We propose a unified explanation for two seemingly disparate empirical findings: the negative abnormal returns of distressed stocks and of small growth stocks. Based on a real option model with operating leverage, we show that higher idiosyncratic risks of sudden corporate failure simultaneously generate lower expected returns and higher valuation ratios among smaller firms. Consistent with the model’s predictions, we show empirically that small growth firms have higher failure risk, and a failure risk factor explains the returns of small growth firms.

Conference presentations: 2015 World Congress of the Econometric Society, 2014 Northern Finance Association Annual Meetings, 2014 SAFE Asset Pricing Workshop, 2014 International Conference on Asia-Pacific Financial Markets

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