Financial Distress Risk and Stock Price Crashes
46 Pages Posted: 17 Sep 2019
Date Written: September 8, 2019
Using 331,917 monthly observations of U.S. public firms, this study documents a strong positive relationship between short-term changes in financial distress risk and future stock price crashes. The results show that a one-unit increase in distress risk increases the probability of a future stock price crash by 15.42 percent. The distress-crash risk relationship is more pronounced when firms’ information asymmetry is higher, as captured by firms’ accounting opacity and stock illiquidity. Interestingly, the results also support that the impact of distress risk on future stock price crashes is stronger during investor sentiment-waning phases, and periods with heightened market-wide distress risk. The findings of this study are of interest to investors who wish to take long-run positions in the stock market because stock price crash risk cannot be easily diversified away. In this vein, investors should be cautious of a firm’s distress risk, as short-term increases could be an early warning sign of forthcoming crash risk problems.
Keywords: stock price crashes, crash risk, distress risk, bad news hoarding, investor sentiment
JEL Classification: G12, G19, G32, G33, M40, D89
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