Corporate Risk-Taking and Stock Returns to Distressed Firms

Motivated by the ‘unexpected negative shock’ explanation on the distress risk puzzle (Chava and Purnanandam, 2010), we propose and test a hypothesis that the anomalous phenomenon is mainly attributable to unexpectedly low returns of distressed firms with a high tendency toward corporate risk-taking. Finance theory suggests that distressed firms have risk-shifting incentives due to the agency problem between shareholders and debtholders, which may lead to more frequent unexpected negative shocks to distressed firms. In this paper, we develop a novel measure of a firm’s propensity toward risk-taking, the Pearson correlation coefficient between the expected market aggregate volatility and the firm’s investment intensity. We find that the negative abnormal return of the long/short hedge portfolio that buys stocks of distressed firms and sells stocks of healthy firms (i.e., the “puzzle”) is more prevalent among firms with more risk-taking investment activities. We add to a strand of literature on the determinant of the distress risk puzzle.