The impact of financial distress risk on equity returns: A case study of non-financial firms of Pakistan Stock Exchange

Sahar IDREES, Abdul QAYYUM

Abstract


Abstract. This study aims to investigate the relationship of financial distress risk and the equity returns of financially distressed firms listed on Pakistan Stock Exchange (PSX). Several studies have suggested that firm distress risk factor could be behind the book-to-market and size effects. Fama and French three factor Model (1993) is used for examining the relationship among equity returns, financial distress risk, size and book-to-market equity ratio. Non-financial firms listed on PSX are taken from the time-period of 2010-2016. Ohlson’s O-Score (1980) “bankruptcy prediction model” is used for the prediction of financial distress risk and forecasted the distress risk firms listed on PSX. The panel (unbalanced) data is used to get the empirical findings and showed that the financial distress risk and book-to-market equity effect are statistically insignificant to explain the stock returns of distress firms due to the inefficiency of market. However, size effect is significant in explaining the stock returns of distress firms. The study also reveals that it is important to predict financial distress risk with a better predictor in order to avoid the uncertainties in PSX.

Keywords. Financial distress risk, Equity returns, Book-to-market effect, Size, Pakistan Stock Exchange.

JEL. G30, G32.

Keywords


Financial distress risk; Equity returns; Book-to-market effect; Size; Pakistan Stock Exchange.

Full Text:


References


Aharony, J., Jones, C.P., & Swary, I. (1980). An analysis of risk and return characteristics of corporate bankruptcy using capital market data. The Journal of Finance, 35(4), 1001-1016. doi. 10.1111/j.1540-6261.1980.tb03516.x

Altman, E.I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609. doi. 10.2307/2978933

Altman, E.I. (1984). The success of business failure prediction models: An international survey. Journal of Banking & Finance, 8(2), 171-198. doi. 10.1016/0378-4266(84)90003-7

Andrade, G., & Kaplan, S.N. (1998). How costly is financial (not economic) distress? Evidence from highly leveraged transactions that became distressed. The Journal of Finance, 53(5), 1443-1493. doi. 10.1111/0022-1082.00062

Avramov, D., Chordia, T., Jostova, G., & Philipov, A. (2009). Credit ratings and the cross-section of stock returns. Journal of Financial Markets, 12(3), 469-499. doi. 10.1016/j.finmar.2009.01.005

Balestra, P., & Nerlove, M. (1966). Pooling cross section and time series data in the estimation of a dynamic model: The demand for natural gas. Econometrica: Journal of the Econometric Society, 34(3), 585-612. doi. 10.2307/1909771

Banz, R.W. (1981). The relationship between return and market value of common stocks. Journal of Financial Economics, 9(1), 3-18. doi. 10.1016/0304-405X(81)90018-0

Basu, S. (1983). The relationship between earnings' yield, market value and return for NYSE common stocks: Further evidence. Journal of Financial Economics, 12(1), 129-156. doi. 10.1016/0304-405X(83)90031-4

Bondt, W.F., & Thaler, R. (1985). Does the stock market overreact? The Journal of Finance, 40(3), 793-805. doi. 10.1111/j.1540-6261.1985.tb05004.x

Campbell, J.Y., Hilscher, J., & Szilagyi, J. (2008). In search of distress risk. The Journal of Finance, 63(6), 2899-2939. doi. 10.1111/j.1540-6261.2008.01416.x

Chan, K.C., & Chen, N.F. (1991). Structural and return characteristics of small and large firms. The Journal of Finance, 46(4), 1467-1484. doi. 10.1111/j.1540-6261.1991.tb04626.x

Chan, K.C., Chen, N.F., & Hsieh, D.A. (1985). An exploratory investigation of the firm size effect. Journal of Financial Economics, 14(3), 451-471. doi. 10.1016/0304-405X(85)90008-X

Chava, S., & Purnanandam, A. (2010). Is default risk negatively related to stock returns? Review of Financial Studies, 23(6), 2523-2559. doi. 10.1093/rfs/hhp107

Chen, H.J., Huang, S.Y., & Lin, C.S. (2009). Alternative diagnosis of corporate bankruptcy: A neuro fuzzy approach. Expert Systems with Applications, 36(4), 7710-7720. doi. 10.1016/j.eswa.2008.09.023

