European Financial Management 2018 Archive

January 2018, VOL 24:1 March 2018, VOL 24:2 June 2018, VOL 24:3 September 2018, VOL 24:4 November 2018, VOL 24:5

European Financial Management, VOL 24:1, January 2018

Investment Beliefs of University Endowments

Andrew Ang, Adnres Ayala and William N. Goetzmann

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

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

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

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

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

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

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

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

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

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

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

European Financial Management, VOL 24:3, June 2018

CEO Talent: A Dime a Dozen, or Worth Its Weight in Gold?

Nicholas Donatielo, David F. Larcke, and Brian Tayan

Very little sophisticated research exists on the size, quality, and efficiency of the labor market for CEO talent. Our paper sheds light on this labor market by considering the perspectives of directors directly responsible for hiring and firing the CEOs of the largest publicly traded corporations in the U.S. We find that directors overwhelmingly believe that the CEO job is exceptionally challenging and only a handful of executives are qualified to run their company and others in their industry. This suggests that the labor market for outstanding CEO talent is significantly tighter and more competitive than governance experts might realize.

Keywords: CEO labor market, CEO recruitment, CEO succession planning, internal talent development, board of directors, CEO compensation, corporate governance

JEL Classification: G34

The Contagion versus Interdependence Controversy between Hedge Funds and Equity Markets

Tae Yoon Kim and Hee Soo Lee

This study considers the ‘contagion versus interdependence’ controversy between hedge funds and equity markets. We find that contagion effects break down the established interdependence between them and conditional return smoothing could play a key role in the contagion process by increasing or decreasing the contagion likelihood during crisis and prosperity. It is noted that the return smoothing tends to produce a biased pattern of returns during crisis and a decreased amount of return during prosperity. These findings are obtained by linking single equation error correction model to factor model and carrying out quantile regression, Z-test and Wald–Wolfowitz runs test.

Keywords: hedge funds; contagion; interdependence; conditional return smoothing, single equation error correction model; factor model

JEL Classification: G01, C22, C58

Asset Pricing Puzzles in an OLG Economy with Generalized Preferences

Amadeu DaSilva and Mira Farka

We seek to explain a number of asset pricing anomalies–the equity premium puzzle, the risk-free rate puzzle, and portfolio allocation puzzle–in a parsimonious overlapping generations model (OLG) with two key features: borrowing constraint and Epstein-Zin-Weil (1989) preference. The model is able to simultaneously match asset pricing moments and individual portfolio decisions using reasonable values of parameters governing behavior. We find that the main driver of savings behavior, equity returns and asset allocation is the relative difference between the two parameters: the level of relative risk aversion and the inverse of the elasticity of substitution.

Keywords: Equity premium puzzle, Overlapping generations model, General- ized Preferences, Portfolio allocation.

JEL Classification: G0, G12, D10, E21.

Selling Winners, Buying Losers: Mental Decision Rules of Individual Investors on Their Holdings

Cristiana Cerqueira Leal, Gilberto Loureiro, and Manuel Armada

We extend the study of the disposition effect – the preference for selling (holding) current winning (losing) stocks- by adding a new element to this decision process: the investors’ preference to purchase additional units of the current losing stocks. Using a unique database, we find that individual investors prefer to sell their winning stocks and, simultaneously, hold and increase their exposure to the losing ones. The additional purchase is pervasive across investors, but stronger for less sophisticated investors. Our evidence suggests that reference prices, prior stock returns, stock visibility, and investor performance and sophistication are determinants of investors’ trading behavior.

Keywords: Disposition effect; additional purchase; portfolio choice; individual investors; mental accounting; trading decision.

