2.1. Corporate risk
We measure corporate risk by stock return volatility. The value
of a stock is the discounted value of expected future cash
flows. We
use stock returns as opposed to accounting returns to measure
corporate risk because the former 1) are forward looking, 2) are
less influenced by general and
firm-specific accounting policies,
and 3) have a high frequency of data points. Furthermore, stock
returns constantly reflect aggregate changes in stock investors and
analysts’ beliefs about future cash
flows. These investors (and
analysts) may not always be correct in their assessments but they
back their opinions by money and thus have strong incentives to
evaluate the future of the
firm (including future risks) thoroughly.
Stock return volatility is affected by general market develop-
ments (systematic risk)12 and
firm-specific developments (idiosyncratic
risk) with the latter generally outweighing the former.
Goyal and Santa-Clara (2003)
find that the effect of idiosyncratic
risk constitutes almost 85% of the average stock variance measure.
Thus, our measure of risk predominantly measures risk related to
the specific
firm as opposed to general market developments.
Guay (1999) notes that stock return volatility measures equity
risk and not overall
firm risk. Most debt in our sample
firms is not
listed on exchanges and therefore we cannot observe volatility of
changes in its price. However, a stock is an option on the
firm’s
assets and as such its value is sensitive to the volatility of the
underlying asset. This justifies the use of stock return volatility as a
proxy for the volatility of the value of the
firm (e.g. Bulan, 2005).
We exclude
firms with negative book equity values to avoid stocks
that are likely to behave like out-of-the money options on
firm
value (i.e., correspondingly where the correlation between stock
value and
firm value is likely to be low).13