Understanding the Distress Puzzle: Surprises in the Pre-Delisting Period

Abstract

This study shows that the negative cross-sectional relation between distress risk and stock returns documented in previous studies is driven by the persistently low ex post realized returns in the pre-delisting period – the two-year period prior to a firm’s ex post delisting from the stock exchange due to financial distress. After controlling for the firm-months in the pre-delisting period, which constitutes only 0.3% of total market capitalization or 3%–5% of NYSE/AMEX/Nasdaq firm-months, distress risk is positively related to ex post realized returns. In the pre-delisting period, (i) ex post realized returns diverge from ex ante expected returns, otherwise they are similar across the sample period; and (ii) distressed firms experience unexpectedly low earnings per share and negative price adjustments around earnings announcements. The price adjustments reflect investors’ correction of their valuation errors about distressed firms’ future prospect.

Keywords: Distress risk, Delisting, Bankruptcy, Expected return, Asset-pricing anomaly, Earnings announcement

JEL Classification: G12, G14, G33