European Financial Management 2013 Archive

January 2013, VOL 19:1 March 2013, VOL 19:2 June 2013, VOL 19:3 September 2013, VOL 19:4 November 2013, VOL 19:5

European Financial Management, VOL 19:1, January 2013

Ruminations on Investment Performance Measurement

Wayne E. Ferson

This is a summary of a keynote address to the European Financial Management Symposium on Asset Management in April, 2012. It makes five observations about the state of the art in investment performance measurement. First, the traditional alphas used in performance measurement are not to be trusted as normative indicators for when to buy or sell funds, but Stochastic Discount Factor (SDF) alphas are better. Traditional alphas can be equivalent to the correct SDF alphas, but this requires that an Appropriate Benchmark be used. Third, mean variance efficient portfolios are almost never Appropriate Benchmarks. Fourth, Sharpe ratios can be justified as performance measures, if they are properly used. Finally, current holdings-based approaches to performance measurement are also flawed, but I offer some suggestions for improving them.

Keywords:Mutual funds, Hedge funds, Bond funds, Stochastic Discount factors, Portfolio Holdings, Bootstrap, Market efficiency, Portfolio Management.

JEL Classification: G11, G14, G23

Deposit Finance as a Commitment Device and the Optimal Debt Structure of Commercial Banks

Jochen Lawrenz and Matthias Bank

We consider a regulated bank with access to bond and insured deposit financing. Bank manager-owners have specific abilities, which allows them to extract rents. We show that deposit finance acts as a commitment device that has the potential to raise the overall debt capacity of the bank and increases pledgeable assets. Our focus is on the optimal mix of bond and deposit financing. We find that in the optimum, the bank chooses a debt structure so as to align internal incentives with external constraints. The model predicts that banks with more risky assets or with more specialized human capital use deposit financing to a lesser extent.

Keywords:Deposit financing, Commitment device, Bank capital structure, Debt structure, Contingent claims valuation

JEL Classification: G21, G32

Margin Changes and Futures Trading Activity: A New Approach

Kate Phylaktis and Antonis Aristidou

In this paper we examine the impact of margins, adjusted for underlying price risk proxied by market volatility, on trading volume and incorporate the relationship between trading volume and price volatility documented in stock markets. We estimate a bivariate GARCH-M model to take account of the inter-relationships and apply them to the Greek derivatives market over the period 1999-2005. The results show that when adjusting margins for market risk there is no impact on trading volume, casting doubts on the results of previous research, and providing support for the view that margin requirements are used only as a mechanism to prevent trader default.

Keywords:Margin Requirements, Financial Market Volatility-Volume, Athens Stock Exchange

JEL Classification: G1, G14, G18

Private Equity Acquisitions of Continental European Firms - The Impact of Ownership and Control on the Likelihood of Being Taken Private

Ann-Kristin Achleitnera, Andr顂etzerb, Marc Goergenc and Bastian Hinterramskogler

This paper studies the motives behind private equity acquisitions of publicly listed firms in continental Europe. As corporate control and ownership in continental Europe tend to be highly concentrated, we argue that it is important to take into account the incentives of the incumbent large shareholder to monitor the management and the private benefits of control the latter may derive from the firm when measuring the likelihood of the firm being taken over by a private equity investor. We find strong and consistent evidence that both have a significant impact on the likelihood of a private equity acquisition.

Keywords:Private equity, going private, continental Europe, ownership

JEL Classification: G34

Common Factors in Default Risk Across Countries and Industries

Kevin Aretz and Peter F. Pope

Global economic crises appear to strongly affect corporate bankruptcy rates. However, several prior studies indicate that changes in default risk are strongly negatively related to equity returns, which in turn depend predominately on country-specific factors. This suggests that country effects - and not global effects - should dominate changes in default risk. To analyze this issue, we decompose changes to default risk, changes to the fundamental determinants of default risk and equity returns into global, country and industry effects. We proxy for default risk through Merton (1974) default risk estimates and CDS rates. Our evidence reveals that changes in default risk always depend most strongly on global and industry effects. However, the magnitude of country effects in equity returns correlates positively with economic stability, rendering it dependent on the studied sample period. Our results have implications for the management of credit-sensitive securities.