JEL Classification: G02,G11,G14

Income Uncertainty and the Decision to Invest in Bulk Shipping

Ioannis Kyriakou, Panos K. Pouliasis, Nikos C. Papapostolou, and Nikos K. Nomikos

We develop a coherent framework for valuing real assets and determining the optimal time to invest. To this end, we model the stochastic nature of income, present a valuation paradigm for freight-linked assets and, using real option theory, we demonstrate its usefulness in investment appraisal and optimal timing of entry in the shipping industry. We find that long-run freight rate and volatility affect the decision timing and investment value that diminishes with increasing vessel age. As time-to-build declines, the value of the option to wait increases implying a high opportunity cost embedded in the investment decision due to construction lags.

Keywords: real options, investment, uncertainty, contingent claims, shipping

JEL Classification: C13, C63, G13, G31, L92

A Unified Theory of Forward- and Backward-looking M&As and Divestitures

Qing Ma and Susheng Wang

In a unified theory of forward- and backward-looking M&As and divestitures, an M&A today may be a cause for a divestiture in the future; conversely a divestiture today may be a consequence of an M&A in the past. M&As and divestitures are not only two sides of the same coin, they are also causes and consequences of each other. In this paper, in a two-period model, two firms consider integrating or separating in each period. We analyze forward- and backward-looking M&As and divestitures, and compare them with static M&As and divestitures.

Keywords: unified framework, forward looking, backward looking, M&A, divestiture

JEL Classification: G34

Corporate Debt Maturity and Stock Price Crash Risk

Viet Anh Dang, Edward Lee, Yangke Liu, Cheng Zeng

We find that firms with a larger proportion of short-term debt have lower future stock price crash risk, consistent with short-term debt lenders playing an effective monitoring role in constraining managers’ bad-news-hoarding behavior. The inverse relation between short-maturity debt and future crash risk is more pronounced for firms that are harder to monitor due to weaker corporate governance, higher information asymmetry, and greater risk-taking. These findings suggest that short-term debt substitutes for other monitoring mechanisms in curbing managerial opportunism and reducing future crash risk. Our study implies that short-maturity debt not only preserves creditors’ interests, but also protects shareholders’ wealth.

Keywords: debt maturity, stock price crash risk, corporate governance, information asymmetry

JEL Classification: G3, G12, G14

European Financial Management, VOL 24:4, September 2018

A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-to-Price

Stephen H. Penman, Francesco Reggiani, Scott A. Richardson and İrem Tuna.

We provide a framework for identifying accounting numbers that indicate risk and expected return. Under specified accounting conditions for measuring earnings and book value, book-to-price (B/P) indicates expected returns, providing justification for B/P in asset pricing models. However, the framework also points to earnings-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. Using this framework we resolve a puzzle: in contrast to previous empirical research, we find that leverage is positively associated with future returns, as predicted by theory.

Keywords: Book-to-price; earnings-to-price: growth and risk; accounting principles.

JEL Classification: G11,G12,M41

Focal Points and Firm Risk

Ye Cai and Hersh Shefri.

The “better than average” effect suggests that relative industry standing should serve as an important focal point for corporate managers. March and Shapira (1992) develop a framework to analyze the impact of focal points on firms’ risk profiles. This paper uses the March-Shapira model to investigate the relationship between firms’ relative industry standings and their risk profiles. We find that firms’ equity returns display strong March-Shapira effects. When we examine the different firm decisions that impact risk, we find the strong presence of March-Shapira effects in firms’ decisions about operating cash flows, diversifying acquisition activity, working capital, and capital structure.

Keywords: Acquisition risk; Aspiration-based risk taking, Overconfidence.

JEL Classification: G02, G34

There are Two Very Different Accruals Anomalies

Andrew Detzel, Philipp Schaberl and Jack Strauss.

We document that several well-known asset-pricing implications of accruals differ for in- vestment and non-investment-related components. Exposure to an investment-accruals factor explains the cross-section of returns better than accruals themselves, and senti- ment negatively predicts this factors returns. The opposite results hold for non-investment accruals. Cash profitability only subsumes long-term non-investment accruals in the cross-section of returns and economy-wide investment accruals negatively predict stock- market returns while other accruals do not. These results challenge existing accruals- anomaly theories and resolve mixed evidence by showing the anomaly is two separate phe- nomena: a risk-based investment accruals premium and a mispricing of non-investment accruals.

