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PURPOSE OF THE STUDY

This study examines the asset pricing impact of idiosyncratic risk and financial distress on cross sectional stock returns. Specifically, I investigate whether financial distress can explain the correlation between conditional idiosyncratic volatility and return and vice versa. Idiosyncratic volatility is defined as standard deviation of the firm return that cannot be explained by the Fama French (1993) three factor model. This study is the first to investigate the interaction between idiosyncratic risk and financial distress by employing generalized autoregressive conditional heteroskedasticity GARCH models to measure conditional idiosyncratic volatility and in addition to unpublished working paper by Song (2008), first to employ Campbell et al. (2008) measure of financial distress using both market and accounting variables.

DATA

This study targets all common shares that are traded in NYSE, AMEX and NASDAQ during the period between 1971 and 2008. The market data is obtained from Center for Research in Security Prices (CRSP) and the accounting data from COMPUSTAT database. The sample consists of 18 795 unique stocks.

RESULTS

The results indicate a positive relation between idiosyncratic risk and expected stock returns, which like many other anomalies is mainly driven by smaller stocks. The relation between distress risk and expected stock returns is found to be negative.

I find that both idiosyncratic volatility and financial distress maintain their explanatory power when both variables are included in the cross-sectional regression. In the multivariate independent sort, the positive relation between idiosyncratic volatility and stock returns is shown to be conditional on low distress risk. A positive relation is found in low distress risk quintiles but in high distress risk quintiles the idiosyncratic volatility spread is insignificant. The negative effect of distress risk persists after controlling for idiosyncratic volatility across idiosyncratic volatility quintiles in multivariate independent sort. The findings indicate that financials distress risk has a more fundamental asset pricing impact than idiosyncratic volatility.