Liquidity, Limit-to-Arbitrage, and Premium for Financial Distress

Stocks under …nancial distress, measured by the Default Likelihood Indicator (DLI, Vassalou and Xing 2004) earn large returns during the …rst month after portfolio formation, a phenomenon di¢ cult to explain using standard asset pricing models. We argue that when stocks experience …nancial distress, they become less liquid at the same time. This lack of liquidity leads to temporary price concession. The subsequent price recovery explains the …rst-month high returns on …nancially distressed stocks. These large returns can therefore be interpreted as compensation for liquidity provision. The lack of liquidity for …nancially distressed stocks is closely related to capital immobility and limit-to-arbitrage. Correspondence: Finance Department, Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston IL 60208. E-mail: [email protected] and [email protected]. We are grateful to Hank Bessembinder, Kent Daniel, Steve Hillegeist, Bob Korajczyk, Mitchell Peterson, Christopher Polk, Todd Pulvino, Ernst Schaumburg, and seminar participants at Northwestern University their for helpful comments. We thank Ravi Jagannathan for guidance. We also thank Ken French, LubošPástor, and Maria Vassalou for making their data available to us. We are responsible for all remaining errors. In a recent paper, Vassalou and Xing (2004) show that stocks that are more likely to default earn a higher return than otherwise similar stocks during the …rst month after portfolio formation. Since defaults are more likely to occur during economic downturns, default risk is likely to contain a component that is nondiversi…able, and requiring a risk premium for bearing it. However, the magnitude of the risk premium appears rather large –the stocks in the highest default risk decile constructed by Vassalou and Xing(2004) earn about 80 basis points per month more than otherwise similar stocks, with an associated Sharpe ratio of above 0:6. A natural question is why those stocks earn such a high risk premium and Sharpe ratio. As Hansen and Jagannathan (1991), and MacKinlay (1995) point out, such high Sharpe ratios can not be easily explained within the “perfect and complete markets”paradigm. In this paper we show that stocks that experience a sharp rise in exposure to default risk, as documented in Vassalou and Xing (2004), become illiquid at the same time, resulting in a temporary depression in price from its “fundamental”value. The later recovery in price contributes to the higher return on such stocks, and indicates a reward for providing liquidity during such times. We attribute the delayed price recovery for …nancially distressed stocks to capital immobility (c.f. Berndt, Douglas, Du¢ e, Ferguson and Schranzk (2005)) and Limit-to-arbitrage (c.f. Shleifer and Vishny (1997), and Gabaix, Krishnamurthy and Vigneron (2005)). It takes time for an investor to identify a good investment opportunity and move capital to it. Moreover, large idiosyncratic risks and high trading costs also keep a risk-averse arbitrageur with limited capital at bay. Both factors result in a short-term lack of liquidity, leading to higher returns to those who provide the liquidity, and such higher return can not be easily justi…ed as compensation to risk as is commonly understood. We attempt to provide evidence on the liquidity provisions, its market microstructure impact, and to a less extent, its asset pricing implication, in the distressed security market. Our research therefore compliments the growing literature documenting the reward for liquidity provision in equity and bond markets. Some recent examples include: Krishnamurthy (2002), Mitchell, Pulvino and Sta¤ord (2004), Coval and Sta¤ord (2005), and Da and Schaumburg (2005). The focus of this paper is on the liquidity event associated with a stock when it becomes …nancially distressed: when the liquidity level associated with a …nancially distressed stock is low, an investor wishing to sell a signi…cant quantity of it will su¤er from a price concession, and