Keywords:Accruals anomaly, profitability, real investment, cross-section of stock returns

JEL Classification: E44, G12

The Relation between Credit Growth and the Expected Returns of Bank Stocks

Priyank Gandhi

Higher bank credit growth implies that excess returns of bank stocks over the next one year are lower by nearly 3%. Credit growth tracks bank stock returns over the business cycle and explains nearly 14% of the variation in bank stock returns over a 1-year horizon. I argue that the predictive variation in returns reflects investors’ rational response to a small time-varying probability of a tail event that impacts banks and bank-dependent firms. Consistent with this hypothesis, the predictive power, as measured by the absolute magnitude of the coefficient on credit growth and the adjusted-R2 at the 1-year horizon, depends systematically on variables that regulate exposure to tail risk.

Keywords: Bank equity returns, Tail risk, Bank credit growth

JEL Classification: G01, G02, G15, G21

The Cost of Capital Effect of M&A Transactions: Disentangling Coinsurance from the Diversification Discount

Patrick Bielstein, Mario Fischer, and Christoph Kaserer

This study argues that in corporate diversification there is a bright side (coinsurance effect) and a dark side (diversification discount). While diversification might reduce systematic risk by its impact on the cost of financial distress, it might increase systematic risk because of inefficient cross-subsidization at the same time. Building on a theoretical model, we analyze mergers and acquisitions in the U.S. over the period 1985 to 2014. We find the coinsurance effect to decrease the cost of capital by 36 bp for the average firm. However, at the same time, we observe a 7bp increase in the cost of capital related to the inefficiency of the firm’s internal capital market. Both effects are statistically significant and robust to endogeneity concerns, different empirical specifications, and variable measurement

Keywords: M&A Transactions; Corporate Diversification; Internal Capital Markets; Cost of Capital.

JEL Classification: G24; G32; G34

Cold Case File? Investor Heterogeneity and Trading.

Anzhela Knyazeva, Diana Knyazeva, and Leonard Kostovetsky.

Institutional investors play a crucial role in the information environment of firms. We argue that heterogeneity in the information ability of institutional investors has a significant impact on trading around information releases. We propose novel measures of within-firm investor heterogeneity and find that investor heterogeneity increases abnormal trading volume around news, holding constant the average levels of investor sophistication. We also find larger spread reductions around announcements for firms with greater investor heterogeneity. The effect of investor heterogeneity on trading continues to hold after accounting for total institutional ownership, the presence of certain types of institutional investors, and analyst coverage.

Keywords: institutional investors, investor heterogeneity, information, trading volume, spreads.

JEL Classification: G10, G12, G14

European Financial Management, VOL 24:5, November 2018

Worthless Companies

J. B. Heaton

Companies with worthless assets can have substantial efficient markets equity values and debt that trades near par if there is a probability that an irrational bidder will acquire the company. Even if most capital market participants recognize that the company’s assets are worthless, efficient markets pricing of the worthless company’s equity and debt precludes arbitrage, and it may be impossible to persuade the potential irrational bidder to abandon its plans. The worthless company hypothesis may shed light on the valuation of some high-profile start-ups, the 1990s dot-com bubble, and the bad performance of some short sellers.

