The Volatility of the Firm’s Assets

This paper investigates the conditional volatility of the firm’s assets in contrast to existing studies that focus primarily on equity volatility. Using a novel dataset that allows us to map out significant portions of the capital structure, we examine the volatility properties of asset returns as calculated by a weighted average of equity, bond and loan prices. The two fundamental findings in this paper are that asset volatility is time-varying and that financial leverage matters and has a large influence on equity volatility. Within this backdrop, several new results emerge. First, leverage plays a more important role than previously thought in explaining the well-documented asymmetric volatility effect. Second, equity volatility possesses both a transitory component due primarily to asset volatility and a more permanent component due to financial leverage. Third, in terms of a breakdown of the determinants of equity volatility, we relate implied equity volatility levels and changes to different components of estimated asset volatility (i.e., both idiosyncratic and market, including lagged volatility and asymmetric return shocks) and to leverage at the firm level. *Stern School of Business, NYU ** NBER and Stern School of Business, NYU We would like to thank Rob Engle and seminar participants at the Inaugural Conference of SoFIE.