Empirical Evidence on Corporate Risk‐Shifting

• Author: Sudipto Sarkar,Gwangheon Hong,Anna N. Danielova
• Date: 01 August 2013
• DOI: http://doi.org/10.1111/fire.12010
• Published date: 01 August 2013

The Financial Review 48 (2013) 443–460

Empirical Evidence on Corporate

Risk-Shifting

Anna N. Danielova∗

McMaster University

Sudipto Sarkar

McMaster University

Gwangheon Hong

College of Business, Sogang University

Abstract

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.

C2013,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

constraints.

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.