Investor Recognition of Bankrputcy Costs : Evidence from the 1987 Market Crash

In this paper, we examine the behavior of stock prices of individual firms with different bond ratings surrounding the October market crash of 1987 and therefrom make inferences about the significance of bankruptcy costs borne by stockholders. The key findings are as follows: Immediately following the crash, stock prices of firms with different bond ratings display dramatically divergent behavior. Specifically, stocks with speculative bond ratings exhibit significantly negative cumulative abnormal returns (CAR) in the wake of crash; the more speculative a firm's bond is, the more negative is the CAR of the firm's stock. Regression analysis confirms that there indeed exists a significantly negative relationship between the post-crash CARs and individual firms' bankruptcy risk proxied by their bond ratings, a variable that measures the likelihood of financial distress ex ante. These results indicate that the bankruptcy costs borne by stockholders are significant and investors recognize it as such, especially during a period of market turbulence