Investing in Chapter 11 Stocks: Trading, Value, and Performance

Abstract:     
This paper addresses several questions about Chapter 11 stocks regarding their trading environment, fundamental value, and performance. First, we show that there exists active trading for Chapter 11 stocks throughout the duration of the bankruptcy process. Second, applying option theory to the valuation of bankrupt equity, we find that equity value of bankrupt firm after filing is positively related to asset value, asset volatility, risk-free rate, and expected duration, and it is negatively related to liabilities. Furthermore, similar to the payoff of out-of-money calls, the return correlation between bankrupt stocks and their matching samples exhibits strong non-linearity: significantly positive when the matching sample performs well and zero otherwise. Third, we find that investing in Chapter 11 stocks incurs large losses. Consistent with the theories of heterogeneous beliefs and limits-to-arbitrage, stocks with higher levels of information uncertainty and more binding short-sale constraints experience more negative returns during the Chapter 11 process.

Number of Pages in PDF File: 48

Keywords: bankruptcy, option pricing, heterogeneous beliefs, limits to arbitrage

JEL Classification: G33, G12, G14

working papers series