Stock returns have been observed to be anomalous compared to the predictions of various models which assert that firm-level characteristics, such as size (ME) and book-to-market equity (BE/ME), should not influence the cross-section of stock returns. Since the seminal works of Chan and Chen (1991) and Fama and French (1992), the concept of financial distress has been used extensively to explain such anomalous pattern in stock returns. The literature has also documented a number of asset pricing anomalies that persist following their discovery. These include the last return (short term momentum and long run reversal), earnings momentum, dispersion, accruals, credit risk (level and changes), and idiosyncratic volatility effects.
Several papers have subsequently examined the market mispricing of distressed firms and its relationship with some anomalies, with conflicting results. As a byproduct, the financial performance of relative distressed stocks and distress risk premium has evolved into a subject of intense academic research (see, for example, Capaul, Rowley, and Sharpe (1993), Garza-G mez, Hodoshima, and Kunimura (1998), Ferguson and Shockley (2003), Chan and Lakonishok (2004), and Fama and French (1996, 2008)).
Despite the enormity of the existing literature, some simple questions remain unanswered. It is not clear to what extent continuation of short-term momentum returns affects the market mispricing of distressed firms. Is short term momentum really a proxy for distress risk? Can we rationalize distress risk associated with size and book-to-market ratio using momentum anomaly? In this paper we address some of these issues. The objective is to examine the interaction of distress and momentum returns, in an effort to disentangle the anomalous behavior of portfolio returns with respect to size and book-to market ratio.
We create a measure of distressed stocks following Campbell, Hilscher, and Szilagyi (2008), and study in detail the inter relationship between firm characteristics and the average returns of distressed firms. We explore the individual and joint role of momentum and distress risk in the cross sectional return spread related to size and book-to market ratio. The goal is to develop an empirical framework to simultaneously account for three major anomalous features of average stock returns that are related to size, BE/ME, and momentum, and their interaction with financial distress. We present a formal cross-sectional test of the relationship between distress risk and firm characteristics that include momentum.
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Firm characteristics, distress risk, and average stock returns
