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Empirical Evidence of Risk Shifting in Financially Distressed Firms



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      Assaf Eisdorfer is from the University of Connecticut. The author thanks Michael Barclay, Clifford Smith, Jerold Warner, Robert Stambaugh (the editor), and an anonymous referee for valuable comments and suggestions.


This paper provides evidence of risk-shifting behavior in the investment decisions of financially distressed firms. Using a real options framework, I show that shareholders' risk-shifting incentives can reverse the expected negative relation between volatility and investment. I test two hypotheses that are consistent with risk-shifting behavior: (i) volatility has a positive effect on distressed firms' investment; (ii) investments of distressed firms generate less value during times of high uncertainty. Empirical evidence using 40 years of data supports both hypotheses. I further evaluate the effect of various firm characteristics on risk shifting, and estimate the costs of the investment distortion.

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