Default Risk, Debt Maturity and Levered Equity's Risk Shifting Incentives

Abstract

This article addresses the limited empirical evidence on risk-shifting behavior in industrial firms, by focusing directly on asset volatilities implied from the U.S. equity market. These are inferred using the iterative algorithm of Moody's KMV and the Leland & Toft (1996) model. Indeed, Leland & Toft (1996) relate key variables relevant for the equityholders' risk incentives, and allow for intermediate financial distress, bankruptcy costs and tax shields. Hypotheses on risk-shifting and risk-avoidance are carefully derived from the model, with a special emphasis on the role of default risk and debt maturity. The results strongly indicate, that firms with a high default risk or leverage subsequently risk-shift relative to their industry peers. In addition, we find firms with an intermediate level of distress to risk-avoid. Some evidence indicates, that long debt maturity makes asset volatility increases more pronounced for firms close to the default barrier. However, the additional increase is larger for firms with the shortest debt maturity. Indeed, these firms are more default risky.

Keywords: risk shifting, agency costs, default risk, debt maturity, structural models

JEL Classification: G13, G32, G33