What drives the distress risk-return puzzle?: A perspective on limits of arbitrage

Yezhou Sha; Ziwen Bu; Zilong Wang

doi:10.1002/ijfe.2608

What drives the distress risk-return puzzle? A perspective on limits of arbitrage

Yezhou Sha, Ziwen Bu, Zilong Wang^*

^*Corresponding author for this work

Finance

Research output: Contribution to journal › Article › peer-review

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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.

Original language	English
Pages (from-to)	3574-3592
Number of pages	19
Journal	International Journal of Finance and Economics
Volume	28
Issue number	4
Early online date	15 Mar 2022
DOIs	https://doi.org/10.1002/ijfe.2608
Publication status	Published - 4 Oct 2023

Bibliographical note

Funding Information:
China Scholarship Council Funding information

Publisher Copyright:
© 2022 John Wiley & Sons Ltd.

Keywords

anomalies
distress risk
limits of arbitrage
market efficiency

Access to Document

10.1002/ijfe.2608

ShaY2022drives
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Cite this

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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.",

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