How Do Financing Constraints Affect Firms’ Equity Volatility?

• Date: 01 June 2018
• DOI: http://doi.org/10.1111/jofi.12610
• Author: DANIEL CARVALHO
• Published date: 01 June 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 3 •JUNE 2018

How Do Financing Constraints Affect Firms’

Equity Volatility?

DANIEL CARVALHO∗

ABSTRACT

Theory suggests that financing frictions can have significant implications for equity

volatility by shaping firms’ exposure to economic risks. This paper provides evidence

that an important determinant of higher equity volatility among research and de-

velopment (R&D)-intensive firms is fewer financing constraints on firms’ ability to

access growth options. I provide evidence for this effect by studying how persistent

shocks to the value of firms’ tangible assets (real estate) affect their subsequent equity

volatility. The analysis addresses concerns about the identification of these balance

sheet effects and shows that these effects are consistent with broader patterns on the

equity volatility of R&D-intensive firms.

FIRMS EXPERIENCE SUBSTANTIAL VOLATILITY IN their equity value. Though most

firm equity volatility is idiosyncratic, it matters for several reasons. For ex-

ample, idiosyncratic volatility is important for determining portfolio alloca-

tions (Campbell et al. (2001)), particularly for the large number of investors

that are imperfectly diversified (Campbell (2006)). It also matters for firm

value in the presence of frictions such as financing constraints, for large share-

holders who might play an important corporate governance role (Shleifer and

Vishny (1986)), for managers who hold equity stakes due to compensation

policies, and for arbitrageurs who trade to exploit the mispricing of individ-

ual stocks (Shleifer and Vishny (1997)).1In addition, equity volatility plays

a central role in a large literature on corporate risk management policies,

∗Daniel Carvalho is with the Kelley School of Business, Indiana University.I would like to thank

Harry DeAngelo, Oguzhan Ozbas, John Matsusaka, Gordon Phillips, Michael Roberts (the Editor),

Lori Santikian, two anonymous referees, and seminar participants at the City University of Hong

Kong, Hong Kong Polytechnic University, University of Hong Kong, and USC Marshall School of

Business for helpful comments. I have not received external financial support for this research. I

do not have any potential conflicts of interest, as identified in the Journal of Finance’s disclosure

policy.

1Even in the United States, large shareholders are important in most publicly traded firms (e.g.,

Amit and Villalonga (2009)). Panousi and Papanikolaou (2012) provide evidence that ownership

by insider managers is also significant for a large subset of firms, especially small firms with high

idiosyncratic volatility.Previous research suggests, both theoretically and empirically, that greater

firm-specific risk leads to weaker incentive contracts for top executives and induces managers to

lower firm investment (e.g., Aggarwal and Samwick (1999), Lin (2002), Panousi and Papanikolaou

(2012)).

DOI: 10.1111/jofi.12610

1139

1140 The Journal of Finance R

and it is important in the pricing of derivatives such as options on a given

stock.2

While previous research suggests that firms’ cash flow fundamentals can

help explain their equity volatility,we still have a limited understanding of the

underlying economic factors that determine the level of their equity volatility.3

Understanding this link is important because different interpretations of the

underlying risks driving equity volatility can have different implications.

This paper studies the role of financing constraints in determining firms’

equity volatility. I argue that higher equity volatility can result from fewer

financing constraints on firms’ ability to take advantage of growth options.

When capital markets are imperfect, the availability of financial resources af-

fects firms’ ability to access growth options. If uncertainty about future growth

opportunities is an important source of firm risk, in particular, if future invest-

ment opportunities can become highly valuable relative to current opportuni-

ties, then, as financing constraints are relaxed, firms may decide to preserve

their increased access to liquidity to fund future potential growth opportunities

rather than use it to finance current investment. Consequently, an increase in

the value of unexercised growth options leads to higher equity volatility. Given

that research and development (R&D) investments represent a major source

of growth options, the growth-options channel is arguably most important

for R&D-intensive firms. This channel suggests that higher equity volatility

among small and young firms, particularly R&D-intensive firms, can reflect

reductions in frictions usually associated with higher firm value and economic

growth.4

The implications of financing frictions for firm equity volatility can be signif-

icantly different if these frictions influence firms’ exposure to liquidity risks.

