European Financial Management 2001 Archive

March 2001, VOL 7:1 June 2001, VOL 7:2 September 2001, VOL 7:3 December 2001, VOL 7:4

European Financial Management, VOL 7:1 March 2001

Efficiency in the pricing of the FTSE 100 futures contract

Joelle Miffre ISMA Centre, The University of Reading, Reading, Berks. UK

This paper studies the pricing efficiency in the FTSE 100 futures contract by linking the predictable movements in futures returns to the time-varying risk and risk premia associated with prespecified factors. The results indicate that the predictability of the FTSE 100 futures returns is consistent with a conditional multifactor model with time-varying moments. The dynamics of the factor risk premia, combined with the variation in the betas, capture most of the predictable variance of returns, leaving little variation to be explained in terms of market inefficiency. Hence the predictive power of the instruments does not justify a rejection of market efficiency.
Keywords: FTSE 100 Futures Contract, Efficiency, Time-varying Risk, Risk Premia.
JEL: G12, G13, G14

The Pricing of French Unit Seasoned Equity Offerings
Pierre Chollet and Edith Ginglinger
IAE, University de Tours, Tours cedex 3, France
ESA, IRG, University Paris XII, Creteil, France

Units are bundles of common stock and warrants. By issuing units, firms precommit to a future and uncertain seasoned offering at the exercise price of the warrants. This study shows that the issuance of units seasoned offerings in France is accompanied by significant abnormal returns of on average 9 to 12%, depending on the computing methods. Underpricing increases with the risk of the issuer and the relative size of the future seasoned equity issue linked to warrant exercises. Our results are consistent with our signaling hypothesis.

Keywords:Units, Warrants, Seasoned Equity Offerings, Underpricing, Signaling

JEL: G14, G32

Competition and Integration Among Stock Exchanges in Europe: Network Effects, Implicit Mergers and Regulatory Considerations
Carmine Di Noia
Divisione Mercati, Commissione Nazionale per le Societa e la Borsa (CONSOB) Roma, Italy

The economic theory of network externalities and a simple-game theoretical framework are used to explore the issue of competition among stock exchanges and the possibility of consolidation in the European stock-exchange industry, among the different exchanges. The main features of this paper are the following: the treatment of exchanges as firms; the application of network externalities to study competition among exchanges; the extension of network externalities, through implementing ``cross-network'' effects; and the existence of equilibria where exchanges may decide, even unilaterally, to achieve full compatibility through implicit mergers and remote access, specializing only in trading or listing services. One implication is that consolidation of European exchanges into one may occur with a welfare-efficient outcome or with a lock-in to a Pareto-inferior equilibrium. This is due to the network externalities and the different starting points of the various exchanges. ``Implicit mergers'' among exchanges together with remote access are always weakly (in half of the cases, strictly) more efficient than the actual competition. This finding also sheds light on the existence and efficacy, especially in the U.S., of automated trading systems, which are exchanges specializing in trading services.

Keywords:Securities Exchanges, Competition, Implicit Merger, Network Effect, Remote Access

JEL: C71, D43, F36, G15

Improving Portfolio Performance with Option Strategies: Evidence from Switzerland
Dusan Isakov and Bernard Morard
HEC, University of Geneva, Switzerland
HEC, University of Geneva, Switzerland

This paper investigates the performance of a global investment strategy that combines diversification and option strategies, in particular the covered call strategy, on the Swiss Exchange over the epriod 1989-1996. As the return distributions of portfolios including options are possibly non-normal, the mean-variance framework may not be appropriate to assess the relative performance of such portfolios. Stochastic dominance and modified betas are the alternative approaches, robust to departure from normality, used in this paper to compare the performance of portfolios. The results show that the use of option strategies consistently improves the performance of stock portfolios, even in the presence of transaction costs.

