A resolution of the distress risk and leverage puzzles in the cross section of stock returns |
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Authors: | Thomas J. George Chuan-Yang Hwang |
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Affiliation: | 1. C. T. Bauer College of Business, University of Houston, Houston, TX 77240, USA;2. Division of Banking and Finance, Nanyang Business School, Nanyang Technological University, Singapore 639798, Singapore |
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Abstract: | We revisit findings that returns are negatively related to financial distress intensity and leverage. These are puzzles under frictionless capital markets assumptions but are consistent with optimizing firms that differ in their exposure to financial distress costs. Firms with high costs choose low leverage to avoid distress, but they retain exposure to the systematic risk of bearing such costs in low states. Empirical results are consistent with this explanation. The return premiums to low leverage and low distress are significant in raw returns, and even stronger in risk-adjusted returns. When in distress, low-leverage firms suffer more than high-leverage firms as measured by a deterioration in accounting operating performance and heightened exposure to systematic risk. The connection between return premiums and distress costs is apparent in subperiod evidence. Both are small or insignificant prior to 1980 and larger and significant thereafter. |
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Keywords: | Financial distress Leverage Bankruptcy costs Cross section of returns |
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