Financial Distress, the Idiosyncratic Volatility Puzzle and Expected Returns

Abstract

This paper explores the asset pricing impact of financial distress and idiosyncratic volatility on cross-sectional stock returns. We show that the puzzling negative correlation between idiosyncratic volatility and return is a manifestation of financial distress. Using daily and monthly return data from 1971 to 2006, we show that while the volatility spread is -1.68% for the most distressed stocks, it is actually positive and significant at 0.61% per month for the least distressed ones. This indicates that financial distress has a more fundamental impact on the cross-sectional returns than idiosyncratic volatility. As volatility is one of the inputs in the measurement of distress, we address the potential endogenous relationship between distress and idiosyncratic volatility using various robustness checks. Moreover, in a horse-race comparison under the Fama-MacBeth firm-level regression set up, financial distress takes away the explanatory power of idiosyncratic volatility on cross-sectional stock returns. Interaction of financial distress with other asset-pricing anomalies, including momentum and value effects, is also explored. It is shown that the momentum effect is mostly driven by the group of most distressed stocks. And similarly, the value effect is the strongest among this group of stocks.