The Association Between Probabilities of Bankruptcy and Market Responses-A Test of Market Anticipation

The association between model-derived probabilities of failure and market reactions is examined for a matched-pair group of 45 failed and 45 nonfailed firms, in the period 1972-1978. The purpose of the analysis is to determine if market expectations are consistent with model estimates of the likelihood of bankruptcy. If market expectations are consistent with model-derived probabilities, via logistic regression, then there should be dramatic market reaction to actual states that are opposite to the model predictions, i. e., Type I and Type II error predictions. The results show that nonfailed firms predicted to fail (Type II errors) exhibited dramatic positive returns in the year after the prediction. Failed firms predicted to survive (Type I errors) are found to have no dramatic market reaction in the year prior to failure. The results show that investors are extremely sensitive to negative news, whether transmitted within or outside published financial reports.