Financial Distress and the Cross Section of Equity Returns

74 Pages Posted: 21 Mar 2007 Last revised: 25 Jun 2010

See all articles by Lorenzo Garlappi

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Date Written: June 25, 2010

Abstract

We explicitly consider financial leverage in a simple equity valuation model and study the cross-sectional implications of potential shareholder recovery upon resolution of financial distress. We show that our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book-to-market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump-shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.

Keywords: Financial distress, value premium, momentum, growth options

JEL Classification: G12, G14, G33

Suggested Citation

Garlappi, Lorenzo and Yan, Hong, Financial Distress and the Cross Section of Equity Returns (June 25, 2010). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=970644 or http://dx.doi.org/10.2139/ssrn.970644

Lorenzo Garlappi (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

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