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 …