European Financial Management 2018 Archive


January 2018, VOL 24:1 March 2018, VOL 24:2

European Financial Management, VOL 24:1, January 2018


Investment Beliefs of University Endowments


Andrew Ang, Adnres Ayala and William N. Goetzmann


Abstract:
American university and college endowments now hold close to one-third of their portfolios in private equity and hedge funds. We estimate that at the end of 2012, the typical endowment believes that its private equity investments will outperform a portfolio of conventional assets by 3.9% per year and that hedge funds will outperform by 0.7% per year, and these out-performance beliefs have increased over time. Private universities, universities with larger endowments and higher spending rates, and those that rely more on the endowment to meet operational budgets tend to believe that alternatives deliver higher alphas.

Keywords: Hedge funds, private equity, alternative assets, portfolio choice, asset allocation


JEL Classification: G11, G14, G23



Consistent Valuation of Project Finance and LBO's using the Flows-to-equity Method


Ian Cooper and Nyborg Kjell


Abstract:
The flows-to-equity method is used to value transactions where debt amortises according to a fixed schedule, requiring a formula that links the changing leverage with a time-varying equity discount rate. We show that extant formulas yield incorrect valuations because they are inconsistent with the basic assumptions of this method. The error from using the wrong formula can be large, especially at currently low interest rates. We derive a formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress. We resolve an important issue about what to use as the cost of debt.

Keywords: valuation, flows-to-equity, equity cash flow, cost of equity, project finance, LBO, cost of debt


JEL Classification: G12, G24, G31, G32, G33, G34



Maximum Diversification Strategies Along Commodity Risk Factors


Simone Bernardi, Markus Leippold, and Harald Lohre


Abstract:
Pursuing risk-based allocation across a universe of commodity assets, we nd diversi ed risk parity (DRP) strategies to provide convincing results. DRP strives for maximum diversi cation along uncorrelated risk sources. A straightforward way to derive uncorrelated risk sources relies on principal components analysis (PCA). While the ensuing statistical factors can be associated with commodity sector bets, the corresponding DRP strategy entails excessive turnover because of the instability of the PCA factors. We suggest an alternative design of the DRP strategy relative to common commodity risk factors that implicitly allows for a uniform exposure to commodity risk premia.

Keywords: Commodity Strategies, Risk-Based Portfolio Construction, Risk Parity, Diversi - cation


JEL Classification: G11, D81



Market-based Estimates of Implicit Government Guarantees in European Financial Institutions


Lei Zhao


Abstract:
I exploit the price differential of credit default swap (CDS) contracts written on debts with different levels of seniority to measure the implicit government guarantees enjoyed by European financial institutions from 2005 to 2013. I determine that the aggregate guarantee increases substantially during the recent financial crises and peaks at an average of 89 bps in 2011. My analysis suggests that the extent of implicit support depends on the type of financial institutions and there exists a Eurozone effect. Further investigation of feedback relationship shows that the guarantee implicitly offered by a government positively “Granger causes” the sovereign’s default risk.

Keywords: Credit default swap, financial crisis, financial institutions, implicit government guarantees, too-big-to-fail


JEL Classification: G01, G21, G28



Optimal Ownership Structure in Private Equity


Bo Liu, Yang Liu, and Jinqiang Yang


Abstract:
We develop a tractable model to analyse the valuation of a general partner (GP) and the ownership allocation in a private equity (PE) fund. Our results indicate that holding ownership will increase GP's value. We further explore the influential factors that affect GP's optimal ownership decision. Our model predicts that GP's managerial skill has positive effects on GP's shareholding choice. Factors such as leverage, unspanned risks, GP's compensation have negative impacts on GP's ownership decision. The fund's maturity has a non-monotonic and concave influence. Moreover, the widely used performance measures implied by our model are consistent with empirical findings.


Keywords: private equity, illiquidity, incomplete market, ownership structure, managerial compensation


JEL Classification: G11, G23, G24



Exchange Traded Funds and Asset Return Correlations


Zhi Da and Sophie Shive


Abstract:
We provide novel evidence supporting the notion that arbitrageurs can contribute to return comovement via ETF arbitrage. Using a large sample of U.S. equity ETF holdings, we document the link between measures of ETF activity and return comovement at both the fund and the stock levels, after controlling for a host of variables and fixed effects and by exploiting the “discontinuity” between stock indices. The effect is also stronger among small and illiquid stocks. An examination of ETF return autocorrelations and stock lagged beta provides evidence for price reversal, suggesting that some ETF-driven return comovement may be excessive.


