European Financial Management 2017 Archive

January 2017, VOL 23:1 March 2017, VOL 23:2 June 2017, VOL 23:3 September 2017, VOL 23:4

European Financial Management, VOL 23:1, January 2017

Bank Risk Dynamics Where Assets are Risky Debt Claims

Sharon Peleg and Alon Raviv

The structural approach views firm’s equity as a call option on the value of its assets, which motivates stockholders to increase risk. However, since bank assets are risky debt claims, bank equity resembles a subordinated debt. Using this assumption, and considering the strategic interaction between a bank and its debtor, we argue that risk shifting is limited to states in which the debtor is in financial distress. Furthermore,risk shifting increases with bankruptcy costs and decreases with bank capital. Thus, increasing a bank’s capital affects stability, not only through the additional capital buffer, but also by affecting the risk shifting incentive.

Keywords: Risk taking, Asset risk, Financial institutions, Stress test, Leverage

JEL Classification: G21, G28, G32, G38

The Market Liquidity Timing Skills of Debt-Oriented Hedge Funds

Baibing Li, Ji Luo and Kai-Hong Tee

We investigate the liquidity timing skills of debt-oriented hedge funds following the 2008 credit crisis, which demonstrated the importance of understanding liquidity conditions to manage the market exposure of investments. We base the analysis on the estimated co-movements of fixed income and equity market liquidity. Our findings, which are statistically robust, show evidence of liquidity timing ability in the fixed income market for all debt-oriented hedge fund strategy categories. Joint market liquidity timing skill, however, is only found in some categories. Our findings suggest that debt-oriented hedge fund managers use a sophisticated set of timing strategies in their investment managements.

Keywords: Fixed income market; hedge funds; liquidity timing skill; market exposure

JEL Classification: G1; G11; G23

Endogenous Credit Spreads and Optimal Debt Financing Structure in the Presence of Liquidity Risk

Eva Luetkebohmert, Daniel Oeltz and Yajun Xiao

We present a structural model that allows a firm to effectively manage its exposure to both insolvency and illiquidity risk inherent in its financing structure. Besides insolvency risk, the firm is exposed to rollover risk through possible runs by short-term creditors. Moreover, asset price volatilities are subject to macro-economic shocks and influence creditors' risk attitudes and margin requirements. Credit spreads are derived endogenously depending on the firm's total default risk. Equity holders have to bear the rollover losses. An optimal debt structure that maximizes the firm's equity value is determined by trading off lower financing costs and higher rollover risk.

Keywords: funding liquidity, optimal capital structure, rollover risk, structural credit risk models

JEL Classification: G01, G32, G33

Financial Flexibility and Investment Ability across the Euro Area and the UK

Annalisa Ferrando, Maria-Teresa Marchica, and Roberto Mura

We use a very large sample of European private and public firms to show that financial flexibility attained through a conservative leverage policy is more important for private, small-medium-sized, and young firms and for firms in countries with less access to credit and weaker investor protection. Further, using the 2007 financial crisis as a natural experiment, we show that a higher degree of financial flexibility allows firms to reduce the negative impact of liquidity shocks on investment. Our findings support the hypothesis that financial flexibility improves companies’ ability to undertake future investment, despite market frictions hampering possible growth opportunities.

Keywords:low leverage, financial flexibility, investment, cross-country analysis

JEL Classification: G31, G32, D92

Announcement Effects of Contingent Convertible Securities: Evidence from the Global Banking Industry

Manuel Ammann, Kristian Blickle and Christian Ehmann

This paper investigates the announcement effects of CoCo bonds issued by global banks between January 2009 and June 2014. Using a sample of 34 financial institutions, we examine abnormal stock price reactions and CDS spread changes before and after the announcement dates. We find that the announcement of CoCos correlates with positive abnormal stock returns and negative CDS spread changes in the immediate post-announcement period. We explain these effects with a set of theories including the lowered probability of costly bankruptcy proceedings, a signaling framework based on pecking order theory and the cost advantage of CoCos over equity (tax shield)

Keywords:contingent convertible securities, CoCo bonds, announcement effects, event study

JEL Classification: G01, G14, G21

Risk control: Who cares?

Nick Taylor

The performance of recently introduced risk-control indices is evaluated and tested with respect to a set of competing indices. Applying a method of moments methodology to these data reveals that the performance of strategies that track risk-control indices have economic and statistical significance to investors with realistic risk aversion parameter values. How- ever, this performance varies over time and appears to be determined by macroeconomic and liquidity conditions.

