Understanding the Distress Puzzle : Surprises in the Pre-Delisting Period

This study shows that the negative cross-sectional relation between distress risk and stock returns documented in previous studies is driven by the persistently low ex post realized returns in the pre-delisting period – the two-year period prior to a firm's delisting due to financial distress. After controlling for the firm-months in the pre-delisting period, which constitutes only 0.3% of total market capitalization or 3%–5% of NYSE/AMEX/Nasdaq firm-months, distress risk is positively related to ex post realized returns. Ex post realized returns and firms' earnings per share meet investors' ex ante expectations for bearing distress risk, but they disappoint investors in the pre-delisting period, which prompt investors to correct their valuation errors around earnings announcements and the delisting month