RDP 9802: Systematic Risk Characteristics of Corporate Equity 5. Conclusion

The results in this paper have established the following points. There is robust and convincing evidence that equity beta convergence is a behavioural phenomenon. Evidence for this conclusion takes the form of estimated laws of motion for equity betas of individual firms. By dealing with firm level data rather than portfolio data, this study has sidestepped the complications introduced by portfolio formation while emphasising the connection between the characteristics of individual firms and their systematic risk.

The empirical analysis of the previous section strongly suggests that equity returns follow a particular pattern over the corporate life cycle of publicly listed corporations. Upon listing, a firm's beta tends to be relatively mobile and is more likely to be extreme relative to unity compared to firms that have been listed longer. However, over time, newly listed firms tend to drive their betas toward unity. Those that are not successful in forcing their beta into the range between about 0.5 and 1.5 have a substantially greater risk of being delisted than would otherwise be the case. This life-cycle view of equity betas reinforces the behavioural interpretation of equity beta convergence. The explanation of systematic risk convergence based on measurement error aggregation is strongly refuted by the direct evidence from firm level data of convergence and the robust relationship between the extent of convergence and observed characteristics of firms.

These results raise a series of questions. While many features of equity beta (and thus systematic risk) behaviour have been established, no behavioural model has been provided to explain the observations about equity returns. Why should extreme equity betas be associated with a higher risk of reduced managerial entrenchment (delisting)? Is equity beta convergence in the interests of investors? If not, why are investors unable to constrain the actions of those that do determine betas? Because of the separation between the asset-pricing literature and the corporate finance literature, these questions are difficult to frame and answer within existing theoretical frameworks.

The asset-pricing literature has generally taken the firm as an exogenous feature of the economy (with notable exceptions being Brock (1982) and Cochrane (1996) who develop asset-pricing models that explicitly incorporate profit maximising behaviour within firms). From this perspective, there has been little point asking why firms should alter their earnings characteristics in response to the equity pricing consequences of their investment profile and their financial structure.

The literature exploring the economic structure of the firm has, for the most part, developed models with asset-pricing consequences that are insufficiently rich to capture concepts like systematic risk. In most cases, these limitations arise directly from the partial equilibrium framework used to study the forces operating within firms.

Models that address systematic risk convergence need to make explicit the instruments through which firms manipulate their systematic risk. The models must also solve the optimisation problems of the agents controlling the firms to show why these instruments are used to drive the observed convergent behaviour in systematic risk. The development of such models is a fruitful direction for future research.