The Volatility of Firm's Assets and the Leverage Effect

Abstract:     
This paper investigates the conditional volatility of the firm’s assets in contrast to existing studies that focus primarily on equity volatility. Using a novel dataset that allows us to map out significant portions of the capital structure, we examine the volatility properties of asset returns as calculated by a weighted average of equity, bond and loan prices. The fundamental findings in this paper are that asset volatility is time-varying and that financial leverage matters and has a large influence on equity volatility. Because asset volatility and leverage tend to be negatively related, we show that it is crucial asset volatility is controlled for when investigating the leverage effect. Within this backdrop, we look at levels and changes in implied equity volatility and relate them to different components of estimated asset volatility and to leverage at the firm level. Of some note, leverage has a more persistent impact on equity volatility than the transitory effect of asset volatility, thus, helping to explain the short- and long-run dynamics of equity volatility documented in the literature.

Number of Pages in PDF File: 49

Keywords: time-varying volatility, firm's assets, leverage, feedback effect

JEL Classification: C22, C53, G12

working papers series