What drives the distress risk–return puzzle? A perspective on limits of arbitrage
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Publication Date
2022-03-15Journal Title
International Journal of Finance and Economics
ISSN
1076-9307
Publisher
Wiley
Type
Article
This Version
AM
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Show full item recordCitation
Sha, Y., Bu, Z., & Wang, Z. (2022). What drives the distress risk–return puzzle? A perspective on limits of arbitrage. International Journal of Finance and Economics https://doi.org/10.1002/ijfe.2608
Abstract
Empirical research has documented a negative relationship between distress risk and stock returns. This negative risk-return trade-off, known as the distress puzzle, poses a challenge to asset pricing models. In this study, we provide a new explanation of the distress puzzle by considering the effect of arbitrage asymmetry. We find that the negative distress risk-return relation is stronger in stocks that have higher limits of arbitrage. The investors are virtually unable to short sell mispriced high distress risk stocks due to the low supply of lendable stocks from institutions and that arbitrage is costly. In addition, we show that the limits of arbitrage effect is distinct from liquidity effect in explaining the distress puzzle.
Embargo Lift Date
2024-03-15
Identifiers
External DOI: https://doi.org/10.1002/ijfe.2608
This record's URL: https://www.repository.cam.ac.uk/handle/1810/334743
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