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An Explanation for bankruptcy's risk-return paradox

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The admission of bankruptcy risk into a single-period CAPM economy leads to two surprising results. First, OLS beta is a biased measure of systematic risk. Second, the expected return conditional on the market is no longer a linear function of beta alone. Instead, it is a linear function of the ratio of conditional to unconditional expected dividends and of that ratio times beta. In this economy very distressed firms should under perform the market because of their high option values and strong contributions to portfolio diversification. This is confirmed by empirical tests that replicate Dichev's paradox.

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