DISTRESS RISK, FINANCIAL CRISIS AND INVESTMENT STRATEGIES – EVIDENCE FROM THE UNITED KINGDOM

Abstract

The thesis focuses on the impacts of market distress conditions and firms’ default probability on two key investment strategies in the UK. These are investment decisions in value firms versus growth firms (chapter 3), and well-performing firms versus poorly-performing firms (chapter 4). Although distress risk (measured by the market conditions and default probability) is a relevant factor in explaining the general movement of stock returns, this is the first study addressing a direct link between these distress elements and the above two investment choices. The thesis employs a range of distress indicators, including the following: firm-specific proxies such as Fama-French’s (1993) three factors (i.e. the market beta, firm size and book-to-market factors), idiosyncratic volatility, default risk, and market-related factors (e.g. business cycles, market downturn and upturn conditions). More recent data and well-developed proxies are used to make sure the results are valid and robust. First of all, the thesis finds positive abnormal returns from investing in value and momentum companies. Among these investment strategies, momentum stocks generate significant profitability in the short run. However, the value firms’ investments generate positive but insignificant profit. In terms of explanatory ability, distress risk is found to play an important role in explaining value and momentum anomalies. For example, there is evidence that highly volatile stocks tend to suffer greater default risk, and that stocks with a higher default risk generate lower returns. The results in this study also suggest that momentum-oriented investors would benefit from significantly high returns during market upturns, however these strategies would lead to great losses during recessions.