We develop and test an agency-based contingent claims model that features debt renegotiation for cross-sectional stock returns. Our model performs well for cross-sectional returns of portfolios formed on financial leverage, book-to-market equity, and asset growth portfolios, because the time-varying stock-cash flow sensitivity we estimate in a closed-form solution captures default risk over the business cycle. Moreover, our structural estimation overcomes the difficulty of finding empirical proxies for unobservable bargaining power at debt renegotiation and provides the first direct evidence that the bargaining power helps alleviate equity risk, particularly during recessions when default probabilities are high.
