2015 Conference

Financial Distress, Bankruptcy, Insolvency, Risk-Shifting, Credit Risk

This paper examines the relationship between financial distress and equity returns. Using strategic action proxies proposed by Davydenko and Strebulaev (2007), I find that financial distress is a robust and negative predictor of future stock returns apart from the effect of strategic actions taken by shareholders. This indicates that the distress puzzle cannot be fully explained by shareholder strategic actions (or shareholder advantages as proposed by Garlappi, Shu, and Yan 2008 and Garlappi and Yan 2011). The distress effect also cannot be explained by traditional risk factors, characteristics, or mispricing. However, the evidence in this paper is consistent with the risk-shifting hypothesis. Three findings support this claim. First, distressed firms tend to overinvest, earn low profits, and exhaust their cash flows. This effect is concentrated in low growth opportunity firms and hard-to-valuate firms. Second, the distress effect is concentrated in firms without credit ratings or convertible debt and in firms in which CEO have equity holdings. Third, distressed firms tend to have high credit spreads.