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

References

• Abel, A.B., Risk premia and term premia in general equilibrium. J. Monet. Econ., 1999, 43(1), 3–33.
   Web of Science ®Google Scholar
• Aït-Sahalia, Y. and Lo, A.W., Nonparametric estimation of state-price densities implicit in financial asset prices. J. Finance, 1998, 53(2), 499–547.
   Web of Science ®Google Scholar
• Almeida, H. and Philippon, T., The risk-adjusted cost of financial distress. J. Finance, 2007, 62(6), 2557–2586.
   Web of Science ®Google Scholar
• Amato, J.D. and Remolona, E.M., The credit spread puzzle. BIS Quart. Rev., 2003, December, 51–63.
   Google Scholar
• Avramov, D., Chordia, T., Jostova, G. and Philipov, A., Credit ratings and the cross-section of stock returns. J. Financ. Markets, 2009, 12(3), 469–499.
   Web of Science ®Google Scholar
• Backus, D., Chernov, M. and Martin, I., Disasters implied by equity index options. J. Finance, 2011, 66(6), 1969–2012.
   Web of Science ®Google Scholar
• Bakshi, G., Madan, D. and Panayotov, G., Returns of claims on the upside and the viability of U-shaped pricing kernels. J. Financ. Econ., 2010, 97(1), 130–154.
   Web of Science ®Google Scholar
• Bansal, R. and Yaron, A., Risks for the long run: A potential resolution of asset pricing puzzles. J. Finance, 2004, 59(4), 1481–1509.
   Web of Science ®Google Scholar
• Bansal, R., Kiku, D. and Yaron, A., An empirical evaluation of the long-run risks model for asset prices. Crit. Finance Rev., 2012, 1(1), 183–221.
   Google Scholar
• Barberis, N. and Huang, M., Stocks as lotteries: The implications of probability weighting for security prices. Am. Econ. Rev., 2008, 98(5), 2066–2100.
   Web of Science ®Google Scholar
• Barndorff-Nielsen, O.E., Processes of normal inverse gaussian type. Finance Stoch., 1997, 2(1), 41–68.
   Google Scholar
• Barro, R.J., Rare disasters and asset markets in the twentieth century. Quart. J. Econ., 2006, 121(3), 823–866.
   Web of Science ®Google Scholar
• Berns, G.S., Capra, C.M., Moore, S. and Noussair, C., A shocking experiment: New evidence on probability weighting and common ratio violations. Judgm. Decis. Mak., 2007, 2(4), 234–242.
   Web of Science ®Google Scholar
• Campbell, J.Y., Consumption-based asset pricing. In Handbook of the Economics of Finance, edited by G. Constantinides, M. Harris, and R. Stulz, volume 1, pp. 803–887, 2003 (Elsevier: Amsterdam).
   Google Scholar
• Campbell, J.Y. and Cochrane, J.H., By force of habit: A consumption-based explanation of aggregate stock market behavior. J. Polit. Econ., 1999, 107(2), 205–251.
   Web of Science ®Google Scholar
• Campbell, J.Y., Hilscher, J. and Szilagyi, J., In search of distress risk. J. Finance, 2008, 63(6), 2899–2939.
   Web of Science ®Google Scholar
• Carr, P., Geman, H., Madan, D.B. and Yor, M., Stochastic volatility for Lévy processes. Math. Finance, 2003, 13(3), 345–382.
   Web of Science ®Google Scholar
• Chen, H., Macroeconomic conditions and the puzzles of credit spreads and capital structure. J. Finance, 2010, 65(6), 2171–2212.
   Web of Science ®Google Scholar
• Chen, L., Lesmond, D.A. and Wei, J., Corporate yield spreads and bond liquidity. J. Finance, 2007, 62(1), 119–149.
   Web of Science ®Google Scholar
• Cochrane, J.H., Macro-finance. Rev. Financ., 2017, 21(3), 945–985.
   Web of Science ®Google Scholar
• Collin-Dufresne, P., Goldstein, R.S. and Helwege, J., Is credit event risk priced? Modeling contagion via the updating of beliefs. Working Paper, National Bureau of Economic Research, 2010.
   Google Scholar
• Constantinides, G.M. and Duffie, D., Asset pricing with heterogeneous consumers. J. Polit. Econ., 1996, 104(2), 219–240.
   Web of Science ®Google Scholar
• Cont, R. and Tankov, P., Financial Modelling with Jump Processes, 2004 (Chapman & Hall/CRC: London).
   Google Scholar
• Cremers, K.J.M., Driessen, J. and Maenhout, P., Explaining the level of credit spreads: Option-implied jump risk premia in a firm value model. Rev. Financ. Stud., 2008, 21(5), 2209–2242.
   Web of Science ®Google Scholar
• Dichev, I.D., Is the risk of bankruptcy a systematic risk? J. Finance, 1998, 53(3), 1131–1147.
   Web of Science ®Google Scholar
• Driessen, J., Is default event risk priced in corporate bonds? Rev. Financ. Stud., 2004, 18(1), 165–195.
   Web of Science ®Google Scholar
• Elton, E.J., Gruber, M.J., Agrawal, D. and Mann, C., Explaining the rate spread on corporate bonds. J. Finance, 2001, 56(1), 247–277.
