Essays on market efficiency and distress risk

This dissertation focuses on distress risk and the market efficiency of the stock market and the credit default swaps (CDS) market.;In my first essay, Financial Distress, Idiosyncratic Volatility, and Stock Returns in Up versus Down Markets, we find that firms with higher distress risk tend to have higher idiosyncratic volatility ( IVOL), and we show that the empirical relation between either firm attribute (distress risk orIVOL) and subsequent stock returns is highly sensitive to the direction and magnitude of market returns. Our evidence suggests that both the credit risk puzzle and theIVOL puzzle are mainly due to the poor performance of high credit risk or high IVOL stocks when the market is down (i.e. during periods of financial distress).;The second essay of my dissertation, When Do Stocks Lag Credit Derivatives? The Role of Information Uncertainty and Short-sale Constraints shows that the CDS market anticipates equity market movements for firms whose stocks exhibit strong information uncertainty, as well as those with more binding short-sale constraints. I also find support for an asymmetric effect - increases in CDS spreads are associated with large subsequent declines in stock prices prior to adverse credit events, particularly for firms with higher degree of information uncertainty or more binding short-sale constraints.;In the third essay, The Effect of Credit Default Swaps on the Pricing of Audit Services, we study whether companies for which lenders can insure against default through credit default swaps (CDS) incur higher or lower audit fees. If borrowers adopt CDS, borrowing firms can benefit through greater supply of bank credit and improvements in credit terms, which reduces client business risk. Yet CDS create empty creditors who lack incentives to monitor borrowing firms or save them from bankruptcy, which increases audit and client business risk. We show that CDS companies incur larger audit fees compared to non-CDS companies. Prior to CDS adoptions, average audit fees for adopting companies are lower than fees for characteristics-matched non-adopters, yet from the year of CDS adoption onward, adopters have higher audit fees. Our findings suggest that auditors perceive CDS to increase client business and audit risks.