Misvaluation and Return Anomalies in Distress Stocks

Return anomalies are most pronounced among distressed stocks. We attribute this finding to the role of misvaluation and investors' inability to value distressed stocks correctly. We treat distressed stocks as options and construct a valuation model that explicitly takes into account the value of the option to default (or abandon the rm). We show that anomalies exist only among the subset of distressed stocks classi fied as misvalued by our model. There is little evidence that more misvalued stocks are harder to arbitrage than less misvalued stocks.