Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2006/8: Financial Distress and Idiosyncratic Volatility: An Empirical Investigation

Jing Chen () and Lorán Chollete ()
Additional contact information
Jing Chen: Columbia University, Graduate School of Business, Postal: Columbia University, Graduate School of Business, 311 Uris Hall, New York, N.Y. 10027, USA
Lorán Chollete: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: We address the twin puzzles of anomalously low returns for high idiosyncratic volatility and high distress risk stocks, documented by Ang, Hodrick, Xing and Zhang (2006) and Campbell, Hilscher and Szilagyi (2005), respectively. We accomplish two objectives in this study. First, we investigate the link between idiosyncratic volatility and distress risk and find that the idiosyncratic volatility effect exists only conditionally on high distress risk. Second, using a corrected single-beta CAPM model, we provide a rational explanation for the twin puzzles. Joint statistical tests cannot reject the null hypothesis of zero abnormal returns across the idiosyncratic volatility and distress risk portfolios, for the corrected model.

Keywords: Distress risk; idiosyncratic volatility; single-beta CAPM

JEL-codes: C12

27 pages, August 4, 2006

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