What drives the distress risk-return puzzle? A perspective on limits of arbitrage

Yezhou Sha, Ziwen Bu, Zilong Wang*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review


Empirical research has documented a negative relationship between distress risk and stock returns. This negative risk–return trade-off, known as the distress puzzle, poses a challenge to asset pricing models. In this study, we provide a new explanation of the distress puzzle by considering the effect of arbitrage asymmetry. We find that the negative distress risk–return relation is stronger in stocks that have higher limits of arbitrage. The investors are virtually unable to short sell mispriced high distress risk stocks due to the low supply of lendable stocks from institutions and that arbitrage is costly. In addition, we show that the limits of arbitrage effect is distinct from liquidity effect in explaining the distress puzzle.
Original languageEnglish
Pages (from-to)3574-3592
Number of pages19
JournalInternational Journal of Finance and Economics
Issue number4
Early online date15 Mar 2022
Publication statusPublished - 4 Oct 2023

Bibliographical note

Funding Information:
China Scholarship Council Funding information

Publisher Copyright:
© 2022 John Wiley & Sons Ltd.


  • anomalies
  • distress risk
  • limits of arbitrage
  • market efficiency


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