Keywords:Default risk, country and industry factors, variance decompositions

JEL Classification: G11, G12, G15

The Analysis of Real Data using a Multiscale Stochastic Volatility Model

Lorella Fatone, Francesca Mariani, Maria. C. Recchioni, Francesco Zirilli

In this paper we use filtering and maximum likelihood methods to solve a calibration problem for a multiscale stochastic volatility model. The multiscale stochastic volatility model considered has been introduced in Fatone et al. (2009), generalizes the Heston model and describes the dynamics of the asset price using as auxiliary variables two stochastic variances on two different time scales. The aim of this paper is to estimate the parameters of this multiscale model (including the risk premium parameters when necessary) and its two initial stochastic variances from the knowledge, at discrete times, of the asset price and, eventually, of the prices of call and/or put European options on the asset. This problem is translated into a maximum likelihood problem with the likelihood function defined through the solution of a filtering problem. Furthermore we develop a tracking procedure that is able to track the asset price and the values of its two stochastic variances for time values where there are no data available. Numerical examples of the solution of the calibration problem and of the performance of the tracking procedure using high frequency synthetic data and daily real data are presented. The real data studied are two time series of electric power price data taken from the U.S. electricity market and the 2005 data relative to the U.S. S&P 500 index and to the prices of a call and a put European option on the U.S. S&P 500 index. The calibration procedure is applied to these data and the results of the calibration are used in the tracking procedure to forecast the asset and option prices. The forecasts of the asset prices and of the option prices are compared with the prices actually observed. This comparison shows that the forecasts are of very high quality even when we consider \spiky" electric power price data. The website: contains some auxiliary material including animations that help with the understanding of this paper. A more general reference to the work of the authors and of their coauthors in mathematical finance is the website:

Keywords:Multiscale stochastic volatility models, filtering problems, calibration model, option pricing

JEL Classification: C53, G12, C61

Are Private Equity Investors Boon or Bane for an Economy? - A Theoretical Analysis

Christian Koziol, Sebastian Ernst and Denis Schweizer

In this paper, we provide a theoretical foundation for the controversial de- bate on the investment behaviour of private equity investors. We separately consider six major characteristics that typically distinguish private equity in- vestors from standard investors. Applying a simple model framework, we compare both the maximum acquisition prices paid by private equity and standard investors for the takeover of a target firm, as well as the subsequent optimal investment volumes. This analysis intends to uncover why private equity investors do (or do not) acquire a company even though they later invest less than standard investors would. We find that most of the usual arguments against private equity transactions, such as higher target return, short-term investment perspective, lower risk aversion, and operational im- provements, cannot explain lower investment volume following a successful takeover by private equity firms, in contrast to other arguments, such as high level of leverage and informational advantages.

Keywords:Private equity, Leveraged buyout (LBO), Takeover competition, Investment strategy

JEL Classification: D40, D61, G34

European Financial Management, VOL 19:2, March 2013

Hedge Fund Characteristics and Performance Persistence

Markus Schmid, Manuel Ammann and Huber Otto

In this paper, we investigate the performance persistence of hedge funds over time horizons between 6 and 36 months based on a merged sample from the Lipper/ TASS and CISDM databases for the time period from 1994 to 2008. Unlike previous literature, we use a panel probit regression approach to identify fund characteristics that are significantly related to performance persistence. We then investigate the performance of two-way sorted portfolios where sorting is based on past performance and one of the additional fund characteristics identified as persistence-enhancing in the probit analysis. We find statistically and economically significant performance persistence for time horizons of up to 36 months. Although we identify several fund characteristics that are strongly correlated with the probability of observing performance persistence, we find only one fund characteristic, a strategy distinctiveness index that attempts to measure manager skills and the uniqueness of the hedge fundӳ trading strategies, to have the ability to systematically improve performance persistence up to a time horizon of 24 months. The economic magnitude of this improvement amounts to a sizeable increase in alpha by approximately 4.0% and 2.3% p.a. for annual and biennial rebalancing, respectively.

Keywords:Hedge Funds, Performance, Alpha, Factor Models, Performance Persistence

JEL Classification: G11, G12, G23

Does Foreign Portfolio Investment Reach Small Listed Firms?

