What drives the distress risk–return puzzle? A perspective on limits of arbitrage

Abstract

Empirical research has documented a negative relationship between distress risk and stock returns. This negative risk–return trade‐off, known as the distress puzzle, poses a challenge to asset pricing models. In this study, we provide a new explanation of the distress puzzle by considering the effect of arbitrage asymmetry. We find that the negative distress risk–return relation is stronger in stocks that have higher limits of arbitrage. The investors are virtually unable to short sell mispriced high distress risk stocks due to the low supply of lendable stocks from institutions and that arbitrage is costly. In addition, we show that the limits of arbitrage effect is distinct from liquidity effect in explaining the distress puzzle.

Limit to Arbitrage and Distress Risk Puzzle in Vietnam: Does Corporate Bankruptcy Regulation Matter?

“…The relationship between limits-to-arbitrage and their influence on stock returns has attracted considerable scholarly attention. Sha et al (2023) uncovered a noteworthy finding, indicating that the negative correlation between distress risk and returns is notably accentuated in stocks subject to stricter limits-to-arbitrage. This phenomenon stems from the constrained ability of investors to short sell overpriced stocks with heightened distress risk, driven by the limited availability of lendable shares and associated high arbitrage costs.…”