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A dynamic logistic model shows that low-litigation-risk firms outperform high-litigation-risk firms, with annual alpha exceeding 8%. Evidence suggests that the excess return comes from investors underreacting to changes in firms’ litigation risk.


Overview

We create a proxy for security litigation risk using a dynamic logistic model and find that low-litigation-risk firms outperform high-litigation-risk firms. The out-of-sample long-short portfolio delivers an annual alpha of over 8%. This anomalous return is mainly driven by long positions in low-litigation-risk firms. The results are not affected by the realization of the lawsuits and are robust after controlling for other well-known anomaly factors. We provide evidence that the litigation-risk anomalous return is driven by investors’ under-reaction to the changes in firms’ litigation risk.

About the Authors

Jun Duanmu

Jun Duanmu is an assistant professor of finance, Department of Finance, Seattle University, Seattle, WA.

Qiping Huang

Qiping Huang is an assistant professor of finance, Department of Economics and Finance, University of Dayton, Dayton, OH.

Yongjia Li

Yongjia Li is an assistant professor of finance, Department of Finance, Boise State University, Boise, ID.

Lingna Sun

Lingna Sun is an assistant professor of finance, Department of Economics and Finance, Louisiana Tech University, Ruston, LA.