Financial Distress Risk Innovations and the Distress Risk-Return Relation
38 Pages Posted: 4 Jun 2012 Last revised: 17 Aug 2017
Date Written: April 18, 2017
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: Suggested Citation