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What Explains the Distress Risk Puzzle: Death or Glory?

49 Pages Posted: 18 Mar 2012  

Jennifer S. Conrad

University of North Carolina Kenan-Flagler Business School

Nishad Kapadia

Tulane University - A.B. Freeman School of Business

Yuhang Xing

Rice University

Date Written: March 15, 2012

Abstract

Campbell, Hilscher, and Szilagyi (2008) show that firms with a high probability of default have significantly low average future returns. We show that there is a large overlap between stocks classified as high default risk, and those that are likely to produce extremely high returns over the next year (‘glory’ stocks). Predicted glory and predicted distress are highly correlated, with over 50% of firms in the top distress risk quintile also in the top quintile of predicted glory. Stocks with high predicted probabilities for glory also earn abnormally low average returns. We find evidence that low returns to high glory firms are also present in firms with zero leverage, where financial distress is unlikely, and that the low returns to high distress risk firms are large and significant in ‘speculative’ firms (with high sales growth and market-to-book ratios) that have high predicted glory; subsequent returns are small and statistically insignificant in ‘traditionally distressed’ firms. Thus, we show that, on average, firms which have a high potential for death (default) also tend to have a high potential for glory; where the two factors can be separated, the results suggest that it is glory, rather than distress, which is responsible for the low expected returns in securities.

Keywords: distress risk, bankruptcy, skewness, stock returns

JEL Classification: G11, G12, G32, G33

Suggested Citation

Conrad, Jennifer S. and Kapadia, Nishad and Xing, Yuhang, What Explains the Distress Risk Puzzle: Death or Glory? (March 15, 2012). Available at SSRN: https://ssrn.com/abstract=2023933 or http://dx.doi.org/10.2139/ssrn.2023933

Jennifer S. Conrad

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Nishad Kapadia

Tulane University - A.B. Freeman School of Business ( email )

A.B. Freeman School of Business
7 McAlister Drive
New Orleans, LA 70118
United States
504-314-7454 (Phone)

Yuhang Xing (Contact Author)

Rice University ( email )

6100 South Main Street
Houston, TX 7705-1892
United States

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