Shareholder Wealth and Firm Risk

The evidence presented here is inconsistent with variants of corporate finance theory which hold that the option properties of growth opportunities or asset substitution incentives are first-order determinants of equity values, but it is supportive of risk management and capital structure theories that emphasize the costs of cash flow volatility. Specifically, controlling for known determinants of changes in shareholder wealth, we find that the change in shareholder wealth over one year is inversely related to the change in expected equity volatility over the same year in cross-section regressions. This relation holds consistently through time for all but the largest firms and is economically significant. It is stronger for firms with weaker financial health. When we decompose volatility into beta risk and idiosyncratic risk, we find that shareholder wealth is positively related to beta changes, so that our evidence cannot be explained by a beta effect. Nor can the evidence be explained by the impact of returns on volatility predicted by the leverage effect studied in the option pricing literature.