Financial Distress and the Cross-section of Equity Returns

Authors

  • LORENZO GARLAPPI,

  • HONG YAN

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    • Garlappi is at the Sauder School of Business, University of British Columbia. Yan is at the Moore School of Business, University of South Carolina and Shanghai Advanced Institute of Finance (SAIF), Shanghai Jiao Tong University. We acknowledge helpful comments from Aydoğan Alti, Kerry Back, Jan Bena, Luca Benzoni, John Campbell, Murray Carlson, Allan Eberhart, Mike Gallmeyer, João Gomes (NBER discussant), Shingo Goto, Jean Helwege, Jennifer Huang, Timothy Johnson, Hong Liu (CICF discussant), Dmitry Livdan, Alexander Philipov (FEA discussant), Eric Powers, Jacob Sagi, Mikhail Simutin, Paul Tetlock, Sheridan Titman, Stathis Tompaidis, Sergey Tsyplakov, Raman Uppal, Lu Zhang (AFA discussant); participants at the 2007 NBER Asset Pricing Program Meeting, the 2007 Financial Economics and Accounting Conference, the 2008 American Finance Association Annual Meeting, the 2008 China International Conference in Finance, the Fall 2009 JOIM Conference Series; and participants of seminars at Baruch College, Brigham Young University, Chinese University of Hong Kong, City University of Hong Kong, Hong Kong University of Science and Technology, McGill University, National University of Singapore, PanAgora Asset Management, Rutgers University, Singapore Management University, State Street Global Advisors, Temple University, Texas A & M University, Texas Tech University, the University of British Columbia, the University of Calgary, the University of Hong Kong, the University of Illinois at Urbana-Champaign, the University of Lausanne, the University of North Carolina at Charlotte, the University of South Carolina, the University of Texas at Austin, the University of Toronto, and Università Bocconi. We thank Moody's KMV for providing us with the data on expected default frequency™ (EDF™) and Shisheng Qu for answering questions about the data. We are grateful to Cam Harvey (the Editor), an anonymous associate editor, and two anonymous referees for constructive suggestions.


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. 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.

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