Risk-Shifting, Equity Risk, and the Distress Puzzle

Abstract

This paper examines the relationship between financial distress and equity returns. Using strategic action proxies, we find that financial distress is a robust and negative predictor of future stock returns apart from the effect of strategic shareholder actions. This shows that the distress puzzle cannot be fully explained by shareholder strategic actions or shareholder advantages. The distress effect also cannot be explained by traditional risk factors, characteristics, or mispricing. However, the results presented in this paper are consistent with the risk-shifting hypothesis. Three findings support this claim. First, distressed firms tend to overinvest, earn low profits, and exhaust their cash flows. This effect is concentrated in low growth opportunity firms and in hard-to-value firms. Second, distress effects are concentrated in firms without credit ratings or convertible debt and in which CEOs have equity holdings. Third, distressed firms tend to have high credit spreads.