An analysis of the relationship between financial distress risk and equity returns

Abstract

The current research aims to examine the systematic and unsystematic relationship between financial distress risk and equity returns based on the Black-Scholes-Merton probability of default measure of financial distress risk in the TSE from 2001 to 2012. This research integrates the theory of financial distress into modern asset pricing theory and examines a particular financial distress phenomenon from the theoretical capital market perspective. We use the portfolio formation method for the monthly data. Findings show that returns of financially distressed stocks are lower than sound stocks, thereby the investors are not rewarded by higher returns for bearing that risk. Also, we found that B/M and Size effects are statistically independent from financial distress risk, but the effect of idiosyncratic volatility is observable.

Keywords

• equity returns
• Financial distress
• idiosyncratic volatility
• systematic risk