Distress Risk & Asset Pricing

Question 1

Classic Distress Risk Measures

Answer 1

Altman 1968

Ohlson 1980

Question 2

Griffin Lemmon 2002 JF

Answer 2

• firms with highest distress risk as proxied by Ohlson’s (1980) O-score, the difference in returns between high and low B/M securities is more than twice as large as that in other firms.
• cannot be explained by the 3FM or by differences in economic fundamentals.
• Consistent with mispricing arguments, firms with high distress risk exhibit the largest return reversals around earnings announcements,
• and the book-to-market effect is largest in small firms with low analyst coverage.

Question 3

Hillegeist, Keating, Cram and Lundstedt 2004

Answer 3

*Like in Vassalou and Xing (2004) develop a distress risk model based on the option pricing model of Black &Scholes (1973), and Merton (1974). *

Question 4

Vassalou and Xing 2004

Answer 4

• Size effect only exist with the high default risk quintile (big - small return = 45% per year)
• small stocks in the high default risk quintine are typically the smallest of the small and have the highest B/M -within this quintile, small firms have much higher default risk than big
• BM effect exists only in the two quintiles with the highest default risk
• Value stocks have much higher default risk than growth stocks, and there is a monotonic relation between BM and default risk

Question 5

Longstaff, Mithal and Neis 2005

Answer 5

• use the information in credit default swaps to obtain direct measures of the size of the default and nondefault components in corporate spreads.
• find that the majority of the corporate spread is due to default risk.
• find that the nondefault component is time varying and strongly related to measures of bond-specific illiquidity as well as to macroeconomic measures of bond market liquidity.

Question 6

Ericsson Renault 2006

Answer 6

Key assumptions of theoretical model

• When firm is solvent, bondholder subject to random liquidity shocks
• Supply side of the markets is an endogenous function of the state of the firm and the prob of liquidity shocks

Findings

• when main determinants of default prob–leverage and asset risk–increase, components of bond yield spreads that are driven by illiquidyt also increase.
• predicts that liquidty spreads are decreasing functions of time to maturity
• provide empirical support

Question 7

Gomes, Yaron, Zhang 2006

Answer 7

• “We find that the shadow price of external funds is strongly procyclical, that is, financial market imperfections are more important when economic conditions are relatively good.”
• “The intuition behind our results is simple. The empirical success of production-based asset pricing models lies in the alignment between the theoretical returns on capital investment and stocks returns.
• Given the forward-looking nature of the firms’ dynamic optimization decisions, the returns to capital accumulation will be positively correlated with expected future profitability.
• Accordingly, the model generates a series of investment returns that is procyclical and leads the business cycle “

Question 8

Odders-White and Ready 2006

Answer 8

• Theoretically and empirically analyze contemporaneous and predictive relations between credit ratings and measures of equity market liquidity
• find that common measures of adverse selection, which reflect a portion of the uncertainty about future firm value, are larger when credit ratings are poorer.
• show that future rating changes can be predicted using current levels of adverse selection.

Question 9

Acharya Johnson 2007

Answer 9

About insider trading in credit derivatives. Find

• significant incremental information revelation in the credit default swap market under circumstances consistent with the use of non-public information by informed banks.
• The information revelation occurs only for negative credit news and for entities that subsequently experience adverse shocks, and increases with the number of a firm’s relationship banks.
• find no evidence, however, that the degree of asymmetric information adversely affects prices or liquidity in either the equity or credit markets.

Question 10

Campbell, Hilscher & Szilagyi (2008)

Answer 10

• failure prob estimated from dynamic logit model using accounting & market data
• Since 1981, distressed stocks have delivered anomalously low returns.
• but much higher std dev, market betas, & loadings on HML and SMB
• patterns more pronounced for stocks with possible informational or arbitrage-related frictions.
• inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress.

Question 11

Da & Gao 2010

Answer 11

• VX results driven by short-term return reversals, not systematic risk.
• Argue that increases in DLI trigger the selling of these stocks by institutional investors into illiquid markets.
• Market makers step in to provide immediacy in exchange for low price, which bounces back once outside investors seize opportunity.
• Mutual fund trades support hypothesis.

Question 12

George and Hwang 2010

Answer 12

• In low-states, which are at least partly sytematic, distress costs depress asset payoffs.
• Thus, high distress cost firms optimally choose lower leverage.
• This explains the high leverage/low return puzzle.
• Also, because high cost firms have low leverage their (measured) probability of default will be low.
• This explains the high default probability/low return puzzle.
• Empirical tests support these explanations.