Default Risk, Idiosyncratic Coskewness and Equity Returns

In this paper, we intend to explain an empirical finding that distressed stocks delivered anomalously low returns. We show that in a model with heterogeneous investors where idiosyncratic skewness is priced, the expected return of risky assets depends on idiosyncratic coskewness betas, which measure the covariance between idiosyncratic variance and the market return. We find that there is a negative (positive) relation between idiosyncratic coskewness and equity returns when idiosyncratic coskewness betas are positive (negative). We construct two idiosyncratic coskewness factors to capture market-wide effect of idiosyncratic coskewness betas. When we control for these two idiosyncratic coskewness factors, the return difference for distress-sorted portfolios becomes insignificant. High stressed firms earn low returns because high stressed firms have high (low) idiosyncratic coskewness betas when idiosyncratic coskewness betas are positive (negative).