DISTRESS RISK, INSTITUTIONAL TRADING AND THE CROSS SECTION OF STOCK RETURNS

This paper provides an alternative explanation for the distress risk puzzle documented in previous studies (e.g. Griffin and Lemmon 2002, Campbell et al. 2008) that firms with high default probability earn low returns by investigating the impact of institutional holding and trading on stock returns. We hypothesize that institutional investors are reluctant to hold stocks of firms with high distress risk and that a decline in their holding or trading lowers distress stocks' prices and causes the returns of these stocks to decrease. Our empirical evidences support these hypotheses. We further find that although both institutional holding and trading can capture the distress risk puzzle, institutional trading seems to be superior. In addition, we document that the holding or trading by either independent or short term institutional investors plays a significant role in explaining this puzzle while the holding or trading by dependent or long term institutional investors does not. Finally, our results suggest an important role of institutional investors in equity markets.