Empirical Evidence on Corporate Risk‐Shifting

Date01 August 2013
Published date01 August 2013
The Financial Review 48 (2013) 443–460
Empirical Evidence on Corporate
Anna N. Danielova
McMaster University
Sudipto Sarkar
McMaster University
Gwangheon Hong
College of Business, Sogang University
We study empirically whether nonfinancial firms’behavior is consistent with systematic
risk-shifting. We compare firms’ operating risk before and after a debt issue, under the as-
sumption that if there is any risk-shifting it is most likely to occur right after a debt issue.
We document a significant increase in firms’ operating risk, even after adjusting for industry
influences. The risk-shifting is higher for firms with no subsequent debt issues, and for firms
with lower credit ratings. Other determinants are earnings volatility, size of debt issue, and
whether the bond is callable.
Keywords: corporate finance, risk-shifting, asset substitution
JEL Classification:G3
Corresponding author: Finance and Business Economics, DeGroote School of Business, McMaster
University, 1280 Main Street West, Hamilton, ON L8S 4M4; Phone: (905) 505-9140 x26193; Fax: (905)
521-8995; E-mail: adaniel@mcmaster.ca.
The authors thank two anonymous reviewers, R. Van Ness (the editor), the discussants at the FMA and
SFA meetings, and I. Osobov for very helpful comments and suggestions. A. Danielova and S. Sarkar
wish to acknowledge financial support from Social Sciences & Humanities Research Council (SSHRC) of
Canada. A. Danielova appreciates funding provided by the Arts Research Board of McMaster University.
C2013,The Eastern Finance Association 443
444 A. N. Danielova et al./The Financial Review 48 (2013) 443–460
1. Introduction
Many authors have pointed out that equity can be viewed as a call option on
the firm’s assets, for example, Black and Scholes (1973), Galai and Masulis (1976),
Jensen and Meckling (1976), Leland (1998) and Merton (1973). Since the value of
a call option is an increasing function of volatility, equity holders (or managers,
acting in shareholders’ interest) can transfer wealth from bondholders to themselves
by increasing the risk of the firm’s assets after debt is in place (Leland, 1998). This
is called the “risk-shifting” or “asset substitution” problem (these two terms will be
used interchangeably in our paper), and is discussed by Galai and Masulis (1976),
Jensen and Meckling (1976), Leland (1998), and others.
The risk-shifting incentive is strongest when the firm is in (or close to) financial
distress, since equity holders have very little to lose and a lot to gain by taking large
gambles at this stage (Jensen and Meckling, 1976; Eisdorfer, 2008). However (and
this aspect has been somewhat ignored in the literature), shareholders of firms not
in financial distress also have the risk-shifting incentive. Galai and Masulis (1976,
p. 57) show that ∂S
∂σ2>0, that is the equity value increases with volatility; this was
also shown by Black and Scholes (1973). Thus, in theory, the risk-shifting incentive
exists for all firms, not just those in financial distress (see, i.e., Douglas, 2009,
p. 152), although there might be practical reasons not to engage in risk-shifting,
for example reputational concerns, compensation schemes, and positive net worth
While a large body of literature exists on different aspects of risk-shifting, there
is little empirical evidence on whether firms generally engage in risk-shifting, with
the exception of the financial sector and financially distressed firms. Esty (1997a,b),
Brown, Goetzmann, and Park (2001) and Basak, Pavlova and Shapiro (2007) find
evidence of risk-shifting in the financial sector (savings and loans, hedge funds,
etc.). For firms in financial distress, the evidence is mixed, with Eisdorfer (2008)
finding evidence of risk-shifting but Andrade and Kaplan (1998) finding no evidence
(although the latter study used a small sample).
However, as discussed above, firms which are not in financial distress should
also be subject to the risk-shifting incentive,1and it has not yet been established
empirically whether these firms do engage in risk-shifting. This is the objective of
our paper: to establish if corporations engage in risk-shifting or asset substitution in
a systematic and significant way, and if so, to identify the factors that determine the
magnitude of risk-shifting.
We analyze earnings volatility around 1983 corporate debt issues by 967 firms
between 1972 and 2009. We find that there is, on average, a statistically significant
increase in operating risk (earnings volatility,measured by the coefficient of variation)
1For instance, in Leland (1998), the firm increases asset volatility when firm valuereaches a certain level,
independent of whether the firm is close to, or far from, bankruptcy. Bhanot and Mello (2006) state that
firms have an incentive to increase asset risk after capital structure choice is made, and this is true for all
firms, not those in or near bankruptcy.

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