April Knill

Because investors generally choose to invest in large firms when investing internationally, it is not immediately obvious whether small listed firms would benefit from foreign portfolio investment. A capital infusion of this form could either serve to alleviate constrained capital markets or make large firms stronger, increasing competition and crowding out small firms. In this paper, I examine the impact of foreign portfolio investment on the capital issuance behavior of small listed firms. I find that foreign portfolio investment (scaled by gross domestic product) is associated with an increased probability of small firm security issuance in all nations, regardless of property rights development. Evidence suggests that the mechanism by which this occurs is a freeing up of capital in domestic markets when large firms utilize foreign investment directly. Long-term debt levels increase in nations where property rights are more developed, suggesting that foreign portfolio investment may reach small firms through the banking channel as well in these nations. The banking channel results, however, are somewhat sensitive to the definition of foreign portfolio investment.

Keywords:foreign portfolio investment, access to capital, emerging markets, small firm

JEL Classification: D92, F32

A, B or C? Experimental Tests of IPO Mechanisms

Stefano Bonini and Olena Voloshyna

Empirical research has provided extensive evidence on the ine ciency of bookbuilding in controlling underpricing. Both academics and practitioners have investigated this phenom- enon proposing innovative oťring methodologies. In this paper we explore the information revelation and underpricing properties of two baseline models, uniform auctions and book- building, and two newly proposed mechanisms, Ausubel auction and Competitive IPO. Our ?ndings con?rm the empirical weaknesses of bookbuilding and provide hints that standard auctions may stimulate less bidding. However, (a) the Competitive IPO features increase competition both among banks and among investors resulting in more information revelation and less underpricing than standard bookbuilding; and (b) the Ausubel auction yields supe- rior price discovery and underpricing outcomes than uniform clock auction and bookbuilding. Our experimental results provide novel insights to the ongoing debate on optimal equity oťr- ing mechanisms, suggesting that the solution to current issuing methodologies shortcomings may require the development of a "hybrid" procedure blending properties of existing and new mechanisms.

Keywords:IPO, Bookbuilding, Underpricing, Experiments, Auctions

JEL Classification: C92, D44, G11, G24

Do Bank Profits Converge?

John Goddard, Hong Liu, Philip Molyneux and John O.S.Wilson

This paper examines the determinants and convergence of bank profitability in eight European Union member countries, between 1992 and 2007, using a dynamic panel model. Average profitability is higher for banks that are efficient and diversified, but lower for those that are more highly capitalized. There is evidence of persistence of excess profit from one year to the next. The persistence of profit was lower in 1999-2007 than it was in 1992-98 in all eight countries. This finding is consistent with the hypothesis of an increase in the intensity of bank competition as a result of an increase in the integration of EU financial markets following the introduction of the euro in 1999, and the implementation of the Financial Services Action Plan.

Keywords:Banking, competition, convergence, dynamic panel estimation, integration, profitability, persistence

JEL Classification: G21, L11

International Capital Flows into the European Private Equity Market

Gael ImadӅddine and Armin Schwienbacher

In this paper, we explore the relationship between institutional investors and funds managers, a relatively little studied field in private equity. We study this relationship within the context of international investment flows. We address the following question: When building risk-return exposure to European private companies, which US limited partners (LPs) are more likely to invest in US funds investing in European targets as opposed to in European funds investing locally? We build our research using a two-level analysis. We first look at which US LPs are more likely to invest in funds focusing on Europe (regardless of whether a US or European fund) to identify the active global players. And second, using only the subsample of LPs investing in Europe-focused funds, we study which types of LPs are more likely to provide capital to European funds investing locally as opposed to US funds with a European focus. We find that financial institutions with facilities in Europe, such as banks and insurance companies, are more prone to invest directly in European funds. This is consistent with the transaction cost hypothesis whereby LPs may benefit from lower costs to access valuable information to screen European funds. The presence of local facilities may further capture size effects. We also find that pension funds often invest directly in European funds although those funds do not possess local facilities in Europe. This may be due to their larger size that drives them to invest abroad or their increased experience in investing in private equity.

Keywords:private equity, international capital flows, fund management

JEL Classification: F21; F3; G23; G24

Fixed Odds Bookmaking with Stochastic Betting Demands

Stewart Hodges, Hao Lin and Lan Liu

This paper studies fixed odds bookmaking in the market for bets in a British horse race. The bookmaker faces the risk of unbalanced liability exposures. Even random shocks in the noisy betting demands are costly to the bookmaker since his book could become less balanced. In our model, the bookmaker sets appropriate odds to influence the betting flow to mitigate the risk. The stylized fact of the favorite-longshot bias only arises from the model under specific assumptions. Our model offers insights into the complexity of managing a series of state contingent exposures such as options.

