Distress Effects in Stock Returns

Abstract

This thesis addresses a fundamental topic in financial economics: the effects of distress risk in the cross section of equities returns. Initial results show that both raw and risk-adjusted excess returns are rising in distress risk, and the remainder of this thesis examines the general robustness of the distress premium. Accordingly, the additional excess returns to stocks having heightened levels of financial distress are contingent upon the stock price being low. These findings are then extended to demonstrate that these same stocks are also microcap firms, thus attributing the anomalous behaviour of distressed stocks to a common factor with many other market anomalies. The economic implication is that arbitrage profits are likely to be limited due to the high transaction costs alongside the limited investment capacity with associated low-priced, microcap stocks.