the Size, Value and Reversal effect.