Predicting Financial Distress and the Performance of Distressed Stocks|
In this paper, we consider the measurement and pricing of distress risk.We present a model
of corporate failure in which accounting and market-based measures forecast the likelihood
of future financial distress. Our best model is more accurate than leading alternative
measures of corporate failure risk.We use our measure of financial distress to examine the
performance of distressed stocks from 1981 to 2008. We find that distressed stocks have
high stock return volatility and high market betas and that they tend to underperform safe
stocks by more at times of high market volatility and risk aversion. However, investors
in distressed stocks have not been rewarded for bearing these risks. Instead, distressed
stocks have had very low returns, both relative to the market and after adjusting for their
high risk. The underperformance of distressed stocks is present in all size and value quintiles.
It is lower for stocks with low analyst coverage and institutional holdings, which
suggests that information or arbitrage-related frictions may be partly responsible for the
underperformance of distressed stocks.