Institutional Investors, Distress Risk and the Cross Section of Stock Returns

Abstract:     
This paper provides an alternative explanation for the distress risk puzzle documented in previous studies (e.g. Dichev (1998), Griffin and Lemmon (2002), Campbell et al (2008)) that firms with high default probability earn low returns by investigating the impact of institutional holding and trading on stock returns. Because firms with high default probability are small and perform worse, we hypothesize that institutional investors are reluctant to hold stocks of these firms and that a decline in their holding or trading lowers distress stocks’ prices and causes the returns of these stocks to decrease. Our empirical evidences support these hypotheses. We document that the characteristics of these firms reduce the motives for institutional investors to provide more firms’ specific information into the market. As a result, idiosyncratic risk of these stocks goes up and time-varying systematic risk goes down, consistent with the evidence that these firms earn low returns. We further find that although both institutional holding and trading can capture the distress risk puzzle, institutional trading seems to be superior. Moreover, we find that the holding or trading by either independent or short term institutional investors plays a significant role in explaining this puzzle while the holding or trading by dependent or long term institutional investors does not. Finally, our results suggest an important role of institutional investors in interpreting anomalies in asset pricing.

Number of Pages in PDF File: 54

Keywords: distress risk, default probability, institutional holding, institutional trading, institutional ownership, short-term institutions, independent institutions

JEL Classification: G12, G20, G21, G22

working papers series