Debt Covenant Violations and Risk Shifting Behavior

This paper examines the risk-shifting tendencies exhibited by firms when making investment decisions after breaching debt covenants, by employing a real options framework. We employ a GARCH model to measure the conditional expected volatility of the market and find that the risk-shifting motivations of shareholders counteract the anticipated negative eiaelation between investment and volatility as firms violate covenants and become financially distressed. Our empirical analysis confirms the hypothesis that volatility positively impacts the investments of these firms. Additionally, we find that financially distressed firms' investments lead to value deterioration during periods of heightened volatility. Our estimate of the cost of risk-shifting shows that the investment choices of such firms reduce the value of their debt from 4.91% to 7.78%.