Empirical Evidence of Risk Shifting in Financially Distressed Firms |
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Authors: | ASSAF EISDORFER |
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Institution: | Assaf Eisdorfer is from the University of Connecticut. The author thanks Michael Barclay, Clifford Smith, Jerold Warner, Robert Stambaugh (the editor), and an anonymous referee for valuable comments and suggestions. |
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Abstract: | This paper provides evidence of risk‐shifting behavior in the investment decisions of financially distressed firms. Using a real options framework, I show that shareholders' risk‐shifting incentives can reverse the expected negative relation between volatility and investment. I test two hypotheses that are consistent with risk‐shifting behavior: (i) volatility has a positive effect on distressed firms' investment; (ii) investments of distressed firms generate less value during times of high uncertainty. Empirical evidence using 40 years of data supports both hypotheses. I further evaluate the effect of various firm characteristics on risk shifting, and estimate the costs of the investment distortion. |
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