Abstract
Recent studies conflict sharply about the stock returns of financially distressed firms. Both the basic empirical pattern and interpretation have been challenged. This study addresses both critiques. Analyzing about 4.3 million firm-months observations in 38 countries from January 1992 to June 2013, we find a strong, negative link between credit risk and subsequent equity returns, concentrated among low-capitalization stocks in developed countries in North America and Europe. Comparisons between countries reveal: 1) no relation to creditor rights, inconsistent with theories based on shareholders expropriation, but 2) a strong, positive relation to individualism, a proxy for investor overconfidence. Additional analysis using within-country proxies for investor overconfidence further supports an overconfidence-based explanation.
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