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

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