Keywords:Covered Call Options, Portfolio Management, Stochastic Dominance

JEL: G11, G13

Stock Exchange Reforms and Market Efficiency: The Italian Evidence
Giovanni Majnoni and Massimo Massa
Banca d'Italia, Research Department, Italy
INSEAD, France

This paper examines whether the reforms introduced by the Italian Stock Exchange from 1991 to 1994 (creation of specialised intermediaries, obligation to trade on the official markets, screen-based trading and cash settlement) did increase market efficiency. The issue is addressed using both the traditional information efficiency model, which tests market efficiency by verifying the predictability of prices conditional on some information subset and a microstructure approach that measures efficiency as the distance of the price movements from their efficient components, represented by a random walk process. The joint analysis of daily and intraday data on prices and volumes validates the hypothesis that most of the reforms have increased market efficiency over the sample period, except for cash settlement, which appears to have substantially reduced it.

Keywords:Stock Market, Informational Efficiency, Trading Systems

JEL: G14


Efficiency Barriers to the Consolidation of the European Financial Services Industry
Allen N. Berger, Robert DeYoung, Gregory F. Udell
Board of Governors of the Federal Reserve System and Wharton Financial Institutions Center
Federal Reserve Bank of Chicago
Kelley School of Business, Indiana University

Cross-border consolidation of financial institutions within Europe has been relatively limited, possibly reflecting efficiency barriers to operating across borders, including distance; differences in language, culture, currency and regulatory/supervisory structures; and explicit or implicit rules against foreign competitors. EU policies such as the Single Market Programme and European Monetary Union attenuate some but not all of these barriers. The evidence is consistent with the hypothesis that these barriers offset most of any potential efficiency gains from cross-border consolidation. Banks headquartered in other EU nations have slightly lower average measured efficiency than domestic banks and non-EU-based foreign banks.

Keywords: Banks, Mergers, Efficiency, Europe, Financial institutions.

JEL: G21, G22, G24, G28, G34, F23

European Financial Management, VOL 7:2 June 2001

Identifying The Risk Structure of Mutual Fund Returns
Martin J. Gruber
Stern School of Business, NYU

Keynote Address at the European Financial Management Association 2000 Annual Meetings, Athens, Greece, June 2000.

Keywords: Mutual Fund Returns; Risk; Benchmarks and Indexes; Asset Management; Performance Measures

JELClassification : G11, G12

The Structure of Banking Systems in Developed and Transition Economies
DwightJaffee and Mark Levonian
Haas School of Business, University of California, Berkeley, USA
Visiting Scholar, Federal Reserve Bank of San Francisco, USA

The paper empirically analyzes the determinants of banking system structure (as measured by bank assets, number, branches and employees) for 26 developed OECD countries.  The estimated regressions are then applied to 23 transition economies, to obtain benchmarks for the efficient structure of their banking systems.  The actual and benchmark measures of banking structure are compared to evaluate the state of banking system development, including the computation of a measure of "banking system convergence". The results are objective and replicable multidimensional measures of banking system development for the transition economies.

Keywords: Banks, Banking systems, Banking structure, Transition economies, Developing Economies

JEL Classification: G21, O16, P34

Paying for Minimum Interest Rate Guarantees: Who Should Compensate Who?
Bjarne A. Jensen and Carsten Sorensen

Defined contribution pension schemes and life insurance contracts often have a mandatory minimum interest rate guarantee as an integrated part of the contract. This guarantee is an embedded put option issued by the institution to the individual, who is forced to hold the option in the portfolio. However, taking the inability to short this saving and other institutional restrictions into account the individual may actually face a restriction on the feasible set of portfolio choices, hence be better off without such guarantees. We measure the effect of the minimum interest guarantee constraint through the wealth equivalent and show that guarantees may induce a significant utility loss for relatively risk tolerant investors. We also consider the case with heterogenous investors sharing a common portfolio. Investors with different risk attitudes will experience a loss of utility by being forced to share a common portfolio. However, the relatively risk averse investors are partly compensated by the minimum interest rate guarantee, whereas the relatively risk tolerant investors are suffering a further utility loss.

