Financial Distress premium in Pakistan’s Banking Stocks

Abstract

This paper examines the role of financial distress premium in explaining the stock returns of banking sector in Pakistan using the sample of twenty listed banks for the period of 2008 to 2018. The study has used two methodologies. Firstly, multifactor model approach of Fama and French (1992) is used to test the financial distress premium (additional risk factor) where portfolio returns are regressed with factor premiums in time series framework. Fama and French (1993) argue that the relationship between the stock return and the selected characteristics occur for that reason these characteristics are proxies for non-diversifiable factor risk. So, the characteristic based model approach of Huang (2009) is used in cross-sectional regression framework where stock returns are regressed with the characteristics. The results indicate that the proposed four factor model is applicable in the banking sector of Pakistan where financial distress premium is priced by the market. The characteristic based model shows insignificant impact of distress proxy of Altman Z score on the banking returns. It suggests that the cross-sectional returns are explained on the covariance structure of returns not the characteristics in the Pakistani banking stocks. The findings of the study suggests that the financial distress is important and consider while forming their portfolios.

Financial Indicators and Corporate Financial Distress Prediction in Context of Pakistan: A Systemic Review.

“…Liquidity issues, characterized by a shortage of short-term assets to cover immediate liabilities, often serve as an initial warning sign. High levels of debt, particularly when accompanied by an inability to service interest payments, increase financial vulnerability (Khan et al, 2020). Poor profitability and declining cash flows can exacerbate financial distress, as they limit a company's ability to generate funds for debt repayment.…”