Financial distress and stock comovement : Evidence, explanation, and implication

Contrary to the financial distress premium notion, the stocks of financially distressed firms comove least. Financially distressed firms are characterized by high valuation uncertainty and information and arbitrage frictions. Therefore, their stocks are prone to mispricing and their stock price movements are idiosyncratic, which drives the low comovement between their stocks. Moreover, financially distressed firms are much more likely to yield both positive and negative extreme returns. Acknowledging all this helps unravel asset pricing puzzles about financial distress including the high profitability of anomaly-based trading strategies for financially distressed firms and the negative relation between financial distress and realized return