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expected equity volatility can be used to proxy for changes in expected firm cash flow
volatility, hence making the link to the traditional line of firm cash flow volatility -
shareholder wealth analysis. 193
They find that there is a significant negative relation between equity returns in a year and
the contemporaneous change in equity volatility – showing a one standard deviation
increase in equity volatility reducing shareholder wealth by about 16.3% on average. They
find no evidence that firms with high growth opportunities benefit from an increase in
equity volatility. However, they find some evidence that an increase in equity volatility has
less of an adverse impact on firms with better growth opportunities.
According to the agency costs of debt theory, shareholders should benefit most from
increases in volatility for highly levered firms. Instead, Shin and Stulz [2000] find that
shareholder wealth decreases more with an increase in equity volatility for firms with high
leverage, low interest coverage, low investment, and low cash flow, as one would expect
with the capital structure and risk management theories that emphasize costs of financial
distress. 194 They also find that the decrease in shareholder wealth associated with an
increase in equity volatility is inversely related to firm size and insignificant for the largest
firms. This result is consistent with the theories that emphasize costs of financial distress in
that larger firms generally have better access to capital markets and benefit from
economies of scale in risk management. All in all, Shin and Stulz [2000] find evidence
consistent with the theoretical corporate finance literature finding that increases in cash
flow volatility are costly for shareholders.
193 Shin and Stulz [2000] argue that forecasting yearly cash flow volatility at the firm level using time-series
cash flow data would be impossible due to lack of sufficient data. However, expected equity volatility for
year t+1 can be proxied with the realized equity volatility in year t+1 calculated from daily equity returns,
assuming rational expectations. In their analysis, Shin and Stulz [2000] control for effects which would
impact equity volatility, but do not impact firm cash flow volatility. These are: 1. a fully anticipated increase
in leverage increases the volatility of equity leaving firm cash flow volatility unchanged, 2. a decrease in
shareholder wealth increases equity volatility keeping firm cash flow volatility constant, 3. an increase in the
volatility of the firm’s equity risk premium would increase the volatility of equity even though cash flow
volatility might be unchanged, 4. an increase in market volatility theoretically leads to an increase in the risk
premium on the market, thereby increasing expected returns but affecting contemporaneous returns
adversely.
194 This also contrasts the view that volatility shocks are first-order determinants of equity values due to the
option property of equity.
192