Abstract:

We analyze the impact of financial distress on expected stock returns accounting for the severity of default. Whereas shareholders’ average losses amount to 32% of equity value from the day before to the day after a bankruptcy filing, outcomes differ substantially among firms. We specify and estimate a model that predicts these losses for individual firms. When sorting stocks into portfolios according to their predicted bankruptcy losses, we find that a long-short strategy buying stocks with high predicted bankruptcy losses and selling stocks with low predicted bankruptcy losses earns a monthly premium of 0.5%. We also sort stocks independently into quintiles according to predicted bankruptcy loss and failure probability. We find that the distress-risk puzzle is not present among stocks in the highest quintile of predicted bankruptcy loss. On the contrary, the long-short returns of stocks sorted by predicted bankruptcy losses are strongest for stocks in the highest quintile of failure probability.