European Financial Management 2003 Archive

March 2003, VOL 9:1 June 2003, VOL 9:2 September 2003, VOL 9:3 December 2003, VOL 9:4

European Financial Management, VOL 9:1 March 2003

Passive Investment Strategies and Efficient Markets

Burton Malkiel

This paper presents the case for and the evidence in favor of passive investment strategies and examines the major criticisms of the technique. I conclude that the evidence strongly supports passive investment management in all markets? Small-capitalization stocks as well as large-capitalization equities, U.S. markets as well as international markets and bonds as well as stocks. Recent attacks on the efficient market hypothesis do not weaken the case for indexing.

Key words: passive investment strategies; efficient markets

JEL classification: G11, G14

What is an Asset Price Bubble? An Operational Definition

Jeremy J. Siegel

This paper reviews and analyzes the current definitions of bubbles in asset prices. It makes the case that one cannot identify a bubble immediately, but one has to wait a sufficient amount of time to determine whether the previous prices can be justified by subsequent cash flows. The paper proposes an operational definition of a bubble as any time the realized asset return over given future period is more than two standard deviations from its expected return. Using this framework, the paper shows how the great crash of 1929 and 1987-both periods generally characterized as bubbles-prove not to be bubbles but the low point in stock prices in 1932 is a "negative bubble." The paper then extends this analysis to the internet stocks and concludes that it is virtually certain that it is a bubble.

Key words: asset prices; asset returns; bubbles; internet bubble; irrational exuberance

JEL classification: G12, G14

Herd Behavior and Cascading in Capital Markets: A Review and Synthesis

David Hirshleifer and Siew Hong Teoh

We review theory and evidence relating to herd behavior, payoff and reputational interactions, social learning and informational cascades in capital markets. We offer a simple taxonomy of effects and evaluate how alternative theories may help explain evidence on the behavior of investors, firms and analysts. We consider both incentives for parties to engage in herding or cascading and the incentives for parties to protect against or take advantage of herding or cascading by others.

Key Words: herd behavior, informational cascades, social learning, analyst herding, capital markets, financial reporting, behavioral finance, investor psychology, market efficiency

Contrarian and Momemtum Strategies in the Spanish Stock Market

Carlos Forner and Joaquin Marhuenda

There is extensive international evidence that the momentum strategy yields positive abnormal returns when short-term periods are considered, while for long-term periods the contrarian strategy is the effective one. However, this topic has received scarce attention in the Spanish Stock Market. In this paper we show that these two phenomena seem to be present in this marketand concretely, that the 12-month momentum strategy and the 60-month contrarian strategy yield positive abnormal returns, although the effectiveness of the contrarian strategy is under suspicion when non-overlapping test-periods are used. So, this work adds additional evidence that the results obtained for the literature on this topic are not from data snooping.

Keywords: Efficiency, Contrarian Strategy, Momentum Strategy, Risk

JEL classification: G14, G11, G12

Post-earnings-announcement Drift in the UK

Weimin Liu, Norman Strong and Xinzhong Xu

This paper fills a void in the market efficiency literature by testing for the presence of post-earnings announcement drift in a non-US market. We test for drift using alternative earnings surprise measures based on: (i) the time-series of earnings; (ii) market prices; and (iii) analyst forecasts. Using each of the measures we find evidence of significant post-earnings-announcement drift, robust to alternative controls for risk and market microstructure effects. Using a one-dimensional analysis, the price-based measure of earnings surprise gives the strongest drift and using a two-dimensional analysis the drift associated with the price-based measure almost subsumes drift associated with the other two measures. Our conclusion is that the UK stock market is inefficient with respect to publicly available corporate earnings information. This evidence provides out-of-sample confirmation of the post-earnings-announcement drift documented in the US.

Keywords: Post-earnings-announcement drift; market efficiency, earnings surprises

JEL classification: G14; M41

Spanish Stock Returns: Where is the Weather Effect?

Angel Pardo and Enric Valor

Psychological studies support the existence of an influence of weather on mood. It could affect the behaviour of market traders, as suggested by some authors, and this should be reflected by the stock returns. This paper investigates the possible relation between weather and market index returns in the context of the Spanish market, in order to test the above hypothesis. In 1989, this market changed its open outcry trading system into a computerised and decentralised trading system. Therefore, it is possible to check the influence of weather variables (sunshine hours and humidity levels) on index returns in an open outcry trading system, and to compare it with a screen traded environment. The empirical evidence indicates that, independently of the trading system, there is no influence of weather on stock prices. Thus, these findings do not contest the notion of efficient market.

