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Financial Distress Premium or Discount? Some New Evidence

Author

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  • Ramya R. Aroul

    (Department of Finance and Real Estate, College of Business, University of Texas at Arlington, 701 S W St, Arlington, TX 76010, USA)

  • Noura K. Kone

    (Department of Finance and Real Estate, College of Business, University of Texas at Arlington, 701 S W St, Arlington, TX 76010, USA)

  • Sanjiv Sabherwal

    (Department of Finance and Real Estate, College of Business, University of Texas at Arlington, 701 S W St, Arlington, TX 76010, USA)

Abstract

This study investigates the contradiction in the finding of a positive distress risk premium in Vassalou and Xing’s study and the finding of a negative distress risk premium, i.e., a distress risk discount, in several other studies. Using the default likelihood measure calculated following Vassalou and Xing’s procedure for 1965–2023, we show that excluding outliers and including the time period beyond the end of Vassalou and Xing’s sample period in 1999 makes a difference in the results. Overall, using portfolio sorting and Fama-MacBeth regressions, this study supports the existence of a distress risk discount. This study also documents that the financial distress risk is negatively reflected in security prices even after accounting for size and book-to-market risk factors. Furthermore, it demonstrates that the negative distress risk premium is strong and persistent across economic expansions, recessions, and the COVID-19 pandemic.

Suggested Citation

  • Ramya R. Aroul & Noura K. Kone & Sanjiv Sabherwal, 2024. "Financial Distress Premium or Discount? Some New Evidence," JRFM, MDPI, vol. 17(7), pages 1-24, July.
    • Handle: RePEc:gam:jjrfmx:v:17:y:2024:i:7:p:286-:d:1430581
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    References listed on IDEAS

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    3. George, Thomas J. & Hwang, Chuan-Yang, 2010. "A resolution of the distress risk and leverage puzzles in the cross section of stock returns," Journal of Financial Economics, Elsevier, vol. 96(1), pages 56-79, April.
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    5. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-636, May-June.
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    7. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
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