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A resolution of the distress risk and leverage puzzles in the cross section of stock returns

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  • George, Thomas J.
  • Hwang, Chuan-Yang
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    Abstract

    We revisit findings that returns are negatively related to financial distress intensity and leverage. These are puzzles under frictionless capital markets assumptions but are consistent with optimizing firms that differ in their exposure to financial distress costs. Firms with high costs choose low leverage to avoid distress, but they retain exposure to the systematic risk of bearing such costs in low states. Empirical results are consistent with this explanation. The return premiums to low leverage and low distress are significant in raw returns, and even stronger in risk-adjusted returns. When in distress, low-leverage firms suffer more than high-leverage firms as measured by a deterioration in accounting operating performance and heightened exposure to systematic risk. The connection between return premiums and distress costs is apparent in subperiod evidence. Both are small or insignificant prior to 1980 and larger and significant thereafter.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 96 (2010)
    Issue (Month): 1 (April)
    Pages: 56-79

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    Handle: RePEc:eee:jfinec:v:96:y:2010:i:1:p:56-79

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Financial distress Leverage Bankruptcy costs Cross section of returns;

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    Cited by:
    1. Muradoğlu, Yaz Gülnur & Sivaprasad, Sheeja, 2012. "Capital structure and abnormal returns," International Business Review, Elsevier, vol. 21(3), pages 328-341.
    2. Berardino Palazzo, 2013. "Net leverage, risk, and credit spreads," 2013 Meeting Papers 436, Society for Economic Dynamics.
    3. Kapadia, Nishad, 2011. "Tracking down distress risk," Journal of Financial Economics, Elsevier, vol. 102(1), pages 167-182, October.
    4. Palazzo, Berardino, 2012. "Cash holdings, risk, and expected returns," Journal of Financial Economics, Elsevier, vol. 104(1), pages 162-185.
    5. Tom Aabo & Marianna Andryeyeva Hansen & Christos Pantzalis, 2012. "Corporate foreign exchange speculation and integrated risk management," Managerial Finance, Emerald Group Publishing, vol. 38(8), pages 729-751, August.
    6. Panayiotis Artikis & Georgia Nifora, 2012. "Capital Structure, Macroeconomic Variables & Stock Returns. Evidence from Greece," International Advances in Economic Research, Springer, vol. 18(1), pages 87-101, February.
    7. Cai, Jie & Zhang, Zhe, 2011. "Leverage change, debt overhang, and stock prices," Journal of Corporate Finance, Elsevier, vol. 17(3), pages 391-402, June.
    8. Nicholas Apergis & John Sorros, 2011. "Long-Term Debt and the Value of the Firm,Evidence from International Listed Manufacturing Firms," Review of Economics & Finance, Better Advances Press, Canada, vol. 1, pages 60-72, February.
    9. Ferreira Filipe, Sara & Grammatikos, Theoharry & Michala, Dimitra, 2014. "Pricing Default Risk: The Good, The Bad, and The Anomaly," MPRA Paper 53373, University Library of Munich, Germany.
    10. Panayotis Artikis & Georgia Nifora, 2011. "Leverage and Returns in Three Countries of Southern European Region," European Research Studies Journal, European Research Studies Journal, vol. 0(4), pages 3-26.

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