Financial Distress Risk Innovations and the Distress Risk-Return Relation

38 Pages Posted: 4 Jun 2012 Last revised: 17 Aug 2017

See all articles by Xiaochun Liu

Xiaochun Liu

University of Alabama

Quan Wen

Georgetown University - Department of Finance

Date Written: April 18, 2017

Abstract

We examine the puzzling negative relation between financial distress risk and the cross-section of expected returns. We find that the negative relation is most pronounced for up to six months after portfolio formation but after that, high distress stocks eventually earn persistently high returns. The negative relation during the first six months is driven by the most recent distress risk shocks to which investors initially underreact, causing temporary overpricing of distressed stocks. In the long run, the relation between distress risk and returns reflects the positive risk premium as distress risk innovations are fully incorporated into prices. We also find that the positive distress risk premium explains the size effect.

Keywords: Financial distress, risk innovation, investor underreaction

JEL Classification: G10, G11, G12

Suggested Citation

Liu, Xiaochun and Wen, Quan, Financial Distress Risk Innovations and the Distress Risk-Return Relation (April 18, 2017). Available at SSRN: https://ssrn.com/abstract=2074674 or http://dx.doi.org/10.2139/ssrn.2074674

Xiaochun Liu

University of Alabama ( email )

P.O. Box 870244
Tuscaloosa, AL 35487
United States

Quan Wen (Contact Author)

Georgetown University - Department of Finance ( email )

37th and O Street, NW
Washington D.C., DC 20057
United States

HOME PAGE: http://faculty.georgetown.edu/qw50

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