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

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  • Akira Yamazaki

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.

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  • Akira Yamazaki, 2020. "Probability weighting and default risk: a possible explanation for distressed stock puzzles," Quantitative Finance, Taylor & Francis Journals, vol. 20(5), pages 745-767, May.
    • Handle: RePEc:taf:quantf:v:20:y:2020:i:5:p:745-767
    DOI: 10.1080/14697688.2019.1698057
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    Cited by:

    1. Akira Yamazaki, 2022. "Recovering subjective probability distributions," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(7), pages 1234-1263, July.
    2. Charles-Cadogan, G., 2021. "Market Instability, Investor Sentiment, And Probability Judgment Error in Index Option Prices," CRETA Online Discussion Paper Series 71, Centre for Research in Economic Theory and its Applications CRETA.

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