Firm's distress risk and profitability in the cross-sectional stock returns

This thesis investigates the cross-sectional stock returns in connection with two corporate characteristics: distress risk and profitability. These are two fundamental factors that determine expected stock returns. The research seeks to explain stock return premiums which are driven by these factors. The first chapter, Limit of Arbitrage and the Distress Puzzle, investigates what lies behind the long-term, persistent distress risk premiums. This chapter finds the distress risk premium is clustered in firms with high bid-ask spread, dollar volume, idiosyncratic volatility and short-selling constraints such as low institutional ownership and low short interest ratio. Upon dissecting the distress risk indicator as measured by failure probability based on Campbell et al. (2008, 2011), it appears that high distress risk firms with extremely small market capitalisation primarily contribute to this equity premium. After the double-sorting method is applied to firms based on these factors and distress risk, the average value-weighted distress premium increases from 0.62% per month for market-wide level to 1.35%- 2.17% per month for the top 20% limit-of-arbitrage effect firms. Furthermore, the interaction of distress risk with stock’s bid-ask spread, illiquidity ratio, short-selling constraints and idiosyncratic volatility further distinguishes the predicting power of distress risk, in which the difference of predicting power of firm’s failure probability can be as large as five standard errors from zero. The second chapter, Profitability, Insider Ownership and Cross-sectional Stock Returns, examines how profitability anomalies are related to firm’s insider ownership regarding determining cross-sectional stock returns in the U.S. market. Gompers et al (2003) find low agency cost firms tend to outperform others and attribute the effect to improved profitability and value-creating decision from corporate governance channel. Portfolio-level analyses confirm that firms with lower agency costs, as proxied by various forms of insider ownership, are positively associated with stock returns. Besides firm’s insider ownership is positively related to the profitability premium in the U.S. stock market for the period 1980-2015. However, in cross-sectional analyses the interactive relationship between firm’s profitability and institutional ownership is sensitive to additional risk factors and sample volume. The third chapter, Profitability Premium, Firm’s Distress Risk and Stock Returns documents a robust relationship between the two pricing factors, linking the two empirical findings together. This chapter finds a significant interaction effect of firm’s profitability, as well as distress risk, in co-determining stock returns cross-sectionally. In line with the findings of Altman (1968), as well as Fama and French (2006), that firm’s past information of profitability predicts future distress event and vice versa. This chapter finds that the profitability premium is partially clustered with firms having high distress risk, and the predicting power of firm’s profitability ratio is different over three standard errors from zero between low and high distress risk firms. Theses findings shed light on exploring the two fundamental pricing factors under a unified framework of asset pricing.