Keywords:Minimum interest rate guarantee, asset allocation restrictions, utility loss, wealth equivalent, heterogenous investors.

JEL Classification: G11,G13

European Managerial Perceptions of the Net Benefits of Foreign Stock Listings
Franck Bancel and Usha R. Mittoo
ESCP-EAP, France
University of Manitoba, Canada

This study surveys the European managers on the costs, benefits and net benefits of foreign listing. Increase in prestige and visibility and growth in shareholders are perceived as the major benefits and the costs of public relations and legal fees are cited as the major costs by the managers. While a majority of managers (60 percent) perceive that benefits outweigh the costs of foreign listing, about 30 percent also view the net benefits to be negative. Perceived net benefits are positively related to the increase in the total trading volume after foreign listing, the financial disclosure levels of the firm and the dual listing on both the U.S. and European foreign exchanges. Without the influence of these factors, the perceived net benefits are negative.

Keywords: Foreign listing, European Managers, survey, costs and benefits

JEL Classification: G15, G30, G39

Shareholder Wealth Effects of Corporate Selloffs: Impact of Growth Opportunities,Economic Cycle and Bargaining Power
George Alexandrou and Sudi Sudarsanam
University of Essex, UK
Cranfield University School of Management, UK

Most of the existing empirical evidence on corporate selloffs documents significant wealth gains for the seller’s shareholders. We investigate the sources of these wealth gains by examining the impact of business and financial strategy, the economic environment during selloff, the bargaining advantages of the seller including information asymmetry. We find evidence that sellers with growth opportunities and financially strong sellers enjoy higher returns. Selloffs during recessions generate larger wealth gains than those during economic boom. Information asymmetry due to the buyer’s location being different from the purchased division’s gives the seller a bargaining advantage leading to larger wealth gains. Relatively large divestments are more beneficial to seller shareholders than small ones. The study highlights the importance of both firm specific and environmental factors in explaining the wealth gains associated with corporate selloffs.

Keywords: Selloffs, business strategy, financial distress, economic environment and information asymmetry

JEL Classification:

The Effects of Liberalization on Market and Currency Risk In The European Union
Francesca Carrieri
Faculty of Management, McGill University, Canada

This paper investigates the effects of liberalization on the pricing of market and currency risk for a number of financial markets in the European Union(EU). An International Asset Pricing Model with a multivariate GARCH-in-Mean specification and time-varying prices of risk is used for the four markets with the largest capitalization in the EU. Only one price of market risk exists and international investors are rewarded for their exposure to currency risk. The evidence shows that all prices of risk are time-varying and have been decreasing during the process of liberalization. There is also evidence that markets react to period of uncertainty in the process toward the completion of liberalization. In addition, the operation of the European Monetary System has generated lower covariances. As a consequence, total risk premia have declined in the last decade.

Keywords: International Asset Pricing, Currency Risk, Liberalization, European Union

JEL Classification: G12, G15

European Financial Management, VOL 7:3 September 2001

Value Maximization, Stakeholder Theory and the Corporate Objective Function
Michael Jensen (
Harvard Business School.