Keywords:Horse betting, bookmaking, state-contingent claims

JEL Classification: G10, G13

European Financial Management, VOL 19:3, June 2013

Tax-adjusted Discount Rates: A General Formula under Constant Leverage Ratios

Peter Molnar and Kjell Nyborg

Cooper and Nyborg (2008) derive a tax-adjusted discount rate formula under a constant proportion leverage policy, investor taxes and risky debt. However, their analysis assumes zero recovery in default. We extend their framework to allow for positive recovery rates. We also allow for differences in bankruptcy codes with respect to the order of priority of interest payments versus repayment of principal in default, which may have tax con- sequences. The general formula we derive differs from that of Cooper and Nyborg when recovery rates in default are anticipated to be positive. However, under continuous rebal- ancing, the formula collapses to that of Cooper and Nyborg. We provide an explanation for why the effect of the anticipated recovery rate is not directly visible in the general con- tinuous rebalancing formula, even though this formula is derived under the assumption of partial default. The errors from using the continuous approximation formula are sensitive to the anticipated recovery in default, yet small. The ԣost of debtԠin the tax adjusted discount rate formula is the debtӳ yield rather than its expected rate of return.

Keywords:tax-adjusted discount rates, tax shields, risky debt, cost of debt, personal taxes, partial default

JEL Classification: G31, G32

Bank Size and Systematic Risk

Amelia Pais and Philip A. Stork

The global financial crisis that started in mid-2007 illustrates the relevance of systemic risk. One key driver of the systemic instability that materialized in the crisis was the elevated level of stress in large banks. We use EVT to analyse the effect of size on banksҠunivariate and systemic risk across ten countries as well as across the EU. Our findings show that size has little impact on banksҠunivariate risk (as measured by VaR), but that large banks have significantly higher systemic risk. Furthermore, systemic risk has significantly increased for banks of all sizes since the beginning of the crisis.

Keywords:systemic risk, banks, Extreme Value Theory, too big to fail

JEL Classification: C14, G01, G15, G21

Product Market Competition, Corporate Governance, and Firm Value: Evidence from the EU-Area

Markus Schmid, Manuel Ammann and David Oesch

This paper investigates whether the valuation effect of corporate governance depends on the degree of competition in the companiesҠproduct markets in a large international sample covering 14 countries from the European Union (EU). Besides providing external validity of previous U.S.-centered studies, the study uses more comprehensive and reliable measures of both product market competition and corporate governance. Consistent with the hypothesis that product market competition acts as a substitute for corporate governance as competitive pressure enforces discipline on managers to maximize firm value, our results show that corporate governance significantly increases firm value in non-competitive industries only. When investigating the channels through which firm value may be increased, we find that good governance for firms in non-competitive industries leads them to have more capital expenditures, spend less on acquisitions and be less likely to diversify. Our results are robust to a large number of robustness checks including the use of alternative measures of competition and governance, as well as using alternative regressions specifications.

Keywords:Product market competition, Corporate governance, Firm valuation

JEL Classification: G34, G38, L1

Stochastic Volatility Jump-Diffusions for European Equity Index Dynamics

Andreas Kaeck and Carol Alexander

Major research on equity index dynamics has investigated only US indices (usually the S&P 500) and has provided contradictory results. In this paper a clarification and extension of that previous research is given. We find that European equity indices have quite different dynamics from the S&P 500. Each of the European indices considered may be satisfactorily modelled using either an affine model with price and volatility jumps or a GARCH volatility process without jumps. The S&P 500 dynamics are much more difficult to capture in a jump-diffusion framework.

Keywords:Equity Indices, Jump-Diffusions, Generalized Autoregressive Conditional Heteroscedasticity, GARCH, Markov Chain Monte Carlo, MCMC

JEL Classification: C15, C32, G15

Herding in a Concentrated Market: A Question of Intent

Phil Holmes, Vasileios Kallinterakis and M P Leite Ferreira

Abstract:While considerable evidence exists that institutions herd, the issue of why herding takes place remains unresolved. Using monthly holdings data for Portugal, we find clear evidence of herding and investigate whether such behaviour is intentional or spurious. By analysing herding under different market conditions, we conclude it is intentional. Month-of-the-quarter analysis suggests reputational reasons drive behaviour. Results are consistent with herding interacting with window dressing to determine funds buy and sell decisions. The findings are important in understanding market dynamics and fund managersҠbehaviour and are of great significance to investors in managed funds.

