School of Economics and Finance

No. 731: Capital Structure and Financial Flexibility: Expectations of Future Shocks

Costas Lambrinoudakis , University of Piraeus
Michael Neumann , Queen Mary University of London
George Skiadopoulos , Queen Mary University of London University of Piraeus

October 27, 2014

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We test one of the main predictions of the financial flexibility paradigm that expectations about future firm-specific shocks affect the firm's leverage. We extract the expectations of small and large future shocks from the market prices of equity options. We find that expectations for future shocks decrease leverage and are statistically significant even when we control for traditional determinants. Moreover, they have a first-order effect to capital structure decisions affecting more the small and financially constrained firms. Our findings confirm the De Angelo et al. (2011) model predictions and evidence drawn from surveys that managers seek for financial flexibility.

J.E.L classification codes: G13, G30, G32

Keywords:Capital structure, Financial flexibility, Options, Risk-neutral volatility, Risk-neutral kurtosis