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The apparent decline in systematic or beta risk with the onset of financial distress is a result that has puzzled a number of researchers. This study validates this result with different data and a new criterion for identifying financial distress. An analytical model presented in this study suggests that the leverage-increasing impact of financial distresson systematic risk may be more than outweighed by possible declines in systematic earnings risk associated with such distress, and it provides empirical evidence that is generally consistent with this proposition. The diminution of systematic risk is unaffected by several variants in beta risk estimation, including the index-weighing scheme and allowance for the turn-of-year effect. While numerically large, the average systematic risk decline is not highly significant in a statistical sense due to considerable variation in the behavior of betas from company to company.
McEnally et al. (Tue,) studied this question.