   Web of Science ®Google Scholar
• Epstein, L.G. and Zin, S.E., Substitution, risk aversion and the temporal behavior of consumption and asset returns: A theoretical framework. Econometrica, 1989, 57(4), 937–969.
   Web of Science ®Google Scholar
• Fama, E.F. and French, K.R., Common risk factors in the returns on stocks and bonds. J. Financ. Econ., 1993, 33(1), 3–56.
   Web of Science ®Google Scholar
• Gabaix, X., Variable rare disasters: An exactly solved framework for ten puzzles in macro-finance. Quart. J. Econ., 2012, 127(2), 645–700.
   Web of Science ®Google Scholar
• Garlappi, L. and Yan, H., Financial distress and the cross-section of equity returns. J. Finance, 2011, 66(3), 789–822.
   Web of Science ®Google Scholar
• Gârleanu, N. and Panageas, S., Young, old, conservative, and bold: The implications of heterogeneity and finite lives for asset pricing. J. Polit. Econ., 2015, 123(3), 670–685.
   Web of Science ®Google Scholar
• Griffin, J.M. and Lemmon, M.L., Book-to-market equity, distress risk, and stock returns. J. Finance, 2002, 57(5), 2317–2336.
   Web of Science ®Google Scholar
• Hansen, L.P. and Sargent, T.J., Robust control and model uncertainty. Am. Econ. Rev., 2001, 91(2), 60–66.
   Web of Science ®Google Scholar
• Jackwerth, J.C., Recovering risk aversion from option prices and realized returns. Rev. Finan. Stud., 2000, 13(2), 433–451.
   Web of Science ®Google Scholar
• Kahneman, D. and Tversky, A., Prospect theory: An analysis of decisions under risk. Econometrica, 1979, 47(2), 278–291.
   Web of Science ®Google Scholar
• Keenan, S.C., Hamilton, D.T. and Berthault, A., Historical default rates of corporate bond issuers, 1920–1999. Moody's Investors Services, 2000.
   Google Scholar
• Lucas Jr, R.E., Asset prices in an exchange economy. Econometrica, 1978, 46(6), 1429–1445.
   Web of Science ®Google Scholar
• Madan, D.B. and Seneta, E., The variance gamma (VG) model for share market returns. J. Bus., 1990, 63(4), 511–524.
   Web of Science ®Google Scholar
• Mehra, R. and Prescott, E.C., The equity premium: A puzzle. J. Monet. Econ., 1985, 15(2), 145–161.
   Web of Science ®Google Scholar
• Merton, R.C., On the pricing of corporate debt: The risk structure of interest rates. J. Finance, 1974, 29(2), 449–470.
   Web of Science ®Google Scholar
• Modigliani, F. and Miller, M.H., The cost of capital, corporation finance and the theory of investment. Am. Econ. Rev., 1958, 48(3), 261–297.
   Web of Science ®Google Scholar
• Polkovnichenko, V. and Zhao, F., Probability weighting functions implied in options prices. J. Financ. Econ., 2013, 107(3), 580–609.
   Web of Science ®Google Scholar
• Prelec, D., The probability weighting function. Econometrica, 1998, 66(3), 497–527.
   Web of Science ®Google Scholar
• Rietz, T.A., The equity risk premium a solution. J. Monet. Econ., 1988, 22(1), 117–131.
   Web of Science ®Google Scholar
• Rosenberg, J.V. and Engle, R.F., Empirical pricing kernels. J. Financ. Econ., 2002, 64(3), 341–372.
   Web of Science ®Google Scholar
• Schaefer, S.M. and Strebulaev, I.A., Structural models of credit risk are useful: Evidence from hedge ratios on corporate bonds. J. Financ. Econ., 2008, 90(1), 1–19.
   Web of Science ®Google Scholar
• Shiller, R.J., Do stock prices move too much to be justified by subsequent changes in dividends? Am. Econ. Rev., 1981, 71(3), 421–436.
   Web of Science ®Google Scholar
• Shiller, R.J., Speculative asset prices. Am. Econ. Rev., 2014, 104(6), 1486–1517.
   Web of Science ®Google Scholar
• Shiller, R.J., Long term stock, bond, interest rate and consumption data, 2017. http://www.econ.yale.edu/shiller/data.htm.
   Google Scholar
• Tversky, A. and Kahneman, D., Advances in prospect theory: Cumulative representation of uncertainty. J. Risk. Uncertain., 1992, 5(4), 297–323.
   Web of Science ®Google Scholar
• Wachter, J.A., Can time-varying risk of rare disasters explain aggregate stock market volatility? J. Finance, 2013, 68(3), 987–1035.
   Web of Science ®Google Scholar
• Weil, P., The equity premium puzzle and the risk-free rate puzzle. J. Monet. Econ., 1989, 24(3), 401–421.
   Web of Science ®Google Scholar
• Wu, G. and Gonzalez, R., Curvature of the probability weighting function. Manage. Sci., 1996, 42(12), 1676–1690.
   Web of Science ®Google Scholar
• Yamazaki, A., A dynamic equilibrium model for U-shaped pricing kernels. Quant. Finance, 2018, 18(5), 851–875.
   Web of Science ®Google Scholar