Working Paper

Options, Equity Risks, and the Value of Capital Structure Adjustments


Abstract: We use exchange-traded options to identify risks relevant to capital structure adjustments in firms. These forward-looking market-based risk measures provide significant explanatory power in predicting net leverage changes in excess of accounting data. They matter most during contractionary periods and for growth firms. We form market-based indices that capture firms' magnitudes of, and propensity for, net leverage increases. Firms with larger predicted leverage increases outperform firms with lower predicted increases by 3.1% to 3.9% per year in buy-and-hold abnormal returns. Finally, consistent with the quality, leverage, and distress risk puzzles, firms with lower predicted leverage increases are riskier but earn lower abnormal returns.

Keywords: Capital Structure; Financial Leverage; Options; Implied Volatility;

JEL Classification: G30; G32; G12; G14;

https://doi.org/10.17016/FEDS.2016.097

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Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2016-10

Number: 2016-097