During the 2007–09 global financial crisis, financial distress was not
common in the nonfinancial sector. To explain this, the authors explore the
determinants of equity price risk of nonfinancial corporations. Over the past
three decades, financial risk has declined and accounts for a minor portion of
observed stock price volatility. Instead of financial risk, the most important
determinants of risk are operating and asset characteristics.
What’s Inside?
The 2007–09 global financial crisis has attracted attention on the effects of financial leverage. Surprisingly, the US nonfinancial sector did not suffer from serious problems during the crisis. In fact, US bankruptcy filings are more frequent in industries that had fundamental economic pressures, such as the automotive manufacturing, newspaper, and real estate industries. This trend suggests that financial risk may not be an important risk factor in nonfinancial firms. The authors find that such economic risk factors as firm size, profit volatility, and dividends—instead of financial leverage—explain the main portion of equity volatility. They also find that, after controlling for all effects of policy on financial risk, the financial risk level is much lower than that measured by the simple debt ratio.
How Is This Research Useful to Practitioners?
Three key observations are relevant to practitioners. First, variation in equity volatility is caused mainly by economic risk factors but not by financial risk factors. Second, implied financial leverage has declined significantly in the past three decades. Third, the marginal effect of debt on total risk decreases as leverage increases, which means that when a firm adds more debt, its marginal effect on total risk is diminishing, which is counterintuitive. The authors attempt to explain these observations.
Variation in equity volatility is caused by economic risk factors. For a median firm in the sample, asset volatility explains 84.7% of total volatility for the firm and financial risk explains only around 15%. In particular, the authors find that larger and more mature firms with higher profitability and lower profit volatility have significantly lower firm risk.
In addition, between the late 1970s and the late 1990s, the implied financial leverage of nonfinancial firms declined significantly. The authors suggest four reasons to explain the trend. First, total debt ratios declined gradually. Second, cash holdings increased during the period, leading to a decrease in net debt (the authors consider the case of “negative debt”). Third, newly listed firms within the period usually involved riskier business (e.g., technology-oriented operations); these firms tended to have less debt. Fourth, financial exposures were lowered by firms’ undertaking various financial activities (e.g., risk management with derivatives). To conclude, because the average leverage has declined over the past 30 years, any increment in equity volatility can only be explained by economic risk factors.
The authors discover something interesting from investigating the effects related to total debt: When total debt levels increase, the marginal effect of debt on total risk decreases. They believe that firms with high debt levels are undertaking more financial risk management. Because the expected cost of bankruptcy increases with the debt level, it is more likely that the firm will hedge the risk with derivatives.
The results must be interpreted with caution. The authors emphasize that their results do not indicate that financial risk is negligible but that the ratio of a firm’s financial risk to economic risk declined over the past three decades, so the economic risks outweigh the financial risks in explaining equity volatility.
How Did the Authors Conduct This Research?
The sample includes firms that have accounting data in the Compustat database between 1964 and 2009 and that have at least 125 nonzero daily stock returns in the CRSP database during the year of the accounting data. The sample excludes utilities and financial services companies because they are regulated and may have different risk-taking incentives. As a result, the sample covers a significant portion of the market value of US firms (excluding financials and utilities)—on average, 90.7% of total market capitalization.
To investigate the sources of equity volatility, the authors conduct two types of empirical analysis. First, they adopt the structural framework of Leland and Toft (Journal of Finance 1996), which allows economic risk to be a determinant of financial policy. Second, they take a time-series approach by estimating an exponential generalized autoregressive conditional heteroskedastic (EGARCH) model that allows firm-specific business and financial risk factors to determine the long-run component of risk. These two approaches complement each other for more reliable results.
The authors also conduct robustness checks, including a reality check; a comparison of accounting and market data; and a less restrictive reduced-form model. The results are generally consistent.
Abstractor’s Viewpoint
Practitioners might overestimate a firm’s financial risk by looking only at the firm’s total debt ratio. According to the authors’ findings, when the leverage ratio is about 1.5, the implied leverage is actually within the range of 1.03–1.11. Firms may use such financial risk management techniques as financial derivatives, special purpose vehicles, or excess cash holdings to mitigate financial risk.