Distress risk and leverage puzzles: Evidence from Taiwan

Abstract

Financial distress has been invoked in the asset pricing literature to explain the anomalous patterns in the cross-section of stock returns. The risk of financial distress can be measured using indexes. George and Hwang (2010) suggest that leverage can explain the distress risk puzzle and that firms with high costs choose low leverage to reduce distress intensities and earn high returns. This study investigates whether this relationship exists in the Taiwan market. When examined separately, distress intensity is found to be negatively related to stock returns, but leverage is found to not be significantly related to stock returns. The results are the same when distress intensity and leverage are examined simultaneously. After assessing the robustness by using O-scores, distress risk puzzle is found to exist in the Taiwan market, but the leverage puzzle is not.