A Brief Review of Catastrophe Theory and a Test in a Corporate Failure Context

Russell B Gregory-Allen and Henderson, Glenn V,

The Financial Review, 1991, vol. 26, issue 2, 127-55

Abstract: Catastrophe theory (CT) is a mathematical theory that attempts to describe a system exhibiting discontinuous behavior under continuous stimuli. Although CT has been used to describe corporate bankruptcy, this is an application that has not been tested. This paper reviews CT and provides such a test. We construct a time series of stock returns on companies that have filed for Chapter 11. Under certain, frequently occurring conditions, CT would predict a structural shift in firm stock returns as the date of filing is approached. Results confirm that such a shift does occur and in a way consistent with the CT prediction. Our findings both support the use of CT to describe corporate bankruptcy and raise questions about some techniques frequently used to study bankruptcies. Copyright 1991 by MIT Press.

Date: 1991
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