Investor Overreaction to Technical Insolvency
and Bankruptcy Risks in the 2008
Stock Market Crash

Abstract

Thaler and De Bondt [1985] demonstrate that investors may overreact to economic events. Studying investor overreaction to economic events has been a popular research topic in finance. However, investor overreaction to certain firm characteristics during economic events has not received sufficient attention. In this article, we study investor overreaction to firm technical insolvency and bankruptcy risks in the 2008 stock market crash. We demonstrate that firms with high technical insolvency and bankruptcy risks lost more value relative to other firms in the 2008 crash. However, these firms gained more value relative to other firms in the post-crash market reversal, implying that investors overreacted to technical insolvency and bankruptcy risks in the 2008 crash. Although firms with a high bankruptcy risk also lost more value in the 1987 stock market crash, these firms did not gain more value relative to other firms in the post-crash market reversal, implying that there was no investor overreaction to bankruptcy risk in the 1987 crash.

TOPICS: Financial crises and financial market history, analysis of individual factors/risk premia, portfolio theory