Abstract
Stocks with high distress risk earn an average market-adjusted return of 0.62% in the five days before earnings announcements and a corresponding average return of -0.96% in the five days after earnings announcements. The five-day post-announcement return accounts for a large portion of the negative cross-sectional relation between distress risk and stock returns. Changes in risk around earnings announcements and cross-sectional differences in risk cannot explain the run-up and subsequent reversal in distressed stocks’ returns. Consistent with the mispricing hypothesis, the return pattern only exists in distressed stocks with binding short-sales constraints and large divergence in investors’ opinion.
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