Default Risk, Firm's Characteristics, and Risk Shifting

This paper examines the relationship between a firm's risk-shifting behavior and its default risk. Using contingent-claims approaches, we estimate the market value of a firm's assets, the volatility of asset return, and the associated default risk based on the stock prices and book value of debt. Our study shows that, consistent with conventional wisdom and many theoretical models, firms with high default risk tend to increase asset volatility more in the subsequent year, reltive to their industry peers. We find that, a firm's risk-shifting is also pronounced when it has very low default risk. In addition, risk shifting is negatively related to firm size, leverage ratio, and current asset volatility. Alternative specifications of default risk confirm that our findings are robust to the choice of default risk measure. A direct estimation of the market values of firms based on market values of stocks and bonds confirms our results based on contingent-claims approaches