Keywords:Herding, window dressing, institutional trading

JEL Classification: G1, G14

Does State Street Lead to Europe? The Case of Financial Exchange Innovations

Mari Komulainen and Tuomas Takalo

We study whether financial exchange innovations are patentable in Europe. We find that exchange-related patent applications surged after the State Street decision. The majority of the applications come from the United States, investment banks and exchanges being among the most active innovators. But the applications seldom result in valid patents, and the post-grant opposition rate is very high. The evidence suggests that patentability standards for financial innovations have not weakened in Europe after the State Street decision and that the combination of inventive step and technical contribution requirements constitutes a major obstacle for applicants seeking financial patents in Europe.

Keywords:Finance patents, business method patents, stock exchanges, management of financial innovations, patent policy

JEL Classification: G24, G28, K29, O32, O34

Forecasting Beyond Fundamentals: Investor Sentiment and Exchange Rate Forecasting

Sebastian Heiden, Christian Klein, Bernhard Zwergel

This paper examines the relation between investor sentiment and exchange rate movements. We use a unique dataset of private and institutional investorsҠsentiment and discover that institutional sentiment significantly predicts returns over medium-term horizons in the EUR/USD market. While institutional investors seem to correctly identify the medium-run direction of this market, private investorsҠsentiment emerges as a contrarian indicator at first sight, however, its predictive power fluctuates heavily and is sample dependent. Our results point towards local investors having an informational advantage in exchange rate forecasting. We test for economic relevance with a simple but realistic out-of-sample trading strategy which yields significant results.

Keywords:Investor Sentiment, Exchange Rates, Institutional Investors, Private Investors, Long-Horizon Regressions, Bootstrapping

JEL Classification: F31, G14

Tiny Prices in a Tiny Market: Evidence from Portugal on Optimal Share Prices

Joao Pedro Pereira and Teresa Cutelo

The Portuguese stock market provides a natural experiment to analyze theories of optimal price per share. The particular characteristics of this market suggest that prices per share should be very low. Using a sample of 20 stocks from the main Portuguese Stock Index (PSI20) in Jan/1999׊un/2010, we observe that Portuguese corporations indeed seek extremely low prices per share through stock splits and similar actions. However, we find that low-price stocks are actually less liquid than high-price stocks. Furthermore, low-price stocks trade at lower valuation ratios. Our results do not support any of the existing theories on optimal price per share and therefore increase the nominal share price puzzle.

Keywords:Price per share, liquidity, valuation, stock split

JEL Classification: G12

Optimal Portfolio Allocation for Corporate Pension Funds

David McCarthy and David Miles

We model the asset allocation decision of a stylized corporate defined benefit pension plan in the presence of hedgeable and unhedgeable risks. We assume that plan fiduciaries ֠who make the asset allocation decision ֠face non׬inear payoffs linked to the planӳ funding status because of the presence of pension insurance and a sponsoring employer who may share any shortfall or pension surplus. We find that even simple asymmetries in payoffs have large and highly persistent effects on asset allocation, while unhedgeable risks exert only a small effect. We conclude that institutional details are crucial in understanding DB pension asset allocation.

Keywords:defined-benefit pension plans, portfolio allocation, moral hazard, pay-off asymmetries

JEL Classification: G11, G23, G34

European Financial Management, VOL 19:4, September 2013

Regulating Banking Bonuses in the European Union: A Case Study in Unintended Consequences

Kevin J. Murphy

Beginning in 2014, the European Union (EU) will limit the amount of bankersҠbonuses to the amount of fixed remuneration; the cap could be increased to 2:1 with the backing of a supermajority of shareholders. I demonstrate that the pending EU regulations restrictions will: (1) increase rather than decrease incentives for excessive risk taking; (2) result in significant increase in fixed remuneration; (3) reduce incentives to create value; (4) reduce the competitiveness of the EU banking sector; and (5) result in a general degradation in the quality of EU investment bankers, thereby decreasing access to capital and increasing the cost of capital.

Keywords: Executive compensation, CEO pay, Banking Bonuses, Financial Crisis, Regulation, European Union

JEL Classification: G32, G34, G38, J33, M12, M52, N20

Banking Regulations after the Global Financial Crisis, Good Intentions and Unintended Evil

Jean Dermine

In this essay, we analyze the impact of the capital and liquidity regulations and call attention to the fact that the banksҠresponses might create unintended evil: a reduced supply of bank loans, incentives to securitize assets, and adverse incentives on bank risk monitoring. The conclusion is that privately-based mechanisms that put most creditors at risk are the best way to increase the soundness of banking markets. It is argued that interbank debt should be put at risk because banks have a comparative advantage in risk monitoring. As putting short-term interbank at risk increases the danger of sudden deposit withdrawals, a mechanism is needed to extend the maturity of short-term debt at the time of a credit-led panic.

