When is Distress Risk Priced? Evidence from Recessionary Failure Prediction

This paper introduces a new measure of firm’s exposure to systematic distress risk — the probability of a recession at the time of a firm’s failure. For stocks in the top quintile of the probability of failure, a median hedge portfolio based on our measure generates a positive risk premium of 10%-12% per annum. Our results differ from the previously documented distress-risk anomaly — a negative correlation between the probability of failure and stock returns. We argue that the probability of failure does not capture systematic distress risk well because it does not differentiate between failures occurring in recessions and expansions.