Understanding the Behavior of Distressed Stocks
54 Pages Posted: 13 Jun 2017 Last revised: 23 Feb 2019
Date Written: February 21, 2019
We construct an asset pricing model with explicit default to develop a risk-based source of the distress anomaly. Distress produces sharply countercyclical betas leading to biased estimates of risk premia and alphas. This is amplified when earnings growth is mean-reverting, so that distressed stocks also have high expected future earnings. The bias is sizable in a calibrated economy that replicates key characteristics of these stocks. We derive an approximate correction for the bias that can be readily applied in practice. Evidence of distressed stocks' underperformance becomes much weaker after this correction, and pricing appears consistent with the CAPM.
Keywords: Distress Anomaly, Asset Pricing, Endogenous Default, Nonlinear Estimation
JEL Classification: G11, G12
Suggested Citation: Suggested Citation