Keywords: banking ; bank regulation

JEL Classification: G21 ; G28

Political Connection, Financing Frictions, and Corporate Investment: Evidence from Chinese Listed Family Firms

Nianhang Xu, Xinzhong Xu, and Qingbo Yuan

Using a sample of Chinese family firms from 2000 to 2007, we investigate the investment behaviour of family firms and the effects of these firmsҠpolitical connectedness on their investments in a relationship-based economy. Consistent with previous evidence that Chinese family firms have difficulty in financing, our results demonstrate that underinvestment due to problems with asymmetric information rather than overinvestment resulting from problems of free cash flow prevails in such firms. We further find that the political connectedness of family firms can help mitigate the underinvestment problem, with the mitigation effect being more pronounced in financially constrained firms.

Keywords:Political Connection, Corporate Investment, Family Firm, China

JEL Classification: G32, G34

Time-Varying World and Regional Integration in European Emerging Equity Markets

Ming-Chieh Wang and Feng-Ming Shih

This study investigates the time-varying world and regional integration in emerging European markets. Dividing the world effect or regional effect into return and volatility spillovers, we also examine the time variation in these spillover effects on the conditions of economic growth. Our results show that growth effect and currency depreciation can predict the degrees of integration and spillover effects for these markets. Growth effect on the level of regional integration is larger in the group adopting floating exchange rate regimes than adopting exchange controls. World effect on European returns is stronger when developed European region is in a recession. However, regional effect on the volatility of emerging Europe is greater during faster economic growth or weaker-than-expected growth.

Keywords:Volatility spillover, Regional and world integration, Economic growth, Exchange rate

JEL Classification: G12, G15

Short-Term Herding of Institutional Traders: New Evidence from the German Stock Market

Dieter Nautz and Stephanie Kremer

This paper employs a new and comprehensive data set to investigate short-term herding behavior of institutional investors. Using data of all transactions made by financial institutions in the German stock market, we show that herding behavior occurs on a daily basis. However, in contrast to longer-term herding measures obtained from quarterly data, results based on daily data do not indicate that short-term herding tends to be more pronounced in small capitalized stocks or in times of market stress. Moreover, we find that herding measures based on anonymous transactions can lead to misleading results about the behavior of institutional investors during the recent financial crisis.

Keywords:Herding, Investor Behavior, Institutional Trading, Anonymous Trans-action Data

JEL Classification: D81, G11, G24

More Than Just Contrarians: Insider Trading in Glamour and Value Firms

Alan Gregory, Rajesh Tharyan and Ian Tonks

This study examines the patterns of, and long-run returns to, directorsҠ(insidersҩ trades along the Value/Glamour continuum in all stocks listed on the main London Stock Exchange from 1986-2003, and analyzes what these directorsҠtrades add to a Ԯa෥Ԡvalue-glamour strategy. We consider alternative definitions of ԶalueԠin defining trades and in the construction of our benchmark portfolios so that directorsҠtrades are evaluated net of any value-glamour effect, variously defined. We find that directors consistently trade in a contrarian fashion, buying more ԶalueԠstocks and selling more ԧlamourԠstocks, with purchases following price falls and sales following price rises. DirectorsҠԢuyԠsignals in ԶalueԠstocks generate significant positive abnormal returns while the ԳellԠsignals in ԧlamourԠstocks generate smaller and generally insignificant negative returns. In contrast to the results from US studies, we find that the positive abnormal returns in ԶalueԠstocks persist for up to two-years after the initial directorsҠtrading signal. Abnormal returns are particularly concentrated in smaller value stocks, and are robust to alternative definitions of ԶalueԮ

Keywords:Insider trading, value, glamour

JEL Classification: G14

Regulation Fair Disclosureӳ Effect on the Information Content of Bond Rating Changes

