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increases. Their results suggest that managers’ efforts to produce smooth financial
statements may add value to the firm.
Shin and Stulz [2000] choose a somewhat different methodology, but come to similar
conclusions. They endeavor to understand how and why increases in expected equity
volatility affect shareholder wealth, in light of the opposing theories of corporate finance
literature. Namely, Merton [1974], Jensen and Meckling [1976] suggest that an increase in
firm cash flow volatility – and as a result, an increase in equity volatility – has a positive
impact on shareholder wealth, even though it may decrease firm value when doing so. The
former views equity as option on firm value, the latter refers to the risk-shifting agency
problem. Also, the literature on real options emphasizes the option properties of growth
opportunities, and argues that cash flow volatility is precious as it makes growth options
more valuable, with a consequent increase in equity volatility.
The literature on capital structure (trade-off theory) and the positive theories on corporate
risk management policies, however, show that increases in cash flow volatility have a
detrimental effect on shareholder wealth. As to be shown in the subsequent sections, recent
literature extends the contingent claim approach to pricing equity to take into account the
endogeneity of the firm’s capital structure. Leland [1998] – for example – shows that
shareholders may find it optimal to reduce firm volatility, and hence, equity volatility, to
preserve the tax benefits of debt despite the existence of the agency costs of debt
emphasized by Jensen and Meckling [1976]. With these theories, an increase in cash flow
volatility that increases equity volatility affects shareholders adversely by reducing their
expected cash flows, so that there is a negative relation between changes in equity
volatility and shareholder wealth.
A Shin-Stulz [2000] modell
Shin and Stulz [2000], therefore, empirically analyze the nature of the relation between
shareholder wealth and changes in equity volatility. They argue that expected equity
volatility generally increases with expected firm cash flow volatility, so that the changes in
192 Allayannis and Weston [2001] assume that the use of foreign exchange derivatives is a proxy for risk
management activity within the firm, so that the hedging premium reflects the premium for risk management
rather than simply the benefit from hedging foreign currency risk.
191