The Effects of Imminent Bankruptcy on Stockholder Risk Preferences and Behavior

Abstract

The conditions derived by Bulow and Shoven concerning the circumstances under which a firm goes bankrupt, can be used to draw inferences about stockholders risk preferences. Bankruptcy becomes less likely, the higher the expected value of the firm as a going concern and, in some interesting cases, the higher the variance of profits. Because stockholders' returns are truncated from below, mean-preserving increases in the variance of firm returns increase only the expected value of stockholders' returns and not their risk. Thus, although equity holders may be risk neutral or risk averse with respect to their own returns, they may be risk preferring with regard to firm returns.