Winnie P. H. Poon and Evans Dorla

The SEC implemented Regulation Fair Disclosure (Reg FD) in 2000. Reg FD requires firms to release material information to everyone simultaneously, thereby reducing information asymmetry between favoured stock analysts and others. Bond rating agencies were exempt from Reg FD in order to continue receiving the private firm information necessary for accurate credit default assessments. The exemption, if valuable to the bond market, should have resulted in an increase in the relative importance of bond rating changes on bond yield premia when Reg FD was implemented. In the first empirical study on the impact of Reg FD on the bond markets, we explore this hypothesis by measuring bond yield premia reactions to bond rating changes around the implementation of Reg FD. For downgrades, we find the impact of Reg FD is related to firm size. The smallest firms experienced a significantly weaker bond yield premia response. The evidence for the relevance of Reg FD for upgrades is weak. Contrary to concerns from the Bond Market Association, it appears Reg FD lessened the impact of downgrades on the smallest firms, and did not affect speculative-grade bonds or bonds with higher debt levels.

Keywords:Regulation Fair Disclosure, Bond Rating Agency, Information Asymmetry, Information Disclosure, Bond Rating Changes, Credit Rating

JEL Classification: G24; G28

IRC and CRM: Modelling Framework for the Ԃasel 2.5ԠRisk Measures

Sascha Wilkens, Jean-Baptiste Brunacand Vladimir Chorniy

This paper presents a modelling framework for the Incremental Risk Charge (IRC) and Comprehensive Risk Measure (CRM) as the new capital requirements for market risks in a bankӳ trading book (Ԃasel 2.5ԩ. Both are Value-at-Risk-type measures projecting losses over a one-year capital horizon at a 99.9% confidence level and are applicable to credit flow and credit correlation instruments, respectively. With no consensus on industry standards for suitable internal models as yet, the article discusses selected risk factor models to derive simulation-based loss distributions and the associated risk figures. Example calculations and implementation aspects complement the discussion.

Keywords: Incremental Risk; IRC; Comprehensive Risk; CRM; Basel 2.5.

JEL Classification: G13; G18.

Consistent Cash Flow Valuation with Tax-deductible Debt: A Clarification

Michael Dempsey

Massari, Roncaglio and Zanetti (2008) argue that the weighted average cost of capital (WACC) approach to discounting expected cash flows is generally inconsistent with the adjusted present value (APV) approach. We show that their argument results from, first, taking a WACC expression that assumes a fixed level of debt in perpetuity and applying it to a scenario where the debt level varies stochastically; and, second, discounting the tax savings from stochastic debt at the rate appropriate for fixed debt. Our paper draws attention to the fundamental proposition by which such errors are avoided when cross-referencing valuation methods. The outcome is that the APV and WACC methods are shown to be algebraically consistent with each other.

Keywords:valuation techniques, growth, APV, wacc, tax-shields

JEL Classification: G31, G32

European Financial Management, VOL 19:5, November 2013

Was There Ever a Lending Channel?

Eugene F. Fama

The lending channel model posits that control of deposits that have reserve requirements allows the Fed to constrain the loans to businesses and consumers that are the comparative advantage of banks. The constraint works because banks do not use traded assets and liabilities with no reserve requirements to offset the effects of variation in deposits on loans. The results presented here are more consistent with an alternative model in which profit-maximizing banks vary traded assets and liabilities with and without reserve requirements to exercise profit opportunities in loans and so shield them from the Fed.


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Does One Size Fit All? The Consequences of Switching Markets with Different Regulatory Standards

Tim Jenkinson and Tarun Ramadorai

As the regulation of public companies has tightened, many companies have switched to stock exchanges with lower regulatory requirements. We analyse the consequences for smaller quoted companies of switching between the two London markets, which differ in their regulatory regimes. Firms that switch to lighter regulation experience, on average, negative announcement returns of approximately 5%. However there is a longer-term upward drift in stock returns after the switch. We relate these financial returns to improvements in operating performance in the years following the switch, suggesting that for some companies, and their investors, a lighter regulatory environment may be appropriate.

Keywords: stock markets, listing, regulation, switching

JEL Classification: G14, G30

Risk Management for Italian Non-Financial Firms: Currency and Interest Rate Exposure

Gordon M. Bodnar, Costanza Consolandi, Giampaolo Gabbi and Ameeta Jaiswal-Dale

This paper surveys risk management practices among Italian non-financial firms. This paperӳ contribution lies in investigating derivative usage particular to Italian businesses, a group whose public disclosure of derivative instruments is not routine. Italy is characterized by a high percentage of small and medium sized family run firms. The survey examines determinants of currency and interest rate derivative use with respect currency and to firm size, geographical location, rating, industry, access to capital markets and educated management. The results from the logistic regressions suggest that Italian non-financial firmsҠ use of derivative contracts is strongly influenced by these characteristics.

