Corporate Risk-Taking and Stock Returns to Distressed Firms
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Motivated by the ‘unexpected negative shock’ explanation on the distress risk puzzle (Chava and Purnanandam, 2010), we propose and test a hypothesis that the anomalous phenomenon is mainly attributable to unexpectedly low returns of distressed firms with a high tendency toward corporate risk-taking. Finance theory suggests that distressed firms have risk-shifting incentives due to the agency problem between shareholders and debtholders, which may lead to more frequent unexpected negative shocks to distressed firms. In this paper, we develop a novel measure of a firm’s propensity toward risk-taking, the Pearson correlation coefficient between the expected market aggregate volatility and the firm’s investment intensity. We find that the negative abnormal return of the long/short hedge portfolio that buys stocks of distressed firms and sells stocks of healthy firms (i.e., the “puzzle”) is more prevalent among firms with more risk-taking investment activities. We add to a strand of literature on the determinant of the distress risk puzzle.
Abstract
Motivated by the ‘unexpected negative shock’ explanation on the distress risk puzzle (Chava and Purnanandam, 2010), we propose and test a hypothesis that the anomalous phenomenon is mainly attributable to unexpectedly low returns of distressed firms with a high tendency toward corporate risk-taking. Finance theory suggests that distressed firms have risk-shifting incentives due to the agency problem between shareholders and debtholders, which may lead to more frequent unexpected negative shocks to distressed firms. In this paper, we develop a novel measure of a firm’s propensity toward risk-taking, the Pearson correlation coefficient between the expected market aggregate volatility and the firm’s investment intensity. We find that the negative abnormal return of the long/short hedge portfolio that buys stocks of distressed firms and sells stocks of healthy firms (i.e., the “puzzle”) is more prevalent among firms with more risk-taking investment activities. We add to a strand of literature on the determinant of the distress risk puzzle.
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