This study explores the distress risk anomaly—the tendency for stocks with high credit risk to perform poorly—among 38 countries over two decades. We find a strongly negative relationship between default probabilities and equity returns concentrated among low-capitalization stocks in developed countries in North America and Europe. Although risk-based explanations provide a poor account of these patterns, several pieces of evidence point to a behavioral interpretation, suggesting that stocks of firms in financial distress are temporarily overpriced.

Recent studies conflict sharply about the stock returns of financially distressed firms. Both the basic empirical pattern and interpretation have been challenged. This study addresses both critiques. Analyzing about 4.3 million firm-months observations in 38 countries from January 1992 to June 2013, we find a strong, negative link between credit risk and subsequent equity returns, concentrated among low-capitalization stocks in developed countries in North America and Europe. Comparisons between countries reveal: 1) no relation to creditor rights, inconsistent with theories based on shareholders expropriation, but 2) a strong, positive relation to individualism, a proxy for investor overconfidence. Additional analysis using within-country proxies for investor overconfidence further supports an overconfidence-based explanation.

ABSTRACT Financial misconduct (FM) rates differ widely between major U.S. cities, up to a factor of 3. Although spatial differences in enforcement and firm characteristics do not account for these patterns, city‐level norms appear to be very important. For example, FM rates are strongly related to other unethical behavior, involving politicians, doctors, and (potentially unfaithful) spouses, in the city.