Keywords: mergers & acquisitions, bad bidders, bubble company, unicorns, short selling

JEL Classification: G02, G32, G34, K22

Are the Fama French Factors Treated as Risk? Evidence from CEO Compensation

Jeremy Bertomeu, Edwige Cheynel, and Michelle Liu-Watts


Keywords: TBA

JEL Classification: TBA

Credit Risk in Italian Banks' Exposure to Non-Financial Firms

Matteo Accornero, Giuseppe Cascarino, Roberto Felici, Fabio Parlapiano, and Alberto Maria Sorre

This paper outlines a framework based on microdata and a structural model to gauge credit risk in banks’ exposures to non-financial firms. Sectoral risk factors are accounted for using a multi-factor model as prompted in Duellman and Masschelein (2006). We use expected and unexpected losses as indicators of credit risk stemming from the corporate sector as a whole, and we put forward a measure of systemic risk relevance of economic sectors. We apply the model to the Italian economy, showing the sensitivity of credit risk indicators to different characteristics of default risk, cyclicality and concentration of economic sectors.

Keywords: Credit risk, Sectoral risk, Systemic risk, Structural Multi-Factor Model

JEL Classification: G21, G32

Earnout Deals: Method of Initial Payment and Acquirers’ Gains

Leonidas Barbopoulos*, Krishna Paudyal, and Sudi Sudarsanam

We analyze the implications of initial payment methods in earnout deals on acquirers’ gains. The results, which are robust to self-selection bias and alternative model specifications, reveal that earnout deals outperform non-earnout deals. The acquirers gain the most from earnout deals when both initial and deferred payments are in stocks. The positive wealth effect of the choice of initial payment method in earnout deals is more prominent in cross-border deals than in domestic deals. Overall, the earnout deals generate higher gains when both the initial and deferred payments help spread the risk between the shareholders of acquiring and target firms.

Keywords: Earnout contracts; Initial payment in earnout deals; Asymmetric information; Acquirers’ gains.

JEL Classification: G34.

The Mixed vs the Integrated Approach to Style Investing: Much Ado About Nothing

Markus Leippold and Roger Ruegg

We study the difference between the returns to the integrated approach to style investing and those to the mixed approach. Unlike the mixed approach, the integrated approach aggregates factor characteristics at security level. Recent literature finds that the integrated approach dominates the mixed approach. Using statistical tools for robust performance testing, we demystify these findings as a statistical fluke. We do not find any evidence favoring the integrated approach. What we do find is that the integrated approach exhibits a higher sensitivity to the low-risk anomaly. However, this reduction in risk does not lead to an improvement in performance.

Keywords: Factor investing, integrated and mixed approach, value, momentum, low volatility.

JEL Classification: G11, G12, G14

Persistency of the Momentum Effect

Hong-Yi Chen, Pin-Huang Chou, and Chia-Hsun Hsieh

The intermediate-term momentum persistency is not universal among all stocks. More than 40% of winners and losers immediately fall out of their respective groups in the month following formation, resulting in a monthly loss of more than 17% for a momentum strategy constructed on such stocks. By contrast, persistent winners and losers, defined as those staying in their groups for at least one more month, exhibit much stronger momentum persistency. Further analysis indicates that, consistent with the delayed reaction hypothesis for price momentum, the persistency is stronger for stocks with greater information asymmetry and more extensively heterogeneous investor beliefs.

Keywords: delayed reaction hypothesis, duration, heterogeneous beliefs, information asymmetry, persistent momentum strategy

JEL Classification: G11, G14

The Effectiveness of Asset, Liability, and Equity Hedging Against the Catastrophe Risk: The Cases of Winter Storms in North America and Europe

Yang-Che Wu, and Ming Jing Yang

The winter storms in North America and Europe are responsible for the majority of the insured natural catastrophe losses. This study analyzes the effectiveness of insurers hedging against the winter storm risk in terms of asset (catastrophe derivatives), liability (catastrophe bonds), and equity (catastrophe equity puts) risk management perspectives. The analysis results of the various financial performances show that our suggested hedging strategies are effective based on the long-term positive profit and the improvement in the insolvency ratios. The conclusions of this study provide the insurers with the less volatile premiums and more diversified portfolios under the catastrophe risk management.

Keywords: Catastrophe Derivatives, Catastrophe Bonds, Catastrophe Equity Puts, Catastrophe Risk Management

JEL Classification: G32, G11, C15