This paper examines the role of the corporate objective function  productivity and efficiency,social welfare ,and the accountability of managers and directors.I argue that since it is logically impossible to maximize in more than one dimension,purposeful behavior requires a single valued objective function.Two hundred years of work in economics and finance implies that in the abscence of externalities and monopoly(and when all goods are priced),social welfare is maximized when each firm in an economy maximizes its total market value.Total value is not just the value of the equity but also includes the market values of all other financial claims including debt,preferred stock  and warrants.
           Stakeholders theory argues that managers should make decisions so as to take account of all the stakeholders in a firm(including not only financial claimants but also employees,customers,communities,government officials and under some interpratations the environment,terrorists,blackmailers and thieves).Because the advocates of stakeholder theory refuse to specify how to make the necessary tradeoffs among these competing intereststhay leave managers with a theory that makes it impossible for them to make purposeful decisions.With no way to keep score,stakeholder theory makes managers unaccountable for their actions.It seems clear that such a theory can be attractive to the selfinterest of managers and directors.
         It takes more than the acceptance of value maximization as the organizational objective to create value.As a statement of corporate purpose or vision,value maximization is not likely to tap into the energy and enthusiasm of employees and managers to create value.Seen in this light,changes in longterm market value becomes the scoreborad that managers,directors  and others use to assess the success or failure of the organization.It must be complemented by the corporate
vision,strategy and tactics that unite participants in the organization in its struggle for survival and dominance in its competitive arena.
     Since a firm cannot maximize value if it ignores the interests of its stakeholders,enlightened value maximization can utilize much of the structure of stakeholder theory by accepting longterm maximization of the value of the firm as the criterion for making the requisite tradeoffs among its stakeholders,managers, directors,strategists and management scientisits can benefit from enlightened stakeholder theory as well.enlightened stakeholder specifies value maximization or value seeking as the firm's objective and therefore resolves the logical problems that cause traditional stakeholder theory to fail as a guide to corporate action.

Keywords: Value Maximization; Stakeholder Theory; Balanced Scorecard; Multiple Objectives; Social Welfare; Social Responsibility; Corporate Objective Function; Corporate Purpose; Tradeoffs; Corporate Governance; Strategy; Special Interest Groups

JEL Classification: G3, G30, G32

Agency Costs and Strategic Considerations behind Sell-offs: The UK Evidence
Kevin M.J. Kaiser and Aris Stouraitis
McKinsey & Co, Paris, France
Department of Economics and Finance, City University of Hong Kong,Hong Kong

We analyse the impact of the motivation behind the sell-off and the use of the proceeds from the sale on the value of UK firms divesting assets during 1984-1994. Our findings suggest that managers do not create value when they divest assets in order to raise cash, in order to reshuffle assets without increasing corporate focus and when they do not announce the motivation behind the transaction. In contrast, we find value increases for firms refocusing during the 1990s and for firms divesting loss-making assets for operational reasons. Returning the proceeds from the sale yo shareholders or reducing leverage were also associated with value increases, whereas reinvesting the proceeds for growth had a negative impact during the 1980s, which disappeared after 1990, as a result of disciplinary role of the economic turndown on the investment behaviour of firms.

Keywords:Corporate Structuring, Sell-offs, Agency Costs, Refocusing

JEL Classification: G34, G14

Smiles, Bid-Ask Spread and Option Pricing
Ignacio Pena, Gonzalo Rubio and Gregorio Serna
Universidad Carlos III de Madrid, Spain
Universidad del Pais Vasco, Spain
Universidad Carlos III de Madrid, Spain

Given the evidence provided by Longstaff (1995) and Pena, Rubio and Serna (1999) a serious candidate to explain the pronounced pattern of volatility estimates across exercise prices might be related to liquidity costs. Using all calls and puts transacted between 16:00 and 16:45 on the Spanish IBEX-35 index futures from January 1994 to October 1998 we extend previous papers to study the influence of liquidity costs, as proxied by the relative bid-ask spread, on the pricing of options. Surprisingly, alternative parametric option pricing models incorporating the bid-ask spread seem to perform poorly relative to Black-Scholes.

Keywords:Smiles, Bid-Ask Spread, Implied Volatility Function, Option Pricing

JEL Classification: G12, G13

Belgian Intragroup Relations and the Determinants of Corporate Liquid Reserves
Marc Deloof
Faculty of Applied Economics, University of Antwerp - UFSIA, Belgium

The determinants of liquid reserves are investigated for a sample of 1038 large Belgian non-financial firms in the 1992-1994 period. The results confirm the hypothesis that the terms of payment of intragroup claims can be adjusted to the firm’s liquidity needs, thereby reducing the need for liquid reserves. Furthermore, the results confirm the transaction motive for holding liquid reserves, but only partially confirm the precautionary motive Finally, the results indicate that liquid reserves play a significant role in the financing of new investments, as predicted by the pecking order model of Myers and Majluf (1984).