Keywords:Risk control, volatility, certainty equivalent return, method of moments

JEL Classification: G53, G11, G17

European Financial Management, VOL 23:2, March 2017

A Theoretical Model for the Term Structure of Corporate Credit based on Competitive Advantage

Myuran Rajaratnam, Bala Rajaratnam and Kanshukan Rajaratnam

We derive the term structure of Corporate Credit based on the Competitive Advantage of a firm and the tax deductibility of its interest payments. We consider the competitive advantage enjoyed by the firm as the central tenet of our model and capture its eventual demise in a probabilistic manner. We compensate the bond holder for expected losses and then provide an additional spread based on the tax deductibility of interest payments. Our simple intuitive model appears to overcome some of the well-known shortcomings of structural credit risk models.

Keywords:Term Structure, Corporate Credit, Competitive Advantage, Value-Investing, Credit Spread Puzzle

JEL Classification: EFM 340 Fixed Income; JEL G12 Bond Interest Rates

Due Diligence and Investee Performance

Douglas Cumming and Simona Zambelli

We estimate the economic value of due diligence (DD) in the context of private equity by investigating the relationship between DD and investee performance, while controlling for endogeneity. With the adoption of a novel dataset, we find evidence highly consistent with the view that a thorough DD is associated with improved investee performance. We also distinguish the role of different types of DD and show that the DD performed by fund managers has a more pronounced impact on performance. Instead, the DD mainly performed by external agents, i.e., consultants, lawyers and accountants, gives rise to puzzling results and imperfect matching

Keywords:Due Diligence, Governance, Performance, Private Equity

JEL Classification: G23, G24, G28

Dynamic Asset Allocation with Liabilities

Daniel Giamouridis, Athanasios Sakkas, Nikolaos Tessaromatis

We develop an analytical solution to the dynamic multi-period portfolio choice problem of an investor with risky liabilities and time varying investment opportunities. We use the model to compare the asset allocation of investors who take liabilities into account, assuming time varying returns and a multi-period setting with the asset allocation of myopic ALM investors. In the absence of regulatory constraints on asset allocation weights, there are significant gains to investors who have access to a dynamic asset allocation model with liabilities. The gains are smaller under the typical funding ratio constraints faced by pension funds.

Keywords: Strategic Asset Allocation,Dynamic Asset Allocation, Asset-Liability Management, Return Predictability, Myopic Investors

JEL Classification: G11, G12, G23

Bankers on the Board and CEO Incentives

Min Jung Kang and Young (Andy) Kim

Governance improvement measures often demand more financial experts on corporate boards. Directors from the lending bank require particular attention because the conflicts of interest between shareholders and debtholders would be severe. Hence, we examine whether commercial banker directors work in the best interests of shareholders in providing incentives to the CEO. We find that the CEO’s compensation VEGA is lower if an affiliated banker director is on the board, especially when the director is the chair of the compensation committee. Further, commercial banker directors increase debt-like compensation and make it more sensitive to performance and less sensitive to risk.

Keywords: bankers on board, financial expertise, conflicts of interest, governance, board of directors, CEO compensation

JEL Classification: G14

The Role of the Conditional Skewness and Kurtosis in VIX Index Valuation

Simon Lalancette and Jean-Guy Simonato

The CBOE VIX index is a widely recognised benchmark measure of expected stock market volatility. As shown in the literature, probability distributions other than Gaussian are key features required to describe the dynamics of the S&P 500, the variable that ultimately determines the VIX index level. As such, it is important to assess if deviations from the Gaussian distribution have important impacts on the VIX index level. We examine herein how a model articulated over a time-varying non-Gaussian distribution with conditional skewness and kurtosis can contribute to the overall explanation of the VIX dynamics.

Keywords:VIX, GARCH, skewness, kurtosis, risk-neutral valuation

JEL Classification: C58, G1

European Financial Management, VOL 23:3, June 2017

Does Ownership Structure Matter?

Sheridan Titman

Capital Assets are held in a variety of ownership structures that can be characterized by how they are taxed, whether or not their equity is publicly traded, and by the relationship between the ownership of the assets and the management of the assets. When taxes and regulations change, the popularity of the different ownership structures change. These changes in ownership structure can affect how the assets are managed, which can in turn influence innovation.

