According to modern finance theory, high risk projects should, in equilibrium, offer high returns. Thus, there should be high returns forbearing elevated risk associated with financial distress, bankruptcy, default, and idiosyncratic volatility. This is not always the case. Indeed, in some instances, the returns on high risk stocks are very low, which flies in the face of modern financial theory.
In this paper we examine the interaction between distress and idiosyncratic volatility, how this interaction affects the required return, and proposearational explanation to two related puzzles uncovered by recent research on distress and idiosyncratic volatility. First, Ang, Hodrick, Xing, and Zhang (2006) discover, unexpectedly, that stocks with high idiosyncratic volatility relative to the Fama-French (1993) model earn anomalously low returns.
Similarly, there have been parallel findings in another line of research focusing on the effect of bankruptcy (distress) risk on stock returns. For example, Dichev (1998), Griffin and Lemmon (2002), and Campbell, Hilscher, and Szilagyi (2008) document that stocks with high likelihood of distress receive anomalously low returns. This suggests that some risky (distressed) stocks do not receive compensatory returns.
There is an intuitive reason to believe that these two puzzles are related to each other. According to the Merton (1974) model, corporate debt is a risk-free bondless a put option on the value of the firm's assets, with a strike price equal tot he face value of the debt. Thus, a firm with more volatile equity may experience an option effect, as it is more likely to reach the boundary condition for default. Indeed, based on this argument, Campbell and Taksler (2003) show that idiosyncratic firm-level volatility can explaina significant part of cross-sectional variation incorporate bond yields. Given this result, the puzzle that stocks with high idiosyncratic volatility receive anomalously low returns may reflect an option-like effect, and therefore bean expression of the distress risk puzzle.
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Financial Distress and Idiosyncratic Volatility: An Empirical Investigation
