Are Financially Distressed Firms Priced Differently?

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