Nature of Firm Risk

Abstract

This article shows that qualitatively different measures of 'firm risk' are significantly correlated, and have a long memory, with significant correlations to at least five years, Regressions find risks arise from a small number of stable firm traits and investor expectations. Firm risk is sourced in a set of latent parameters which change slowly and - like an attractor in a chaotic system - confine firms to a high or low risk region. Using constituents of the S&P 500 Index during the most recent full cycle in the US equity market during 1998 to 2003, five datasets are merged to develop 11 measures of risk relating to uncertainty in market and accounting returns, variability in cash flows, and business risks such as product recalls, unsafe workplaces and fraud. The data also provide 16 independent variables previously shown to affect firm risk propensity and risk. Cross-sectional analysis through the cycle explains variation between firms' risk in terms of structural features (Altman's Z), CEO compensation with options, management strategy (acquisition and R&D expenditures), and variability in accounting margin. Annual data show that market-based risk factors explain about 37 percent of the variation between firms in returns. Investor returns are also impacted significantly by measures of business risk to counterparties, especially customers, employees and shareholders. The results contribute to growing literature on behavioral corporate finance and shed light on sources of firm-specific risk that now dominate equity risks.