Distress Anomaly and Shareholder Risk: International Evidence

Abstract

Financially distressed stocks in the United States earn puzzlingly low returns giving rise to the distress risk anomaly. We provide evidence that the anomaly exists in developed countries, but not in emerging ones. Using cross-country analyses, we explore several potential drivers of returns to distressed stocks. The distress anomaly is stronger in countries with stronger takeover legislation, lower barriers to arbitrage, and higher information transparency. In contrast, shareholder bargaining power and expected stock return skewness in a country do not affect the anomaly. These findings suggest that various aspects of shareholders' risk play an important role in shaping distressed stocks returns.

Essay on Distress

“…Debt enforcement risk: Returns to distressed stocks are likely to be higher in countries with higher probability of renegotiation failure, higher debt priority, greater creditor recovery, stronger creditor rights, and lower insider ownership [5]. For Example, a U.S. exporter of electrical equipment for the trade has to contend with non-payment by a Brazilian reseller.…”

“…Limits to arbitrage risk: Returns to distressed stocks are likely to be higher in countries with lower institutional ownership, higher market illiquidity, and higher Amihud's illiquidity [5]. For Example, There is no way to go short housing.…”

Is Bankruptcy Risk a Systematic Risk? Evidence from Pakistan Stock Exchange

“…Besides that, it is a historic US market specific phenomena only (Chava & Purnanandam, 2010). Also, the prices of distressed stocks miscalculate because investors are unable to estimate failure risk (Eisdorfer et al, 2015). This phenomenon is due to the empirical limitation of the simple linear model in capturing excess returns that lead to partialities in estimated factor loadings of distressed stocks portfolio (Boualam et al, 2017).…”

“…The study cites robust takeover legislation of distressed companies, weak arbitrage barriers, and greater information transparency as some reasons behind a more robust anomaly. It is challenging to take arbitrage positions in stocks of distressed companies (Eisdorfer et al, 2015), making them riskier. Within the US market, distress anomaly observes to be higher in small-cap companies (Campbell et al 2008).…”

Equity Misvaluation and Default Options

“…The fact that we do not see overvaluation of equity of distressed stocks in our analysis suggests that some other aspects of distressed stocks such as skewness (CHS ()) or reduced riskiness due to high shareholder advantage (Garlappi, Shu, and Yan (), Garlappi and Yan ()) must be driving the returns to distressed stocks. See also Eisdorfer, Goyal, and Zhdanov () for an international study on the determinants of distressed stock returns.…”