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Idiosyncratic risk, financial distress and the cross section of stock returns
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School of Economics |
Master's thesis
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en
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84
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Abstract
PURPOSE OF THE STUDY
This study examines the asset pricing impact of idiosyncratic risk and financial distress on
cross sectional stock returns. Specifically, I investigate whether financial distress can explain
the correlation between conditional idiosyncratic volatility and return and vice versa.
Idiosyncratic volatility is defined as standard deviation of the firm return that cannot be
explained by the Fama French (1993) three factor model. This study is the first to investigate
the interaction between idiosyncratic risk and financial distress by employing generalized
autoregressive conditional heteroskedasticity GARCH models to measure conditional
idiosyncratic volatility and in addition to unpublished working paper by Song (2008), first to
employ Campbell et al. (2008) measure of financial distress using both market and accounting
variables.
DATA
This study targets all common shares that are traded in NYSE, AMEX and NASDAQ during
the period between 1971 and 2008. The market data is obtained from Center for Research in
Security Prices (CRSP) and the accounting data from COMPUSTAT database. The sample
consists of 18 795 unique stocks.
RESULTS
The results indicate a positive relation between idiosyncratic risk and expected stock returns,
which like many other anomalies is mainly driven by smaller stocks. The relation between
distress risk and expected stock returns is found to be negative.
I find that both idiosyncratic volatility and financial distress maintain their explanatory power
when both variables are included in the cross-sectional regression. In the multivariate
independent sort, the positive relation between idiosyncratic volatility and stock returns is
shown to be conditional on low distress risk. A positive relation is found in low distress risk
quintiles but in high distress risk quintiles the idiosyncratic volatility spread is insignificant.
The negative effect of distress risk persists after controlling for idiosyncratic volatility across
idiosyncratic volatility quintiles in multivariate independent sort. The findings indicate that
financials distress risk has a more fundamental asset pricing impact than idiosyncratic
volatility.