Distressed Stocks in Distressed Times
53 Pages Posted: 2 Dec 2015 Last revised: 27 Mar 2017
Date Written: March 26, 2017
This paper shows that the well-documented distress anomaly does not hold in market downturns. The asset beta and financial leverage of distressed stocks rise significantly during bear markets, resulting in a dramatic increase in their equity beta. Hence, a long/short healthy-minus-distressed trading strategy leads to significant losses when the market rebounds. Managing this risk mitigates the severe losses of financial-distress strategies and significantly improves their Sharpe ratios. Our results remain strongly significant controlling for the momentum effect and are robust to various estimation procedures.
Keywords: Anomalies, Financial distress, Time-varying risk
JEL Classification: G11, G12
Suggested Citation: Suggested Citation