Does Financial Distress Anomaly Exist In Chinese Listed Firms?

In 1998,the Shanghai Stock Exchange(SSE)and the Shenzhen Stock Exchange(SZSE)announced that they would deal with stocks with financial problems and other abnormalities,the Special Treatment(ST)System.From this,ST stocks appear in the Chinese A-share market.Compared with the US stock market,the number of A shares in China is relatively small.In addition,the market is facing a very serious IPO regulation.As a result,Chinese listed companies rarely go bankrupt.In this case,the Special Treatment system can well test whether the company is entering financial distress.Domestic scholars have studied the factors which affecting financial distress based on theoretical and empirical analysis.However,the impact of financial distress on stocks,especially the impact of financial distress risk on stock returns(or the relation between financial distress risk and stock return),has rarely been deeply studied and discussed in China.As a risk that cannot be diversified away,financial distress risk must have a positive relation with stock return,this means the higher the financial distress risk of the stock,the higher the stock must provide(the financial distress premium),so that the investor will choose to hold.This has been used to explain some anomalies in stock cross-sectional returns,such as size effect and value effect,which are all thought to be driven by financial distress risk.Specifically,Chan and Chen(1991)argue that stock with a small market value are distressed stock,therefore small market value stocks have high returns(size effect)just as they describe marginal and distressed firms as follows:"They have lost market value because of poor performance,they are inefficient producers,and they are likely to have high financial leverage and cash ow problems.They are marginal in the sense that their prices tend to be more sensitive to changes in the economy,and they are less likely to survive adverse economic conditions." Same to their argument,Fama and French(1992)argue book to market ratio(B/M)is an important factor to impact stock cross-section returns,and stocks with high book to market ratio have high financial distress risk,therefore they offer investors high returns(value effect).However,research on the US market proves that the US market only exist negative relation between financial distress risk and stock return,which has become the unexplained financial distress anomaly(Campbell et al.,2008).This paper contains Chinese A-share market data and financial data from 2002 to 2016,Constructing explanatory variables in accordance with the methods of Shumway(2001)and Campbell et al.(2008,2011)to construct a financial distress prediction model to calculate the possibility of the company in financial distress.Firstly,this paper test performance of Shumway model and CHS(Campbell,Hilscher and Szilagyi)model in Chinese A-share market,then construct a dynamic logit model to measure the probability of distress risk,basing on a dataset contains Chinese A-share market daily data from 2009 to 2017 to explore the relationship between financial distress risk and stock returns.Further,this paper examines the impact of company characteristics and arbitrage costs,such as turnover,on financial distress anomaly.Due to arbitrage cost constraints,it is difficult for investors to carry out arbitrage trading strategy,and some market anomalies are thus existing.In addition,the paper demonstrates the use of Guo and Jiang(2015)to test whether the financial distress anomaly is caused by Idiosyncratic variance(IV).Finally,the paper examines the impact of investor sentiment and asset restructuring on the financial distress anomaly,investor sentiment can lead to irrational mispricing that arbitrageurs cannot eliminate.Specifically,when investor sentiment is high,the number of irrational investors increases,lead to the number of irrational behaviors increases.Thus,it become quite difficult for arbitrageurs to eliminate mispricing causing by arbitrage behaviors.Therefore,the financial distress anomaly is more likely to result from mispricing during the period of high investor sentiment.The reorganization of assets by enterprises will give the company a high potential value,so the relevant stocks will have lower returns,which lead to the financial distress anomaly.The main conclusion of this paper is that in Chinese A-share market,the financial distress risk is significantly negatively correlated with stock returns in stocks with high market value,showing financial distress negative premium(financial distress vision).However,financial distress risk and stock returns in small stocks Significantly positive correlation,showing the financial distress premium.This suggests that value effect and size effect are not driven by financial distress risk.After that,this paper finds that the financial distress anomaly is not caused by arbitrage cost constraints or Idiosyncratic variance.Finally,this paper finds that the financial distress anomaly is a mispricing issue caused by investor sentiment.