Distress anomaly revisited – Distance to default in the US stock market

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School of Business | Master's thesis
Degree programme
52 + 3
This thesis replicates the study by Vassalou and Xing (2004) which claims that higher level of financial distress risk is the explanation for higher stock returns in small and undervalued firms, a return anomaly identified in financial literature since 1992. They used a financial distress indicator in the US stock market during 1971-1999 to conclude that the higher returns are compensation for carrying financial distress risk that cannot be diversified away. I replicate their study using the same model, but with a smaller sample from US stock market from 2006-2020 and minor differences in data specifications. I find that small firms indeed have higher stock returns, but undervalued firms seem to have unexpectedly lower stock returns, but this latter effect is less precise. I also find no indication that these effects would happen only among high-risk firms or that high distress risk firms in general would have higher stock returns, which was a central result of Vassalou and Xing. After the publication of their study there has been identified both in the area of financial research and other scientific areas a possibility that several of their results might be a result of data snooping. As the authors use methods that have been later identified to inflate the results in this topic area and they also perform multiple tests without correcting acceptance margins, it is likely that their results are not as robust as they claim. Other possible explanations for the absence of the default effect in our sample is the exclusion of smallest firms also known as microcaps, as they also have been identified to inflate results in return anomaly analysis. Related literature has also given several alternative explanations for anomalies that are inconsistent with the classical risk-based explanation for excess returns, and these might affect both the original results and the results of this study. As a conclusion, either distress risk is not able to explain higher returns among larger firms or the model used in this study is able to quantify this risk only among smaller companies. In results of this study the only firm characteristic that indicates higher returns in almost every test even with a higher acceptance margin is small size.
Thesis advisor
Terviö, Marko
anomaly, default risk, bankruptcy, stock returns
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