The relation between the
probability of financial distress and stock return - is there relation between
the two? According to classical financial theory, if financial distress is
systematic risk, we expect to find a posituve relationship between stock return
and probability of financial distress. It means that firms with higher
probability of financial distress earn higher returns then firms with lower
probability. In the current research I find negative relationship between
probability of financial distress (expressed in Altman and Ohlson indexes) and
stock return. At the same time I show the application of financial distress
prediction models to stock returns predictability. The research is based on a
sample of stock prices at the last decade of 20th century. The
research method is based on Fama and MacBeth (1973) monthly regressions method
and Fama and French (1992, 1993) portfolio analysis. Despite the finding of a
counter intuitive negative relationship, I find a positive relation between
stock returns and probability of financial distress found in the part of “firms
that need attention” (Altman, 1968). Number of the “firms that need attention”
was meager in the research sample and this demonstrates that the positive
relationship exists in the short area of bankruptcy risk only. In addition to
the main findings, I show again the declining influence of firm size to stock
returns. On the other hand, the book-to-market effect on stock returns was
clear and significant. At the end, I check the improved Ohlson model
predictability that included regression running of improved Ohlson index and
book-to-market value against stock returns. The regression supplied the
explanation of 58 percents of the control sample variance.
