Small Growth and Distress Returns: Two Sides of the Same Coin?
2015 World Congress of the Econometric Society
1st Place 2015 CQAsia Academic Competition, Hong Kong
2014 SAFE Asset Pricing Workshop
Best Paper on Valuation, 2014 26th Annual Meetings Northern Finance Association, Ottawa
2014 International Conference on Asia-Pacific Financial Markets
53 Pages Posted: 21 Nov 2013 Last revised: 23 Feb 2016
Date Written: February 23, 2016
We propose a unified explanation for two seemingly disparate empirical findings: the negative abnormal returns of distressed stocks, and of small growth stocks. Based on a counterintuitive result relating option prices to jump risk (Merton 76), we show via an investment valuation model that higher idiosyncratic risks of sudden corporate failure simultaneously generate lower expected returns and higher valuation ratios among smaller firms. Consistent with the model, high failure risk traits characterize small growth stocks, and a failure risk factor subsumes small growth returns while explaining several asset pricing anomalies.
Keywords: Distress, size, book-to-market, small, growth, glamor, stocks, failure risk, default risk, anomalies, cross section of stock returns, asset pricing, real options, growth options, mixed jump-diffusion process
JEL Classification: G10, G12, G13, G19, G30, G31, G32, D21, D92
Suggested Citation: Suggested Citation