Prof. Lorenzo Garlappi from the University of Texas at Austin is giving a VGSF research seminar on "Default Risk, Shareholder Advantage, and Stock Returns" on FRIDAY, May 19th, from 15:30 to 17:00 at the Institute for Advanced Studies (Institut für Höhere Studien, Stumpergasse 56, 1060 Wien), Lecture Room (HS) 2. Please find the paper's abstract below. Coffee and snacks are going to be available in the cafeteria of IHS, which is located next to the lecture room, before and after the seminar. Information regarding the further schedule of the VGSF research seminar can be found at www.vgsf.ac.at! Lorenzo is going to be available for discussions on Friday before and after the seminar, and on the following Monday (22.5.) and Tuesday (23.5.). If you would like to meet him, please let me know. Best, Michael Halling Abstract In this paper, we study the relationship between default probability and stock returns. Using the market-based measure of Expected Default Frequency (EDF) constructed by Moody's KMV, we first demonstrate that higher default probabilities are not necessarily associated with higher expected stock returns, a finding that complements the existing empirical evidence. We then show that the puzzling and complex relationship between stock returns and default probability is consistent with the implications of existing structural models that account for possible negotiated benefits for equity-holders upon default. Adapting the setting of the Fan and Sundaresan (2000) model that explicitly considers the bargaining game between equity-holders and debt-holders in financial distress, we are able to obtain a theoretical relationship between expected returns and default probability that resembles the empirically observed pattern. Our analysis indicates that, depending on the level of shareholder advantage, the relationship between default probability and equity return may be either upward sloping (low shareholder advantage) or humped and downward sloping (high shareholder advantage). Moreover, we show that distressed firms in which shareholders have a stronger advantage in renegotiation exhibit lower expected returns, and that their default probabilities do not adequately represent the risk of default born by equity. We test these implications using several proxies for shareholder advantage and find strong support in the data.