The distress risk puzzle in China: a mispricing explanation

Purpose The negative distress–return relationship has been documented not only in the U.S. but also in China, posing a puzzling challenge for financial economics research. This paper aims to provide a behavioral explanation for the distress puzzle in China. Design/methodology/approach The data sample includes more than 4,700 A-shares listed on the Shenzhen and Shanghai stock exchanges from 2005 to 2025. Distress risk is measured by the distance-to-default of Merton (1974) or the Z″-score of Altman et al. (2017). Stock mispricing is measured based on the decomposition framework proposed by Rhodes-Kropf et al. (2005). To examine the effect of mispricing on the distress risk anomaly, we perform double-sort analyses, asset pricing models and Fama–MacBeth cross-sectional regressions. Findings We document a distress risk anomaly in China, whereby average stock returns systematically increase as distress risk declines, regardless of the risk proxy. In the double-sort analysis, the distress risk premium disappears in the undervalued group, whereas it becomes more robust in the overvalued group. The anomalous distress–return relationship is also insignificant after controlling for mispricing in asset pricing models and Fama–MacBeth regressions. Therefore, stock mispricing provides a compelling explanation for the distress risk puzzle in China. Originality/value The paper is the first to examine the effect of mispricing on the anomalous distress–return relationship in China, the second-largest market with unique characteristics. We also contribute to the asset pricing literature by constructing a mispricing factor for the Chinese stock market. Our findings have several essential implications for both investors and policymakers. Investors seeking abnormal returns from default-risk strategies should focus on undervalued distressed stocks and incorporate mispricing factors into asset pricing models. Chinese policymakers should develop effective policies to strengthen institutional investor participation and reduce market frictions.