Empirical Evidence on Corporate Risk‐Shifting

Danielova, Anna N.; Sarkar, Sonali; Hong, Gwangheon

doi:10.1111/fire.12010

Cited by 18 publications

(21 citation statements)

References 41 publications

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“…There is some evidence that companies do make operating changes after debt issues; for instance, Danielova et al . () report a significant jump in earnings volatility (which is consistent with increase in DOL) subsequent to a debt issue (which increases DFL). Thus, the second scenario is also of practical interest, although it is yet to be analysed.…”

Section: The Modelmentioning

confidence: 70%

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The relationship between operating leverage and financial leverage

Sarkar

2018

Accounting & Finance

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We model the relationship between operating and financial leverage. When operating leverage is exogenously specified, financial leverage is a monotonically decreasing function of operating leverage. When financial leverage is exogenously specified, operating leverage is initially increasing and subsequently decreasing in financial leverage. Finally, when both operating and financial leverage are chosen by the firm, they can be positively related, negatively related or unrelated, depending on which underlying parameter is driving the changes. Thus, operating leverage and financial leverage do not always behave as substitutes, as argued in the traditional literature. The relationship is complex, possibly non-monotonic and dependent on the circumstances; empirical tests need to take this reality into account.

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Section: The Modelmentioning

confidence: 70%

“…There is some evidence of corporate adjustments in the operating side in response to changes in leverage ratio; for instance, Danielova et al . () report a significant rise in earnings volatility (consistent with rise in operating leverage) following an increase in leverage ratio (resulting from new debt issue).…”

Section: Numerical Resultsmentioning

confidence: 98%

The relationship between operating leverage and financial leverage

Sarkar

2018

Accounting & Finance

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“…The risk-shifting incentive is possible in a corporation because equity holders have a limited liability feature that not only protects the equity holders from excessive losses but also creates a chance for the equity holders to reap enormous profits when the investment yields a substantial return (Harris and Raviv, 1991). Previous researchers identified risk shifting as an automatic behaviour when equity holders decide to engage in debt-based activities (Danielova et al, 2013). At that time, the debt holders lose wealth because they are not compensated for the increased likelihood of default on their claims, while equity holders ultimately continue to gain through dividend payments (Turkiela, 2014).…”

Section: Literature Reviewmentioning

confidence: 99%

“…Although extensive academic research has explored risk-shifting behaviour in debt (Black and Scholes, 1973;Brunnermeier and Oehmke, 2012;Danielova et al, 2013;Fang and Zhong, 2004;Harris and Raviv, 1991;Jensen and Meckling, 1976;Landier et al, 2011;Loktionov, 2010;Turkiela, 2014), previous researchers have not investigated the possibility of risk-shifting behaviour in sukuk investments. The investigation of risk shifting in sukuk is crucial.…”

Section: Introductionmentioning

confidence: 99%

Risk shifting elimination and risk sharing exposure in equity-based financing – a theoretical exposition

Hamzah

Ishak

Rasedee

2018

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Purpose The purpose of this paper is to examine incentives for risk shifting in debt- and equity-based contracts based on the critiques of the similarities between sukuk and bonds. Design/methodology/approach This paper uses a theoretical and mathematical model to investigate whether incentives for risk taking exist in: debt contracts; and equity contracts. Findings Based on this theoretical model, it argues that risk shifting behaviour exists in debt contracts only because debt naturally gives rise to risk shifting behaviour when the transaction takes place. In contrast, equity contracts, by their very nature, involve sharing transactional risk and returns and are thus thought to make risk shifting behaviour undesirable. Nonetheless, previous researchers have found that equity-based financing also might carry risk shifting incentives. Even so, this paper argues that the amount of capital provided and the underlying assets must be considered, especially in the event of default. Through mathematical modelling, this element of equity financing can make risk shifting unattractive, thus making equity financing more distinct than debt financing. Research limitations/implications Global awareness of the dangers of debt should be increased as a means of reducing the amount of debt outstanding globally. Although some regulators suggest that sukuk replaces debt, they must also be aware that imitative sukuk poses the same threat to efforts to avoid debt. In short, efforts to ensure future financial stability cannot address only debts or bonds but must also address those types of sukuk that mirrors bonds in their operation. In the wake of the global financial crisis, amid the frantic search for ways of protecting against future financial shocks, this analysis aims to help create future stability by encouraging market players to avoid debt-based activities and promoting equity-based instruments. Practical implications This paper’s findings are relevant for countries that feature more than one type of financial market (e.g. Islamic and conventional) because risk shifting behaviour can degrade economic and financial stability. Originality/value This paper differs from the previous literature in two important ways, viewing risk shifting behaviour not only in relation to debt or bonds but also when set against debt-based sukuk, which has been subjected to similar criticism. Indeed, to the extent that debts and bonds encourage risk shifting behaviour and threaten the entire financial system, so, too, can imitation sukuk or debt-based sukuk. Second, this paper is unique in exploring the ability of equity features to curb equityholders’ incentive to engage in risk shifting behaviour. Such an examination is necessary for the wake of the global financial crisis, for researchers and economists now agree that risk shifting must be controlled.