Keywords:Liquid Reserves, Corporate Groups, Pecking Order

JEL Classification: G31, G32

Decomposing and Testing Long-Run Returns With An Application to Initial Public Offerings in Denmark
Jan Jakobsen and Ole Sorensen
Department of Finance, Copenhagen Business School, Denmark
Department of Accounting and Auditing, Copenhagen Business School, Denmark

An improved method for measuring and testing long-run returns is proposed. The method adjusts for the right-skewed distribution of long-run buy-and-hold returns by decomposing average cross-sectional buy-and-hold returns into mean components and volatility components. The method is applied to initial public offerings in Denmark. The mean component under performance of initial public offering stocks compared to the market is 30 percent and significant after five years. Comparing to matching firms, the underperformance of IPO stocks is 13 percent after five years but insignificant.

Keywords: Initial Public Offerings; Long-Run Returns; Right Skewed Distributions

JEL Classification: G14, G32


The Impact of the Introduction of the Euro on Foreign Exchange Risk Management in UK Multinational Companies

Eilidh Christie and Andrew Marshall
Arthur Anderson, Glasgow and the Department of Accounting and Finance, University of Strathclyde,UK
Department of Accounting and Finance, Curran Building, Glasgow ,Scotland,UK

One of the arguments in favour of the euro is that it will eliminate foreign exchange risk for companies in the euro-zone. There could also be benefits for companies outside this zone, although their currency risk with the euro remains. This paper considers this, by examining the effect of the euro on the currency risk management of UK multinational companies (MNCs). Using the responses from a questionnaire and interviews we found that the euro, which is being widely used in UK MNCs, is generally favoured due to reductions in exchange uncertainty and costs of managing currency risk. Nonetheless, contrary to what would theoretically be expected, there was no exact relationship in the reduction in hedging activity accompanied by this reduction in risk. The majority of MNCs stated that their hedging activities would remain unchanged. The capacity of MNCs to benefit from reductions in risk and hedging depend on the proportion of non-UK European trade, the industry sector and the ability to transfer risk down the supply chain. Finally, despite the reductions in currency exposure experienced by the majority of companies the euro will not encourage UK MNCs to expand international trade.

Keywords: Euro, foreign exchange risk management.

JEL Classification : F23; F31

European Financial Management, VOL 7:4 December 2001

The Emerging Role of the European Commission
in Merger and Acquisition Monitoring:The Boeing / Mc Donnell Douglas Case

Nihat Aktas,Eric de Bodt,Michel Levasseur and Andre Schmitt
Institut d’Administration et de Gestion, Universite Catholique de Louvain,Belgium
Institut d’Administration et de Gestion, Universite Catholique de Louvain,Belgium  and Ecole Superieure des Affaires, University de Lille , France
Institut d’Administration et de Gestion, University Catholique de Louvain,Belgium  and Ecole Superieure des Affaires, University de Lille , France
Ecole Superieure des Affaires, University de Lille , France

The object of this study is to evaluate the consequences of the application of the EEC regulation n 4064/89  to non-European companies. We focus on the Boeing – Mc Donnell Douglas merger case, one of the first non-European mergers considered by the Commission. The analysis of abnormal returns on the two securities shows that the threat of a ban of the merger by the Commission were not perceived as credible at first. But when Boeing decided to ask the support of the American government, just after the decision of the European Commission to extend its investigations to the long term exclusivity contracts, the role of the Commission emerged.

