Journal of EconomicsBibliography www.kspjournals.org Volume 5 June 2018 Issue 2 The impact of financial distress risk on equity returns: A case study of non-financial firms of Pakistan Stock Exchange By Sahar IDREES a† & Abdul QAYYUMa b Abstract. This study aims to investigate the relationship of financial distress risk and the equity returns of financially distressed firms listed on Pakistan Stock Exchange (PSX). Several studies have suggested that firm distress risk factor could be behind the book-to- market and size effects. Fama and French three factor Model (1993) is used for examining the relationship among equity returns, financial distress risk, size and book-to-market equity ratio. Non-financial firms listed on PSX are taken from the time-period of 2010- 2016. Ohlson’s O-Score (1980) “bankruptcy prediction model” is used for the prediction of financial distress risk and forecasted the distress risk firms listed on PSX. The panel (unbalanced) data is used to get the empirical findings and showed that the financial distress risk and book-to-market equity effect are statistically insignificant to explain the stock returns of distress firms due to the inefficiency of market. However, size effect is significant in explaining the stock returns of distress firms. The study also reveals that it is important to predict financial distress risk with a better predictor in order to avoid the uncertainties in PSX. Keywords. Financial distress risk, Equity returns, Book-to-market effect, Size, Pakistan Stock Exchange. JEL. G30, G32. 1. Introduction inancial distress risk generally refers to possibility that a levered firm won’t have the capacity to pay principal amount or contractual interest on its debt commitments (Garlappi et al., 2008). Financial distress is observed as costly for the firms because it generates a tendency for the organizations to perform those activities which are averse to the non-financial stakeholders (i.e. suppliers, employees and customers), and debt-holders, increasing the stakeholders’ relationships cost and damaging access to loan (Jensen, 1989). Such financial charges are having the priority over distribution of the income to the company’s shareholders and therefore, uncertainty of stock returns to equity shareholders rises. This uncertainty of the stock returns to shareholders give rise to the high risk premium required of stocks. It also effects the market value of firm negatively (Pindado & Rodrigues, 2005). Ferri et al., (1998) stated that problems of the firm’s financial structure have been a significant factor in East Asian Corporations in the contribution of Asian Financial Crisis, which lead to bankruptcy of many corporations. aa† Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. . + 051-9248040 . saharidrees_15@pide.edu.pk b Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. . + 0321-5112374 . qayyumdr@gmail.com F