Downside Risk, Capital Flexibility and Operating Leases

50 Pages Posted: 24 Apr 2015

See all articles by Jose M. Carabias

Jose M. Carabias

London School of Economics & Political Science (LSE) - Department of Economics

Date Written: June 20, 2014

Abstract

In this paper, I investigate whether firms’ risk-hedging incentives affect their choices between owned and rented capital (operating leases). In recessions, firms facing negative demand shocks are loaded with unproductive capital. Absent of any trading frictions, firms can trade their assets to adjust their capacity in response to these shocks. However, due to costly reversibility of capital, firms might lack the flexibility to cut capital and deviate from their optimal investment. I find that the proportion of operating leased assets is positively correlated with downside risk. Furthermore, the relationship between operating leases and downside risk strengthens with firms’ inflexibility and the overall leverage in the industry. Finally, I show that contrary to conventional wisdom, by using operating leases, firms are able to reduce their risk exposure and expected return. My findings suggest that firms might be unwilling to retain the economic ownership of assets when, after an aggregate demand shock, the likelihood of being loaded with unproductive capital is high. As such, operating lease contracts might serve as risk-hedging mechanisms through which lessees transfer some of their operating risk to the lessor. These results suggest that, to some extent, companies use (and equity investors value) operating leases consistently with the economic interpretation underlying the “ownership approach” towards lease classification.

Keywords: Downside risk, investment, leasing, macro economy

JEL Classification: E3, G1, M4

Suggested Citation

Carabias, Jose M., Downside Risk, Capital Flexibility and Operating Leases (June 20, 2014). Available at SSRN: https://ssrn.com/abstract=2598101 or http://dx.doi.org/10.2139/ssrn.2598101

Jose M. Carabias (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

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