The Dual Effect of Financial Distress on Stock Pricing and Realized Return

40 Pages Posted: 6 May 2022

See all articles by Zhuo (June) Cheng

Zhuo (June) Cheng

Hong Kong Polytechnic University - School of Accounting and Finance

Jing Fang

University of Central Arkansas

Yinglei Zhang

The Chinese University of Hong Kong

Date Written: March 15, 2022

Abstract

Financial distress has a dual effect on stock pricing: it affects both investors’ expected return and stock pricing efficiency. Therefore, the estimated relation between it and realized return captures both the relation between it and expected return and the relation between it and the mispricing-engendered component. The sign of the estimated relation between it and the mispricing-engendered component is indeterminate in a particular sample. Our findings suggest that the relation between it and the mispricing-engendered component dominates the relation between it and expected return. One thus cannot infer the sign of the relation between it and expected return from the estimated relation between it and realized return. Altogether, our study suggests that the overall negative relation between financial distress and realized return documented in some studies doesn’t necessarily contradict the prediction of classic rational asset pricing theories.

Keywords: Financial distress; Asset pricing puzzle; Expected return; Realized return; Stock pricing efficiency

JEL Classification: G12, G14, G40

Suggested Citation

Cheng, Zhuo (June) and Fang, Jing and Zhang, Yinglei, The Dual Effect of Financial Distress on Stock Pricing and Realized Return (March 15, 2022). Available at SSRN: https://ssrn.com/abstract=4058257 or http://dx.doi.org/10.2139/ssrn.4058257

Zhuo (June) Cheng

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

Hung Hom
Kowloon
Hong Kong

Jing Fang (Contact Author)

University of Central Arkansas ( email )

College of Business
201 Donaghey Ave
Conway, AR N/A 72035
United States

Yinglei Zhang

The Chinese University of Hong Kong ( email )

Shatin, N.T.
Hong Kong
Hong Kong

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