be positively related to risk and has since been consistently negatively related to risk. This is related to findings by Brown and Kapadia (2007) that recent trends in idiosyncratic risk are related to stock listings by younger and riskier firms.
Perhaps the most interesting result from our analysis is that our measures of implied financial leverage have declined over the last 30 years at the same time that measures of equity price risk (such as idiosyncratic risk) appear to have been increasing. In fact, measures of implied financial leverage from our structural model settle near 1.0 (i.e., no leverage) by the end of our sample. There are several possible reasons for this. First, total debt ratios for non-financial firms have declined steadily over the last 30 years, so our measure of implied leverage should also decline. Second, firms have significantly increased cash holdings, so measures of net debt (debt minus cash and short-term investments) have also declined. Third, the composition of publicly traded firms has changed with more risky (especially technology-oriented) firms becoming publicly listed. These firms tend to have less debt in their capital structure. Fourth, as mentioned above, firms can undertake a variety of financial risk management activities. To the extent that these activities have increased over the last few decades, firms will have become less exposed to financial risk factors.
We conduct some additional tests to provide a reality check of our results. First, we repeat our analysis with a reduced form model that imposes minimum structural rigidity on our estimation and find very similar results. This indicates that our results are unlikely to be driven by model misspecification. We also compare our results with trends in aggregate debt levels for all U.S. non-financial firms and find evidence consistent with our conclusions. Finally, we look at characteristics of publicly traded non-financial firms that file for bankruptcy around the last three recessions and find evidence suggesting that these firms are increasingly being affected by economic distress as opposed to financial distress.
In short, our results suggest that, as a practical matter, residual financial risk is now relatively unimportant for the typical U.S. firm. This raises questions about the level of expected financial distress costs since the probability of financial distress is likely to be lower than commonly thought for most companies. For example, our results suggest that estimates of the level of systematic risk in bond pricing may be biased if they do not take into account the trend in implied financial leverage (e.g., Dichev, 1998). Our results also bring into question the appropriateness of financial models used to estimate default probabilities, since financial policies that may be
difficult to observe appear to significantly reduce risk. Lastly, our results imply that the fundamental risks born by shareholders are primarily related to underlying economic risks which should lead to a relatively efficient allocation of capital.
Before proceeding we address a potential comment about our analysis. Some readers may be tempted to interpret our results as indicating that financial risk does not matter. This is not the proper interpretation. Instead, our results suggest that firms are able to manage financial risk so that the resulting exposure to shareholders is low compared to economic risks. Of course, financial risk is important to firms that choose to take on such risks either through high debt levels or a lack of risk management. In contrast, our study suggests that the typical non-financial firm chooses not to take these risks. In short, gross financial risk may be important, but firms can manage it. This contrasts with fundamental economic and business risks that are more difficult (or undesirable) to hedge because they represent the mechanism by which the firm earns economic profits.
The paper is organized at follows. Motivation, related literature, and hypotheses are reviewed in Section 2. Section 3 describes the models we employ followed by a description of the data in Section 4. Empirical results for the Leland-Toft model are presented in Section 5. Section 6 considers estimates from the reduced form model, aggregate debt data for the no financial sector in the U.S., and an analysis of bankruptcy filings over the last 25 years. Section 6 concludes.
2 Motivation, Related Literature, and Hypotheses
Studying firm risk and its determinants is important for all areas of finance. In the corporate finance literature, firm risk has direct implications for a variety of fundamental issues ranging from optimal capital structure to the agency costs of asset substitution. Likewise, the characteristics of firm risk are fundamental factors in all asset pricing models.
The corporate finance literature often relies on market imperfections associated with financial risk. In the Modigliani Miller (1958) framework, financial risk (or more generally financial policy) is irrelevant because investors can replicate the financial decisions of the firm by themselves. Consequently, well-functioning capital markets should be able to distinguish between frictionless financial distress and economic bankruptcy. For example, Andrade and Kaplan (1998) carefully distinguish between costs of financial and economic distress by analyzing highly leveraged transactions, and find that financial distress costs are small for a subset of the firms that did not
experience an “economic” shock. They conclude that financial distress costs should be small or insignificant for typical firms. Kaplan and Stein (1990) analyze highly levered transactions and find that equity beta increases are surprisingly modest after recapitalizations.
The ongoing debate on financial policy, however, does not address the relevance of financial leverage as a driver of the overall riskiness of the firm. Our study joins the debate from this perspective. Correspondingly, decomposing firm risk into financial and economic risks is at the heart of our study.
Research in corporate risk management examines the role of total financial risk explicitly by examining the motivations for firms to engage in hedging activities. In particular, theory suggests positive valuation effects of corporate hedging in the presence of capital market imperfections. These might include agency costs related to underinvestment or asset substitution (see Bessembinder, 1991, Jensen and Meckling, 1976, Myers, 1977, Froot, Scharfstein, and Stein,1993), bankruptcy costs and taxes (Smith and Stulz, 1985), and managerial risk aversion (Stulz,1990). However, the corporate risk management literature does not generally address the systematic pricing of corporate risk which has been the primary focus of the asset pricing literature.
Lintner (1965) and Sharpe (1964) define a partial equilibrium pricing of risk in a mean variance framework. In this structure, total risk is decomposed into systematic risk and idiosyncratic risk, and only systematic risk should be priced in a frictionless market. However, Campbelletal (2001) find that firm-specific risk has increased substantially over the last four decades and various studies have found that idiosyncratic risk is a priced factor (Goyal and Santa Clara,2003, Ang, Hodrick, Xing, and Zhang, 2006, 2008, Spiegel and Wang, 2006). Research has determined various firm characteristics (i.e., industry growth rates, institutional ownership, average firm size, growth options, firm age, and profitability risk) are associated with firm-specific risk. Recent research has also examined the role of equity price risk in the context of expected financial distress costs (Campbell and Taksler, 2003, Vassalou and Xing, 2004, Almeida and Philippon, 2007, among others). Likewise, fundamental economic risks have been shown to be to be related to equity risk factors (see, for example, Vassalou, 2003, and the citations therein). Choiand Richardson (2009) examine the volatility of the firm?s assets using issue-level data on debt and find that asset volatilities exhibit significant time-series variation and that financial leverage has a substantial effect on equity volatility.
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