A Resolution of the Distress Risk and Leverage Puzzles in the Cross Section of Stock Returns

Journal of Financial Economics, Vol. 96, pp. 56-79, 2010

55 Pages Posted: 25 Mar 2008 Last revised: 6 Jul 2010

See all articles by Thomas J. George

Thomas J. George

University of Houston - Department of Finance

Chuan-Yang Hwang

Nanyang Technological University (NTU)

Date Written: April 1, 2009

Abstract

We revisit findings that returns are negatively related to financial distress intensity and leverage. These are puzzles under frictionless capital markets assumptions, but consistent with optimizing firms that differ in their exposure to financial distress costs. Firms with high costs choose low leverage to avoid distress, but retain exposure to the systematic risk of bearing such costs in low states. Empirical results are consistent with this explanation. The return premiums to low leverage and low distress are significant in raw returns, and even stronger in risk-adjusted returns. When in distress, low leverage firms suffer more than high leverage firms as measured by a deterioration in accounting operating performance and heightened exposure to systematic risk. The connection between return premiums and distress costs is apparent in subperiod evidence—both are small or insignificant prior to 1980 and larger and significant thereafter.

Suggested Citation

George, Thomas J. and Hwang, Chuan-Yang, A Resolution of the Distress Risk and Leverage Puzzles in the Cross Section of Stock Returns (April 1, 2009). Journal of Financial Economics, Vol. 96, pp. 56-79, 2010. Available at SSRN: https://ssrn.com/abstract=1009045

Thomas J. George

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States

Chuan-Yang Hwang (Contact Author)

Nanyang Technological University (NTU) ( email )

Singapore, 639798
Singapore
65-67905003 (Phone)
65-6791-3697 (Fax)

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