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Financial Distress and Idiosyncratic Volatility: An Empirical Investigation

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  • Chen, Jing

    ()
    (Columbia University, Graduate School of Business)

  • Chollete, Lorán

    ()
    (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

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    Abstract

    We address the twin puzzles of anomalously low returns for high idiosyncratic volatility and high distress risk stocks, documented by Ang, Hodrick, Xing and Zhang (2006) and Campbell, Hilscher and Szilagyi (2005), respectively. We accomplish two objectives in this study. First, we investigate the link between idiosyncratic volatility and distress risk and find that the idiosyncratic volatility effect exists only conditionally on high distress risk. Second, using a corrected single-beta CAPM model, we provide a rational explanation for the twin puzzles. Joint statistical tests cannot reject the null hypothesis of zero abnormal returns across the idiosyncratic volatility and distress risk portfolios, for the corrected model.

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    Bibliographic Info

    Paper provided by Department of Business and Management Science, Norwegian School of Economics in its series Discussion Papers with number 2006/8.

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    Length: 27 pages
    Date of creation: 04 Aug 2006
    Date of revision:
    Handle: RePEc:hhs:nhhfms:2006_008

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    Postal: NHH, Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
    Phone: +47 55 95 92 93
    Fax: +47 55 95 96 50
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    Web page: http://www.nhh.no/en/research-faculty/department-of-business-and-management-science.aspx
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    Related research

    Keywords: Distress risk; idiosyncratic volatility; single-beta CAPM;

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    1. Campbell, John & Taksler, Glen, 2003. "Equity Volatility and Corporate Bond Yields," Scholarly Articles 3153307, Harvard University Department of Economics.
    2. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    3. Ilia D. Dichev, 1998. "Is the Risk of Bankruptcy a Systematic Risk?," Journal of Finance, American Finance Association, vol. 53(3), pages 1131-1147, 06.
    4. Gibbons, Michael R & Ross, Stephen A & Shanken, Jay, 1989. "A Test of the Efficiency of a Given Portfolio," Econometrica, Econometric Society, vol. 57(5), pages 1121-52, September.
    5. Andrew Ang & Robert J. Hodrick & Yuhang Xing & Xiaoyan Zhang, 2006. "The Cross-Section of Volatility and Expected Returns," Journal of Finance, American Finance Association, vol. 61(1), pages 259-299, 02.
    6. Newey, Whitney K & West, Kenneth D, 1987. "Hypothesis Testing with Efficient Method of Moments Estimation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 777-87, October.
    7. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    8. Roll, Richard, 1977. "A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory," Journal of Financial Economics, Elsevier, vol. 4(2), pages 129-176, March.
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