Keywords: exchange-traded-fund, correlation, arbitrage


JEL Classification: G23, G12




European Financial Management, VOL 24:2, March 2018


Negative Bubbles: What Happens After a Crash


William N. Goetzmann, and Dasol Kim


Abstract:
We study crashes using data from 101 global stock markets from 1698 to 2015. Extremely large, annual stock market declines are typically followed by positive returns. This is not true for smaller declines. This pattern does not appear to be driven by institutional frictions, financial crises, macroeconomic shocks, political conflicts, or survivorship issues.


Keywords: Negative Bubbles, Stock Market Crash, Global Markets


JEL Classification: G02, G11, G15, G17




Non-Myopic Portfolio Choice with Unpredictable Returns: The Jump-to-Default Case


Anna Battauz and Alessandro Sbuelz


Abstract:
If a risky asset is subject to a jump-to-default event, the investment horizon affects the optimal portfolio rule, even if the asset returns are unpredictable. The optimal rule solves a non-linear differential equation that, by not depending on the investor's pre-default value function, allows for its direct computation. Importantly for financial planners offering portfolio advice for the long term, tiny amounts of constant jump-to-default risk induce marked time variation in the optimal portfolios of long-run conservative investors. Our results are robust to the introduction of multiple non-defaultable risky assets.


Keywords: Dynamic asset allocation, time-varying hedging portfolio, jump-to-default risk, return predictability, irreversible regime change


JEL Classification: G01, G11, G12, C61




Growth Options and Firm Valuation


Holger Kraft, Eduardo Schwartz and Farina Weiss


Abstract:
This paper studies the relation between firm value and a firm's growth options. We find strong empirical evidence that Tobin's Q increases with firm-level volatility. The significance mainly comes from R&D firms which have more growth options than non-R&D firms. By decomposing firm-level volatility into its systematic and unsystematic part, we document that only idiosyncratic volatility has a significant effect on valuation. Second, we analyze the relation of stock returns to realized contemporaneous idiosyncratic volatility and R&D expenses. Sorting on idiosyncratic volatility yields a significant negative relation between portfolio alphas and contemporaneous idiosyncratic volatility for non-R&D portfolios.


Keywords: Firm valuation, Real options, Volatility, R&D expenses, PCA


JEL Classification: G12




Monetary Policy Uncertainty, Positions of Traders and Changes in Commodity Futures Prices


Nikolay Gospodinov and Ibrahim Jamali


Abstract:
This paper examines the sensitivity of commodity price changes to monetary policy uncertainty. We find evidence that the response of commodity price changes hinges on the sign of the monetary policy shock, the level of monetary policy uncertainty as well as a recession dummy. Uncertainty associated with negative monetary policy shocks leads to a decrease in commodity prices and excess speculative activity. The results from estimating an asset pricing model suggest that monetary policy uncertainty appears not to be a priced risk factor in the cross-section of commodity price changes.


Keywords: Commodity prices, monetary policy uncertainty, futures data, Fama-Macbeth regression, asset pricing model, futures basis, positions of traders, speculators.


JEL Classification: G13, G14, G17.




Pricing Sovereign Debt: Foreign Versus Local Parameters


Michael Bradley, Elisabeth de Fontenay, Irving Arturo de Lira Salvatierra, and Mitu Gulati


Abstract:
Sovereign bonds may be issued under either local or foreign parameters. This decision involves a tradeoff between the sovereign retaining discretion in managing the issue and relinquishing control to third parties. Examining three key bond parameters—governing law, currency, and stock exchange listing—we find that investors generally consider foreign-parameter debt to be less risky than comparable local-parameter debt of the same sovereign. By matching the foreign- and local-parameter bonds of sovereigns that have issued both, we find that, with few exceptions, both investment grade and non-investment grade sovereigns are able to issue their foreign-parameter bonds at relatively lower yields.


Keywords: contracts, asset pricing, bonds, sovereign debt, currency risk, governing law


JEL Classification: F33, F34, G15, K12