Distressed Risk Puzzle Essay

5248 WordsDec 16, 201221 Pages
The Distress Risk Puzzle in Turbulent Times - Default risk during the financial crises SANNA BATZ* ANDERS NORDSTRÖM** Bachelor Thesis Department of Finance, Stockholm School of Economics Tutor: Jungsuk Han, Assistant Professor June 1, 2011 ABSTRACT Studies on whether risk of default is systematic or not have led to the discovery of the distress risk puzzle. It is a rather new anomaly and its implications are that empirical evidence seems to indicate that higher default risk results in lower returns. The purpose of this thesis is to clarify whether default risk is systematic, using Altman’s Z-score as a proxy for default risk. We also investigate some of the possible explanations of the distress risk puzzle by applying empirical tests on the times surrounding the financial crisis. We first confirm the existence of the puzzle during a longer period; however our findings suggest that this relationship is spurious due to a leverage effect. We then find that both the puzzle and the spuriousness seem to disappear during the financial crisis. We dedicate this disappearance to a shift in the bargaining power from equity holders to debt holders or to the hypothesis that investors became more aware of the default risk during the financial turmoil. Keywords: Distress risk puzzle, bankruptcy risk, systematic risk, asset pricing, Altman Z-score Introduction A. Background The definition of default, according to the Cambridge Advanced Learner’s Dictionary, is “to fail to do something, such as pay a debt, that you legally have to do”. One of the most prominent risks for an individual firm is the risk of not being able to repay its debts and therefore declaring bankruptcy. According to the American Bankruptcy Institute (Annual Business Filings by Year (1980-2009)), bankruptcy filings for American businesses reached its highest level 2009 since 1993. Meaning that the risk of

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