Empirical evidence of risk shifting in financially distressed firms

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.