Stock Return Volatility and Capital Structure Decisions

Abstract

Stock return volatility significantly predicts active leverage adjustment, consistent with the trade-off theory. Firms respond asymmetrically to rising volatility instead of falling volatility, more with debt reduction than equity issuance. The forecasting power of stock return volatility mostly resides on surprise (idiosyncratic) volatility, as a proxy for uncertainty; while the forecasting power of expected (systematic) volatility is largely subsumed by those of firm fundamentals and market information. Falling earning growth appears to be the channel through which increasing volatility predicts leverage reduction and investment contraction.

Keywords: Stock Return Volatility, Leverage Ratio, Surprise Shocks, Idiosyncratic Volatility, Uncertainty

JEL Classification: G32, G17