Solvency and Liquidity in Distressed Equity Returns

52 Pages Posted: 16 May 2014 Last revised: 25 Aug 2016

See all articles by Mamdouh Medhat

Mamdouh Medhat

City University London - Sir John Cass Business School

Date Written: December 9, 2014

Abstract

I show theoretically and empirically that solvency and liquidity can help rationalize low distressed equity returns. In my model, levered firms facing financing constraints optimally choose liquidity reserves and optimally default when insolvent. I find empirical evidence consistent with the model's predictions: (1) In all solvency levels, the average firm holds enough liquid assets to cover its short-term liabilities; less solvent firms have (2) a higher fraction of their total assets in liquid assets and therefore (3) lower conditional betas and (4) lower returns; (5) the profits of strategies are concentrated among low liquidity firms; and (6) the profits of liquidity strategies are concentrated among low solvency firms. My results suggest that solvency and liquidity are essential to understanding the distress puzzle.

Keywords: Distress risk, equity returns, cash holdings, insolvency, illiquidity

JEL Classification: G12, G32, G33, G35

Suggested Citation

Medhat, Mamdouh, Solvency and Liquidity in Distressed Equity Returns (December 9, 2014). Paris December 2014 Finance Meeting EUROFIDAI - AFFI Paper. Available at SSRN: https://ssrn.com/abstract=2437390 or http://dx.doi.org/10.2139/ssrn.2437390

Mamdouh Medhat (Contact Author)

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

HOME PAGE: http://https://sites.google.com/site/mamdouhmedhatresearch/

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