Chen, J., & Hill, P. (2013). The impact of diverse measures of default risk on UK stock returns. Journal of Banking & Finance, 37(12), 5118-5131. doi. 10.1016/j.jbankfin.2013.06.013

Chen, N.F., & Zhang, F. (1998). Risk and return of value stocks. The Journal of Business, 71(4), 501-535. doi. 10.1086/209755

Chen, N.F., Roll, R., & Ross, S.A. (1986). Economic forces and the stock market. Journal of Business, 59(3), 383-403. doi. 10.1086/296344

Cheng, J.H., Yeh, C.H., & Chiu, Y.W. (2007, April). Improving business failure predication using rough sets with non-financial variables. In International Conference on Adaptive and Natural Computing Algorithms (pp. 614-621). Springer Berlin Heidelberg.

Cybinski, P. (2001). Description, explanation, prediction-the evolution of bankruptcy studies. Managerial Finance, 27(4), 29-44. doi. 10.1108/03074350110767123

Davydenko, S.A. (2012). When do firms default? A study of the default boundary. In A Study of the Default Boundary (November 2012). EFA Moscow Meetings Paper. [Retrieved from].

Denis, D.J., & Denis, D.K. (1995). Causes of financial distress following leveraged recapitalizations. Journal of Financial Economics, 37(2), 129-157. doi. 10.1016/0304-405X(94)00792-Y

Dichev, I.D. (1998). Is the risk of bankruptcy a systematic risk? The Journal of Finance, 53(3), 1131-1147. doi. 10.1111/0022-1082.00046

Dugan, M.T., & Forsyth, T.B. (1995). The relationship between bankruptcy model predictions and stock market perceptions of bankruptcy. Financial Review, 30(3), 507-527. doi. 10.1111/j.1540-6288.1995.tb00843.x

Edwin, J.E. (1999). Expected return, realized return and asset pricing tests. Journal of Finance, 54(4), 1199-1220. doi. 10.1111/0022-1082.00144

Fama, E.F., & French, K.R. (1992). The cross‐section of expected stock returns. The Journal of Finance, 47(2), 427-465. doi. 10.1111/j.1540-6261.1992.tb04398.x

Fama, E.F., & French, K.R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3-56. doi. 10.1016/0304-405X(93)90023-5

Fama, E.F., & French, K.R. (1995). Size and book‐to‐market factors in earnings and returns. The Journal of Finance, 50(1), 131-155. doi. 10.2307/2329241

Fama, E.F., & French, K.R. (1996). Multifactor explanations of asset pricing anomalies. The Journal of Finance, 51(1), 55-84. doi. 10.1111/j.1540-6261.1996.tb05202.x

Farooq, U., & Nazir, M. S. (2012). An analysis of operating and financial distress in Pakistani firms. Elixir Finance, 44(2012), 7133-7137.

Gao, P., Parsons, C.A., & Shen, J. (2015). The global relation between financial distress and equity returns, Working paper. [Retrieved from].

Garlappi, L., & Yan, H. (2011). Financial distress and the cross‐section of equity returns. The Journal of Finance, 66(3), 789-822. doi. 10.1111/j.1540-6261.2011.01652.x

Garlappi, L., Shu, T., & Yan, H. (2008). Default risk, shareholder advantage, and stock returns. Review of Financial Studies, 21(6), 2743-2778. doi. 10.1093/rfs/hhl044

George, T.J., & Hwang, C.Y. (2010). A resolution of the distress risk and leverage puzzles in the cross section of stock returns. Journal of Financial Economics, 96(1), 56-79. doi. 10.1016/j.jfineco.2009.11.003

Gordon, M.J. (1971). Towards a theory of financial distress. The Journal of Finance, 26(2), 347-356. doi. 10.1111/j.1540-6261.1971.tb00902.x

Griffin, J.M., & Lemmon, M.L. (2002). Book–to–market equity, distress risk, and stock returns. The Journal of Finance, 57(5), 2317-2336. doi. 10.1111/1540-6261.00497

Jaikengkit, A.O. (2004). Corporate Governance and Financial Distress: An Empirical Analysis. The Case of Thai Financial Institutions (Doctoral dissertation, Case Western Reserve University).

Jensen, M.C. (1997). Eclipse of the public corporation. Harvard Business Review (Sept.-Oct. 1989), revised.

