Default Risk, Idiosyncratic Coskewness and Equity Returns

Abstract

In this paper, we intend to explain an empirical finding that distressed stocks delivered anomalously low returns (Campbell et. al. (2008)). We show that in a model where investors have heterogeneous preferences, the expected return of risky assets depends on idiosyncratic coskewness betas, which measure the the co-movement of the individual stock variance and the market return. We find that there is a negative (positive) relation between idiosyncratic coskewness and equity returns when idiosyncratic coskewness betas are positive (negative). We construct two idiosyncratic coskewness factors to capture market-wide effect of idiosyncratic coskewness betas. When we control for these two idiosyncratic coskewness factors, the return difference for distress-sorted portfolios becomes insignificant. High stressed firms earn low returns because high stressed firms have high (low) idiosyncratic coskewness betas when idiosyncratic coskewness betas are positive (negative). Our idiosyncratic coskewness factors can also explain the negative and significant relation between the maximum daily return over the past one month (MAX) and expected stock returns documented in Bali et. al. (2009).

Keywords: Financial distress, Higher moment returns

JEL Classification: G11, G12, G14, G33