Previous research argues that financing frictions lead to undesirable fluctua-

tions in firms’ liquidity positions that can affect decisions such as firm invest-

ment (Froot, Scharfstein, and Stein (1990), Holmstrom and Tirole (1998), Opler

et al. (1999)). According to this literature, such liquidity risks reduce firm value

and create a motive for financially constrained firms to reduce fluctuations in

their value through risk management policies. Since firms may be limited in

their ability to reduce their exposure to liquidity risks, tighter financing con-

straints can lead to an increase in firm equity volatility as a consequence of

their increased risks. Therefore, higher levels of equity volatility among small

2See, for example, Froot, Scharfstein, and Stein (1990), Opler et al. (1999), Almeida, Campello,

and Weisbach (2004), and Bates, Kahle, and Stulz (2009).

3Variation in equity volatility both across firms and over time is positively correlated with

higher cash flow volatility (e.g., Pastor and Veronesi (2003), Comin and Philippon (2005), Irvine

and Pontiff (2009)). Moreover, decompositions of firm-level stock price fluctuations suggest that

news about expected cash flows plays an important role in driving them (Vuolteenaho (2002)).

4According to this view, financing constraints cannot explain the greater volatility of small

and young firms, which might be explained instead by their greater economic exposure to growth

options. However, financing constraints can explain why such firms might have higher volatility in

environments with fewer financing frictions limiting small and young firms’ growth. For example,

Bartram, Brown, and Stulz (2012) provide evidence that U.S. firms have significantly higher equity

volatility than similar firms in other countries.

How Do Financing Constraints Affect Firms’ Equity Volatility? 1141

and young firms may be explained by greater financing constraints and liquid-

ity risks, which can significantly reduce firms’ value and impose costs on their

investors.5

Two main challenges arise in examining the importance of these effects.

First, it is necessary to identify a significant source of variation across firms

in the importance of financing frictions. Second, it is necessary to empirically

disentangle variation in the importance of these frictions from variation in

the underlying economic conditions that firms face. In this paper, I address

these challenges by examining the impact of persistent shocks to the value of

firms’ real estate holdings. A large literature shows that increases in the value

of firms’ tangible assets can relax financing constraints, and that shocks to

the value of firms’ real estate holdings are an important source of shocks to

firms’ balance sheets.6While R&D-intensive firms rely less on tangible assets,

a significant fraction of R&D-intensive firms are potentially exposed to this

source of variation in financing constraints. As a first step in the analysis,

I illustrate the theoretical possibilities above using a model in which firm

investment decisions are subject to collateral constraints, with increases in the

value of tangible assets relaxing their financing constraints.

Next, I construct instrumented shocks to local real estate prices using dif-

ferences across U.S. regions in the geographically determined availability of

land, which leads different regions to have different exposures to national real

estate cycles. I then estimate the effect of shocks to the value of firms’ real

estate holdings by combining these local real estate shocks with preexisting

differences across firms in their exposure to real estate in their balance sheet. I

find that increases in the value of firms’ real estate holdings lead to significant

increases in the subsequent volatility of their stock returns.

Further, I provide evidence that this effect is driven by the growth-options

channel. These persistent shocks to firms’ balance sheets are associated with

immediate increases in firm equity volatility. These shocks are also associated

with increases in firm investment and debt issuance, although these effects

are arguably small in magnitude when compared to the changes in the value of

real estate holdings, and with decreases in firm market leverage or net market

leverage, but are not associated with higher subsequent cash flow volatility. In

additional analysis, I find that the documented effects are driven by increases

in the idiosyncratic volatility of R&D-intensive firms. I also find no evidence

that persistent shocks to the value of firms’ real estate holdings are associated

with changes in the equity volatility of firms less likely to rely on growth op-

tions, such as firms that are not R&D-intensive as well as mature and large

5An important issue is that relaxed financing constraints will lead to endogenous changes in

firms’ financial policies (e.g., higher leverage) that can also affect the volatility of firm value. I

address this issue in the empirical analysis.

6See, for example, Hart (1995) and the references therein. Gan (2007) and Chaney, Sraer, and

Thesmar (2012) provide evidence that increases in the value of firms’ real estate holdings lead to

increases in their borrowing capacity and real investment. Benmelech and Bergman (2009)provide

evidence that higher collateral values reduce borrowing costs.