Corporate Risk-Taking and Stock Returns to Distressed Firms

Abstract

Motivated by i) the ‘unexpected negative shock’ explanation on the distress risk puzzle by Chava and Purnanandam (2010a) and ii) the positive relation between the stock returns of distressed firms and the marketwide volatility reported by Campbell et al. (2008), I propose a testable hypothesis on the distress risk puzzle that the anomalous phenomenon is attributable to the low returns for distressed firms with high tendency towards asset substitution. The hypothesis is based on the corporate finance theory that asset substitution is a common channel for risk-shifting from the equityholders to the debtholders. In the preliminary empirical tests, I proxy for a firm’s propensity toward corporate risk taking by using the Pearson correlation coefficient between the expected market volatility and the firm’s investment intensity. The result of the analysis supports my hypothesis: I do find very low FamaFrench 3-factor alphas for distressed firms with risk-taking investment activities (high asset substitution).