Keywords:Corporations, Master Limited Partnerships, Real Estate Investment Trusts, Private Equity, Family businesses

JEL Classification: G31 and G38

Conservative Accounting, IFRS Convergence and Cash Dividend Payments: Evidence from China

William Bradford*, Chao Chen and Song Zhu

We investigate the governance role of conservative accounting in mitigating the creditor–stockholder conflict by affecting firms’ dividend policies, and how the convergence to International Financial Reporting Standards (IFRS) affects the governance role of conservative accounting as it relates to dividend policy. We analyze data on Chinese listed firms from 2000 through 2011. The use of conservative accounting reduced cash dividend payouts, thereby playing a governance role by mitigating the firm’s creditor–stockholder agency conflict. However, China’s convergence to IFRS reduced the governance role of conservative accounting on dividend policy by reducing the accounting conservatism of listed firms in China.

Keywords:accounting conservatism, mandatory IFRS adoption, cash dividend policy.

JEL Classification: G32, G35, G38

Financial Hedging and Firm Performance: Evidence from Cross-Border Mergers and Acquisitions

Zhong Chen, Bo Han and Yeqin Zeng

Using a sample of 1,369 cross-border acquisitions announced by Standard & Poor's 1500 firms between 2000 and 2014, we find strong evidence that derivatives users experience higher announcement returns than nonusers, which translates into a $193.7 million shareholder gain for an average-sized acquirer. In addition, we find that acquirers with hedging programmes have higher deal completion probabilities, longer deal completion times, and better long-term post-deal performance. We confirm our findings after employing an extensive array of models to address potential endogeneity. Overall, our results provide new insights into a link between corporate financial hedging and firm performance.

Keywords: Cross-border M&As; risk management; financial derivatives

JEL Classification: F31; G13; G32; G34

Where will the “Silver Money” Go?

Na Young Park

Using international country-level data, this paper shows that demographic ageing is likely to significantly expand the insurance industry. This expansion is driven by the increased need to secure earnings for post-retirement consumption, the desire to hedge against risks associated with increasing age, and the older generation’s risk aversion to increasing the demand for safer assets such as insurance and pension products. Moreover, such an expansion of the insurance industry is particularly apparent in financially liberalized countries. This is because risk and asset management associated with insurance and pension products could be facilitated and more effective in liberalized financial markets.

Keywords: demographic ageing, demographic change, financial liberalization, insurance industry, insurance markets

JEL Classification: G21, G28, G30

Innovation-Related Diversification and Firm Value

Zhao Rong and Sheng Xiao

We examine a novel determinant of corporate diversification and its valuation effect: corporate innovations. We find consistent evidence that corporate innovations increase the extent of diversification. To establish causality, we estimate the firm fixed effects, 2SLS and GMM models. The 2SLS model uses the U.S. state-level R&D tax credits as an instrumental variable for corporate innovations. We also find that a firm is more likely to diversify into an industry where it has more applicable innovations. Further, such innovation-related diversification is associated with significantly higher firm value. Our results are robust to various measures of corporate innovations.

Keywords:innovation; diversification; firm value

JEL Classification: G34 and O32

Tax Havens, Tax Evasion and Tax Information Exchange Agreements in the OECD

David M. Kemme, Bhavik Parikh and Tanja Steigner

Using data on Foreign Portfolio Investment (FPI), we find a positive relationship between higher tax burden and OECD residents’ tax evasion, especially via tax havens. Contrary to established investor preference for certain country characteristics, we find they are less important to tax evaders who value privacy and want to remain undetected by their home tax authorities. We find very limited evidence that OECD Tax Information Exchange Agreements (TIEAS) reduce tax evasion, controlling for other determinants of overall OECD FPI. Without the US in the OECD sample, tax havens play a lesser role and OECD policies appear to make marginal impact.

Keywords: Tax Haven, Tax Evasion, Foreign Portfolio Investment, Tax Information Exchange Agreements, OECD

JEL Classification: F38, G38, H26

European Financial Management, VOL 23:4, September 2017

The Investment CAPM

Lu Zhang

A new class of Capital Asset Pricing Models (CAPM) arises from the first principle of real investment for individual firms. Conceptually as “causal” as the consumption CAPM, yet empirically more tractable, the investment CAPM emerges as a leading asset pricing paradigm. Firms do a good job in aligning investment policies with costs of capital, and this alignment drives many empirical patterns that are anomalous in the consumption CAPM. Most important, integrating the anomalies literature in finance and accounting with neoclassical economics, the investment CAPM succeeds in mounting an efficient markets counterrevolution to behavioral finance in the past 15 years

Keywords: the investment CAPM, the consumption CAPM, the CAPM, asset pricing anomalies, efficient markets, behavioral finance, the aggregation critique, general equilibrium, the joint-hypothesis problem

JEL Classification: D53, E22, G12, G14, G31

The Manipulation Potential of Libor and Euribor

Alexander Eisl, Rainer Jankowitsch, and Marti G. Subrahmanyam

The London Interbank Offered Rate (Libor) and the Euro Interbank Offered Rate (Euribor) are two key benchmark interest rates used in a plethora of financial contracts. The integrity of the rate-setting processes has been under intense scrutiny since 2007. We analyze Libor and Euribor submissions by the individual banks and shed light on the underlying manipulation potential for the actual and several alternative rate-setting procedures. We find that such alternative fixings could significantly reduce the effect of manipulation. We also explore related issues such as the sample size and the particular questions asked of the banks in the rate-setting process.

