European Financial Management 2016 Archive

January 2017, VOL 23:1 March 2017, VOL 23:2

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