Rotterdam Brown Bag Seminars in Finance

Claus Schmitt (RSM)
Wednesday, 19 April 2017


We analyze the impact of financial distress on expected stock returns accounting for the severity of default. Whereas shareholders’ average losses amount to 32% of equity value from the day before to the day after a bankruptcy filing, outcomes differ substantially among firms. We specify and estimate a model that predicts these losses for individual firms. When sorting stocks into portfolios according to their predicted bankruptcy losses, we find that a long-short strategy buying stocks with high predicted bankruptcy losses and selling stocks with low predicted bankruptcy losses earns a monthly premium of 0.5%. We also sort stocks independently into quintiles according to predicted bankruptcy loss and failure probability. We find that the distress-risk puzzle is not present among stocks in the highest quintile of predicted bankruptcy loss. On the contrary, the long-short returns of stocks sorted by predicted bankruptcy losses are strongest for stocks in the highest quintile of failure probability.