Are Financially Distressed Firms Priced Differently?

30 Pages Posted: 17 Jun 2005

See all articles by Assaf Eisdorfer

Assaf Eisdorfer

University of Connecticut - Department of Finance

Date Written: June 2005

Abstract

Unexpected stock returns are driven by changes in rational expectations of future cash flows and future returns. Since each of these two components reflects innovations concerning all future horizons, the relative importance of the components may be different between firms with short and long life expectancies. I argue that in firms with financial difficulties, which face high bankruptcy risk, the effect of cash-flow news is more dominant than that of expected-return news, comparing to healthy firms. I find empirical support for my prediction, both by applying Campbell's (1991) variance decomposition framework to three financial-distress-based indices, and by directly examining the sensitivity of stock returns to concurrent shocks to expected volatility. I also examine the relative effect of cash-flow and expected-return news on the occurrence of actual bankruptcies. Both market-level and firm-level tests show that although market prices are mainly affected by changes in expected future returns, more bankruptcies occur after market-declines that are driven by negative shocks to expected cash flows than after market-declines that are driven by positive shocks to expected returns.

Keywords: Variance decomposition, financial distress

Suggested Citation

Eisdorfer, Assaf, Are Financially Distressed Firms Priced Differently? (June 2005). Available at SSRN: https://ssrn.com/abstract=743684 or http://dx.doi.org/10.2139/ssrn.743684

Assaf Eisdorfer (Contact Author)

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States

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