Key words: mergers and acquisitions, regulation costs, concentration control, event studies

JEL Classification : G14; G18; G34

Why do firms raise foreign currency denominated debt?Evidence from Finland

Matti Keloharju and Mervi Niskanen
Helsinki School of Economics and Business Administration, Helsinki,Finland
H宥 Polytechnic University, Finland

This study examines the determinants of the decision to raise currency debt.  The  results  suggest  that  hedging  figures  importantly  in  the currency-of- denomination  decision:  firms  in  which  exports constitute a significant  fraction  of net sales are more likely to raise currency debt.However,  firms  also  tend  to borrow in periods when the nominal interest rate  for  the  loan  currency, relative to other currencies, is lower than usual.   This  is  consistent  with  the currency debt issue decision being affected  by  speculative motives.  Large firms, with a wider access to the international  capital  markets,  are  more  likely  to  borrow  in
foreign currencies than small firms.

Keywords: Currency of denomination, hedging, speculation

JEL classification: F23, G32

Simulating the Evolution of the Implied Distribution

George Skiadopoulos and Stewart Hodges
Associate Research Fellow at the Financial Options Research Centre,University of Warwick,UK
Director of the Financial Options Research Centre, Warwick Business School,University of Warwick.UK.

Motivated by the implied stochastic volatility literature (Britten-Jones and Neuberger (1998), Derman and Kani (1997), Ledoit and Santa-Clara (1998)),this paper proposes a new and general method for constructing smile-consistent stochastic volatility models. The method is developed by recognizing that option pricing and hedging can be accomplished via the simulation of the implied risk neutral distribution. We devise an algorithm for the simulation of the implied distribution, when the first two moments change over time. The algorithm can be implemented easily and it is based on an economic interpretation of the concept of mixture of distributions. It
can also be generalized to cases where more complicated forms for the mixture are assumed.

Keywords: Smile-Consistent stochastic volatility models, Implied Distribution, Mixture of Distributions, Simulation.

JEL Classification: G 13

What Determines IPO Gross Spreads in Europe?

Sami Torstila
Helsinki School of Economics and Business Administration, Finland.

This paper examines the behavior of underwriting gross spreads in European IPO markets using a data set of 565 IPOs by European issuers in the period 1986 - 1999. Privatizations have lower gross spreads than other IPOs, other things remaining equal. Gross spreads on European listings by European issuers are significantly lower than on U.S. listings by European issuers, except on the technology stock - oriented EASDAQ and Frankfurt Neuer Markt exchanges. IPOs involving a U.S. bulge bracket underwriter (for joint U.S./Europe listings) or bookbuilding are characterized by relatively higher spreads.

Keywords: initial public offerings, gross spreads, European equity markets

JEL classification: G24, G32

Binomial Option Pricing Biases and Inconsistent Implied Volatilities

Brent J. Lekvin and Ashish Tiwari
School of Business and Economics, Michigan Technological University, Houghton, MI,USA
Department of Finance, Henry B. Tippie College of Business Administration, University of Iowa, Iowa City, IA ,USA

We evaluate the binomial option pricing methodology (OPM) by examining simulated portfolio strategies. A key aspect of our study involves sampling from the empirical distribution of observed equity returns.  Using a Monte Carlo simulation, we generate equity prices under known volatility and return parameters.  We price American-style put options on the equity and evaluate the risk-adjusted performance of various strategies that require writing put options with different maturities and moneyness characteristics.  The performance of these strategies is compared to an alternative strategy of investing in the underlying equity.  The relative performance of the strategies allows us to identify biases in the binomial OPM leading to the well-known volatility smile.  By adjusting option prices so as to rule out dominated option strategies in a mean-variance context, we are able to reduce the pricing errors of the OPM with respect to option prices obtained from the LIFFE.  Our results suggest that a simple recalibration of inputs may improve binomial OPM performance.

Keywords: option pricing; binomial model; implied volatility; volatility smile

JEL classification: G13