Keywords:risk management; derivatives; hedging; corporate finance

JEL Classification: F30; G15; G32

Trade Timing, Price Volatility and Serial Correlation

Ming-Chang Wang and Lon-Ping Zu

This study sets up a multiple-period, competitive rational expectations model to facilitate an examination into how informed traders time their trading on private information so as to maximize their expected utility. We find that, in equilibrium, informed traders may elect to trade late on their information, a result which contradicts other competitive rational expectations models in which it is generally assumed that informed traders will trade immediately upon receiving private information. Our results imply that price volatility will increase and price changes may display positive serial correlation. This phenomenon helps to explain the excess volatility puzzle of asset prices and medium-term continuations (momentum).

Keywords: Asymmetric information, Informed trading, Price volatility, Rational expectations model, Serial correlation, Trade timing.

JEL Classification: G11, G12, G14

An International Perspective on Risk Management Quality

Nick Taylor and Svetlana Mira

This paper introduces an alternative method for assessing the quality of risk management models. Specifically, using the forecast efficiency notion that forecast errors should be independent of a pertinent information set, we consider the extent to which unanticipated downside risk (extreme risk) is independent of overseas extreme risk. This is achieved using a bootstrap version of the non-causality test recently introduced by Hong et al (2009), data covering 45 international equity markets, and by measuring extreme risk via a class of risk management models recently introduced by Xiao and Koenker (2009). In doing this, we find significant evidence of transmission (causality) across national borders. Moreover, we discuss how risk managers in developed and emerging markets can parsimoniously incorporate such information (international dependency) into their risk management models to produce measures of downside risk that have more desirable ex post properties (viz. forecast efficiency properties).

Keywords:Value at risk, extreme risk, causality

JEL Classification: C22, C52, G15

Managers' Private Information, Investor Underreaction and Long-run SEO Performance

Pawel Bilinski and Norman Strong

For a sample of 2,879 SEOs by US stocks from 1970ֲ004, this paper decomposes an average three-year post-issue buy-and-hold abnormal return of -25.9% (relative to size- and B/M-matched non-issuing stocks) into two components. One component, representing 41% of the total, is due to lower risk exposure. The second component, representing the remaining 59%, is abnormal performance related to the surprise element of the issue decision, which the paper attributes to managersҠprivate information that the market does not incorporate into the announcement return. This second component results in abnormal returns during the 16 months after the offering.

Keywords:managerial private information, investor underreaction, seasoned equity issues, long-run performance

JEL Classification: G1, G2, G3

Corporate governance and the value of excess cash holdings of large European firms

Marc Schauten, Dick van Dijk and Jan-Paul van der Waal

We examine the relation between the quality of corporate governance and the value of excess cash for large publicly listed European firms from common-law and civil-law countries. Besides different law origins, we distinguish different dimensions of corporate governance by using ratings for the quality of Shareholder rights, Takeover defences, Disclosure and Board structure. We find that the value of excess cash is positively related to the Takeover defences score only. This finding is mainly driven by firms from common-law countries. If we focus on changes in the level of excess cash, we do find significant effects for civil-law country firms, where the marginal value of 1 of excess cash in a poorly governed firm is only 0.78 while the value is 1.10 for a good governed firm. We furthermore show that the spending of excess cash by poorly governed firms has a negative impact on their operating performance.

Keywords:corporate governance, excess cash, take-over defences

JEL Classification: G30, G32, G34

Hedge Fund Activism and Information Disclosure: The Case of Germany

Peter Weber and Heinz Zimmermann

Based on the German regulatory framework, we provide a more detailed picture of the information disclosure process surrounding the announcement of major shareholdings of hedge funds in listed companies. We separate price and volume effects between three event dates: the transaction date when the investor reaches a notification threshold, the announcement date when potential insiders (the target firm and the regulator) receive advance information, and the publication date when the information is officially released to the public. This separation makes it possible to analyze information and price pressure effects in some detail. The paper also documents the extent and nature of delays in hedge fundsҠnotification behaviour.

Keywords:Shareholder activism, Hedge funds, Corporate governance, Mandatory disclosure

JEL Classification: G14, G34, G23, K22