Financial Distress, Short Sale Constraints, and Mispricing
46 Pages Posted: 18 Nov 2018
Date Written: October 27, 2018
This paper specifically examine how the extent of the distress puzzle differs according to the degree of mispricing and short sale constraints. We find that the distress puzzle observed for overpriced stocks, not for underpriced stocks, becomes insignificant after adjustment for short sale constraints due to an asymmetric pricing effect of short sale constraints only on the short-leg side of distress. However, after adjustment for arbitrage risk, the distress puzzle remains unchanged. These results indicate that the distress puzzle is mainly attributable to short sale constraints, rather than other limits-to-arbitrages such as arbitrage risk, which has a bi-lateral pricing effect on both short-leg and long-leg sides of distress. To mitigate a possible endogeneity problem relation among financial distress, mispricing, and short sale constraints, we measure these variables with different timing.
Keywords: Financial distress puzzle, Short sale constraints, Degree of mispricing, Asymmetric pricing effect, Benchmark-adjusted returns
JEL Classification: G12, G14
Suggested Citation: Suggested Citation