Risk-Shifting, Equity Risk, and the Distress Puzzle

34 Pages Posted: 24 Nov 2015 Last revised: 16 Oct 2019

See all articles by Keming Li

Keming Li

Texas A&M University (TAMU) - San Antonio

Jimmy Lockwood

Southern Illinois University - Department of Finance

Hong Miao

Colorado State University, Fort Collins - Department of Finance & Real Estate

Date Written: March 29, 2017

Abstract

Higher default probabilities are associated with lower future stock returns. The anomaly cannot be explained by strategic shareholder actions, traditional risk factors, characteristics, or mispricing, but, instead, is consistent with a risk-shifting hypothesis. Consistent with the risk-shifting hypothesis, we find that distressed firms tend to overinvest, destroy value, and exhaust their cash flows. Effects are concentrated in firms with wide credit spreads, firms with no convertible debt, and in cases where CEOs receive above-average equity-based compensation. As default risk rises, credit spreads rise, equity betas fall, and equity returns fall.

Keywords: Financial Distress; Bankruptcy; Risk-Shifting; Credit Spread

JEL Classification: G02, G11, G33

Suggested Citation

Li, Keming and Lockwood, Jimmy and Miao, Hong, Risk-Shifting, Equity Risk, and the Distress Puzzle (March 29, 2017). Journal of Corporate Finance, Vol. 44, April, 2017, Available at SSRN: https://ssrn.com/abstract=2694934 or http://dx.doi.org/10.2139/ssrn.2694934

Keming Li

Texas A&M University (TAMU) - San Antonio ( email )

One University Way
San Antonio, TX 78224
United States

Jimmy Lockwood (Contact Author)

Southern Illinois University - Department of Finance ( email )

Mail Code 4626
Carbondale, IL 62901-4626
United States
682.305.6095 (Phone)

HOME PAGE: http://https://business.siu.edu/people/finance/lockwood.html

Hong Miao

Colorado State University, Fort Collins - Department of Finance & Real Estate ( email )

Fort Collins, CO 80523
United States

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