Keywords: Money markets, Libor, Euribor, manipulation, collusion

JEL Classification: G01, G14, G18

An Examination of European Firms’ Derivatives Usage: The Importance of Model Selection

Anthony Carroll, Fergal O'Brien, and James Ryan*

This paper investigates the determinants of foreign currency (FX) and interest rate (IR) derivatives usage for European non-financial firms. We employ a Tobit model and a two-part model which allows the determinants of the usage decision to differ from the extent of usage decision. We find FX derivatives usage is motivated by economies of scale and FX exposure, while IR derivatives usage is motivated by the magnitude and nature of firms’ debt. We also find that for IR derivatives the determinants of the usage decision differ from the determinants of the extent of usage decision.

Keywords:foreign exchange exposure, interest rate exposure, hedging policies

JEL Classification: G32

Retail Investor Attention and IPO Valuation

Hugh M. J. Colaco, Amedeo De Cesari, and Shantaram P. Hegde

Given restrictions placed on communication with prospective investors, retail investor attention can help firms/underwriters with the task of initially valuing an IPO. Using Google search volume to proxy for retail investor attention, we find that the presence of and an increase in retail attention following initial filing but prior to initial pricing are positively related to initial valuations. Our results are robust to alternative matching methods to identify our matched sample of non-IPO firms and to including several controls for institutional demand. We conclude that retail investor attention plays a critical role in the early stages of IPO valuation.

Keywords: initial public offering; equity valuation; retail investor; investor attention

JEL Classification: G30; G32

Extreme Returns in the European Financial Crisis

Andreas Chouliaras and Theoharry Grammatikos

We examine the transmission of financial shocks among the euro-periphery (Portugal, Ireland, Italy, Greece, Spain), the euro-core (Germany, France, the Netherlands, Finland, Belgium), and the major European Union (but not euro) countries (Sweden, the United Kingdom, Poland, the Czech Republic, Denmark). Using extreme returns on daily stock market data from 2004 until 2013, we find transmission effects for the tails of the returns distributions for the pre-crisis, US crisis and euro crisis periods from the euro-periphery to the non-euro and euro-core groups. During the crises, the shocks transmitted were more substantial, indicating significantly higher losses on extreme return days.

Keywords: Financial crisis, financial contagion, spillover, euro crisis, stock markets

JEL Classification: G01, G15

Cold Case File? Inventory Risk and Information Sharing during the pre-1997 Nasdaq Preopening

Laurence Lescourret

This paper shows that dealers in OTC markets might choose to share information about transient price pressures. Using data from the pre-1997 NASDAQ preopening, I find that the frequency and magnitude of non-positive spreads (the information-sharing vehicle) initiated by wholesalers (specialized marketmakers with a high exposure to inventory risk) are strongly related to opening price reversals and daily rading imbalances. This activity is more likely to occur on days of large liquidity shocks, and it is not observed for other dealers. Overall, the obligation to absorb price pressure at a yet unknown opening price might induce dealers to communicate the direction in which the opening price should move. The findings contain lessons for the design of today's OTC markets.

Keywords: OTC markets, Preopen, NASDAQ, Information Sharing, Price Reversals

JEL Classification: G12, G14, D82

Relationship Lending and Firms Leverage: Empirical Evidence in Europe

Roberto Guida and Valentina Sabato

Using a novel measure of relationship lending based on the kind of information banks use to assess borrowers, we investigate the role of relationship lending in firms’ capital structure. Using a unique dataset of European manufacturing firms, we measure relationship lending based on three dimensions (closeness, soft information, exclusivity) and relate them to firms’ leverage. Overall our results support the hypothesis that supply factors matter. We find that the actual use of soft information increases leverage and only firms without soft information-intensive relationships increase their leverage through multiple relationships. However, the effect of relationship lending on leverage varies across countries.

Keywords: relationship lending; soft information; capital structure; leverage; financial systems

JEL Classification: D45, G15, G21, G32