Probability weighting and default risk: a possible explanation for distressed stock puzzles

Akira Yamazaki

Quantitative Finance, 2020, vol. 20, issue 5, 745-767

Abstract: This paper suggests incorporating investor probability weighting and the default risk of individual firms into a consumption-based asset pricing model. The extended model provides a unified explanation for several anomalous patterns observed in financial markets. The analysis addresses not only widely recognized asset pricing puzzles, such as the equity premium puzzle, but also less-studied anomalies on financially distressed stocks. The simulation, under which the model is calibrated according to U.S. historical data, shows that a combination of mild overweighting of probability on tail events and nonlinearity of equity values caused by default risk has the potential to resolve these patterns.

Date: 2020
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DOI: 10.1080/14697688.2019.1698057

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