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“…A corporation may find risk shifting attractive because its equity holders enjoy limited liability that not only protects them from excessive losses but also creates a chance for them to reap enormous profits when their investments yield a significant return (Harris and Raviv, 1991). Indeed, previous researchers have identified risk shifting as an automatic behavior when equity holders decide to engage in debt-based activities (Danielova, Sarkar and Hong, 2013). At such a time, debtholders lose their wealth without being compensated for the increased likelihood of default on their claims even as equity holders continue to gain through dividend payments (Turkiela, 2014).…”

Section: Risk Shiftingmentioning

confidence: 99%

Empirical evidence of risk shifting in bonds and debt-basedsukuk

Hamzah

Bacha

Mirakhor

et al. 2018

JIABR

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Purpose The purpose of this paper is to examine the extent of risk shifting behavior in bonds and sukuk. The examination is significant, as economists and scholars identify risk shifting as the primary cause of the global financial crisis. Yet, the dangers of this debt-financing feature are largely ignored – one needs to only witness the record growth of global debt even after the global financial crisis. Design/methodology/approach To identify the signs of risk shifting existence in the corporations, this paper compares each corporation’s operating risk before and after issuing debt. Operating risk or risk of a firm’s activities is measured using the volatility of the operating earnings or coefficient variation of earning before interest, tax, depreciation and amortization (EBITDA). Using EBITDA as the variable offers one distinct advantage to using asset volatility as previous research has – EBITDA can be extracted directly from firms’ accounting data and is not model-specific. Findings Risk shifting can be found in not only the bond system but also the debt-based sukuk system – a noteworthy finding because sukuk, supposedly in a different class from bonds, have been criticized in some quarters for their apparent similarity to bonds. On the other hand, this study thus shows that equity feature, when it is embedded in bonds (as in convertible bonds) or when a financial instrument is based purely on equity (as in equity-based sukuk), the incentive to shift the risk can be mitigated. Research limitations/implications Global awareness of the dangers of debt should be increased as a means of reducing the amount of debt outstanding globally. Although some regulators suggest that sukuk replace debt, they must also be aware that imitative sukuk pose the same threat to efforts to avoid debt. In short, efforts to ensure future financial stability cannot address only debts or bonds but must also address those types of sukuk that mirror bonds in their operation. In the wake of the global financial crisis, amid the frantic search for ways of protecting against future financial shocks, this analysis aims to help create future stability by encouraging market players to avoid debt-based activities. Originality/value This paper differs from the previous literature in two important ways, viewing risk shifting behavior not only in relation to debt or bonds but also when set against debt-based sukuk, which has been subjected to similar criticism. Indeed, to the extent that debts and bonds encourage risk shifting behavior and threaten the entire financial system, so, too, can imitation sukuk or debt-based sukuk. Second, this paper is unique in exploring the ability of equity features to curb equity holders’ incentive to engage in risk shifting behavior. Such an examination is necessary for the wake of the global financial crisis, for researchers and economists now agree that risk shifting must be a controlled behavior – and that one way of controlling risk shifting is by implementing the risk sharing feature of equity-based financing into the financial system.

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Empirical Evidence on Corporate Risk‐Shifting

Cited by 18 publications

References 41 publications

The relationship between operating leverage and financial leverage

The relationship between operating leverage and financial leverage

Risk shifting elimination and risk sharing exposure in equity-based financing – a theoretical exposition

Empirical evidence of risk shifting in bonds and debt-basedsukuk

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