Abstract
This study explores the distress risk anomaly—the tendency for stocks with high credit risk to perform poorly—among 38 countries over two decades. We find a strongly negative relationship between default probabilities and equity returns concentrated among low-capitalization stocks in developed countries in North America and Europe. Although risk-based explanations provide a poor account of these patterns, several pieces of evidence point to a behavioral interpretation, suggesting that stocks of firms in financial distress are temporarily overpriced. Received March 5, 2013; editorial decision December 4, 2016 by Editor Andrew Karolyi.
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