Katz, S., Lilien, S., & Nelson, B. (1985). Stock market behavior around bankruptcy model distress and recovery predictions. Financial Analysts Journal, 41(1), 70-74. doi. 10.2469/faj.v41.n1.70

Lakonishok, J., Shleifer, A., & Vishny, R.W. (1994). Contrarian investment, extrapolation, and risk. The journal of finance, 49(5), 1541-1578. doi. 10.1111/j.1540-6261.1994.tb04772.x

Lang, L.H., &Stulz, R. (1992). Contagion and competitive intra-industry effects of bankruptcy announcements: An empirical analysis. Journal of Financial Economics, 32(1), 45-60. doi. 10.1016/0304-405X(92)90024-R

Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. The Review of Economics and Statistics, 47(1), 13-37. doi. 10.2307/1924119

Malik, U.S., Aftab, M., & Noreen, U. (2013). Distress Risk and Stock Returns in An Emerging Market. Research Journal of Finance and Accounting, 4(17), 81-85.

Merton, R.C. (1974). On the pricing of corporate debt: The risk structure of interest rates. The Journal of Finance, 29(2), 449-470. doi. 10.1111/j.1540-6261.1974.tb03058.x

Mselmi, N., Hamza, T., & Lahiani, A. (n.d.). Corporate financial distress and stock return: Empirical evidence from the French stock market. [Retrieved from].

Ohlson, J.A. (1980). Financial ratios and the probabilistic prediction of bankruptcy. Journal of accounting research, 18(1), 109-131. doi. 10.2307/2490395

Opler, T.C., & Titman, S. (1994). Financial distress and corporate performance. The Journal of Finance, 49(3), 1015-1040. doi. 10.2307/2329214

Pindado, J., & Rodrigues, L. (2005). Determinants of financial distress costs. Financial Markets and Portfolio Management, 19(4), 343-359. doi. 10.1007/s11408-005-6456-4

Purnanandam, A. (2008). Financial distress and corporate risk management: Theory and evidence. Journal of Financial Economics, 87(3), 706-739. doi. 10.1016/j.jfineco.2007.04.003

Rosenberg, B., Reid, K., & Lanstein, R. (1985). Persuasive evidence of market inefficiency. The Journal of Portfolio Management, 11(3), 9-16. doi. 10.3905/jpm.1985.409007

Sharpe, W.F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425-442. doi. 10.1111/j.1540-6261.1964.tb02865.x

Shumway, T. (1996). Size, overreaction, and book-to-market effects as default premia, Working Paper, University of Michigan. [Retrieved from].

Shumway, T.G. (1996). The premium for default risk in stock returns (Doctoral dissertation, University of Chicago Graduate School of Business).

Taffler, R.J. (1999). Rational asset pricing and bankruptcy risk: a z-score perspective. In Helsinki European Finance Association’s 26th Annual Meeting.

Turetsky, H.F., & McEwen, R.A. (2001). An empirical investigation of firm longevity: a model of the ex-ante predictors of financial distress. Review of Quantitative Finance and Accounting, 16(4), 323-343. doi. 10.1023/A:1011291425075

Vassalou, M., & Xing, Y. (2004). Default risk in equity returns. The Journal of Finance, 59(2), 831-868. doi. 10.1111/j.1540-6261.2004.00650.x

Wallace, T.D., & Hussain, A. (1969). The use of error components models in combining cross section with time series data. Econometrica, 37(1), 55-72. doi. 10.2307/1909205

Wooldridge, J. M. (2010). Econometric Analysis of Cross Section and Panel Data. MIT press.

Wruck, K.H. (1990). Financial distress, reorganization, and organizational efficiency. Journal of Financial Economics, 27(2), 419-444. doi. 10.1016/0304-405X(90)90063-6

Zavgren, C.V., Dugan, M.T., & Reeve, J.M. (1988). The association between probabilities of bankruptcy and market responses—a test of market anticipation. Journal of Business Finance & Accounting, 15(1), 27-45. doi. 10.1111/j.1468-5957.1988.tb00118.x




DOI: http://dx.doi.org/10.1453/jeb.v5i2.1623

Refbacks

  • There are currently no refbacks.


.......................................................................................................................................................................................................................................................................................................................................

Journal of Economics Bibliography - J. Econ. Bib.  - JEB - www.kspjournals.org

ISSN: 2149-2387.

Editor: [email protected]  Secretarial: [email protected]  Istanbul - Turkey.

Copyright © KSP Library