Solvency and Liquidity in Distressed Equity Returns

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

Date Written: December 9, 2014


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: or

Mamdouh Medhat (Contact Author)

Dimensional Fund Advisors ( email )

6300 Bee Cave Road, Building One
Austin, TX 78746
United States

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