European Financial Management, VOL 9:2 June 2003

Secured Creditor Recovery rates from Management Buy-outs in Distress

David Citron, Mike Wright, Rod Ball and Fred Rippington

Buy-out literature suggests that secured creditors will recoup substantial proportions of the funds they extend to finance the initial buy-out. This paper uses a unique dataset of 42 failed MBOs to examine the extent of credit recovery by secured lenders under UK insolvency proceduresand the factors that influence the extent of this recovery. On average, secured creditors recover 62 per cent of the amount owed. The percentage of secured credit recovered is increased where the distressed buy-outs is sold as a going concern and where the principal reason for failure concerns managerial factors. The presence of a going concern qualification in the audit report and the size of the buy-out reduce the recovery rate by secured creditors.

Keywords: bankruptcy; secured debt; financial distress resolution

JEL Classification: G33; G32

The Underinvestment and Overinvestment Hypothesis: An Analysis using Panel Data

Arthur Morgado and Julio Pindado

We study the relationship between firm value and investment to test the underinvestment and overinvestment hypotheses. The results obtained, using panel data methodology as the estimation method, indicate that the abovementioned relation is quadratic, whichimplies that thereexists an optimal level of investment. As a consequence, firms that invest less than the optimal level suffer from an underinvestment problem, while those investing more than the optimum suffer from overinvestment. The quadratic relation is maintained when firms are classified depending on their investment opportunities, the optimum being in accordance with the quality of investment opportunities.

Keywords: Firm investment, firm value, underinvestment, overinvestment, investment opportunities.

JEL Classification: G31

Dynamic Portfolio Selection: The Relevance of Switching Regimes and Investment Horizon

Andreas Graflund and Birger Nilsson

This paper investigates the questions of dynamic portfolio selection and intertemporal hedging within a Markovian regime-switching framework. The investment opportunity set is spanned by a well-diversified home-market portfolio and the risk-free asset. Our results highlight the economic importance of regimes, as optimal portfolio weights are clearly dependent on the prevailing regime. We present evidence that the question of intertemporal hedging is a more complex issue than is hinted in the previous literature, since demand for intertemporal hedging is present in some regimes, but not in others. Finally, our main findings are qualitatively unchanged across the four largest stock markets in the world.

Keywords: intertemporal hedging, dynamic portfolio selection, regime switching

JEL Classification: G11, G15, C15, C32

Conditioning Information and European Bond Fund Performance

Maria Ceu Cortez, Florida Silva and Manuel Rocha Armada

In this paper we evaluate the performance of European bond funds using unconditional and conditional models. As conditioning information we use variables that we find to be useful in predicting bond returns in the European Market. The results show that, in general, bond funds are not able to outperform passive strategies. These findings are robust to whatever model (unconditional versus conditional and single versus multi-index) we use. The multi-index model seems to add some explanatory power in relation to the single-index model. Furthermore, when we incorporate the predetermined information variables, we can observe a slight tendency towards better performance. This evidence is consistent with previous studies on stock funds and comes in support of the argument that conditional models might allow for a better assessment of performance. However, our results suggest that the impact of additional risk factors seems to be greater than the impact of incorporating predetermined information variables.

Keywords: Performance Evaluation, Conditional Models, Bond Funds

JEL Classification: G11, G12, G14

Managerial Equity Ownership and the Demand for Outside Directors

Kenneth V. Peasnell, Peter F. Pope and Steve Young

This paper examines the linkage between the use of outside directors and managerial ownership. We conjecture there are two linkages: the standard incentive-alignment demand for monitoring when managers own little stock and an entrenchment-amelioration demand when managerial stock ownership is high. As a consequence, we predict the association between managerial ownership and board composition will be nonlinear (U-shaped if the entrenchment effect is sufficiently pronounced). Using U.K. data, we find that both quadratic and logarithmic models outperform the simple linear relationship assumed in prior research and that the substitution between managerial ownership and board composition is stronger than hitherto supposed.

Keywords: managerial ownership; board of directors; Cadbury Report

JEL Classification: G32; G3


Simple Construction of the Efficient Frontier

David Feldman and Haim Reisman

We provide simple methods of constructing known results. At the core of our methods is the identification of a simple concise basis that spans the Capital Market Line (CML). We show that a portfolio whose risky assets weights are the product of the inverse variance-covariance matrix of (nonredundant) security rates of return times the vector of the excess expected rates of return over the risk-free rate is a CML portfolio. This portfolio and the risk-free security span the CML. In addition, with this basis, there is immediate construction of the efficient frontier of risky assets (the "hyperbola"), "tangency" portfolios, "reflection" portfolios, and a CAPM relationship. Our method is quick and simple. It is easy to derive, teach, implement, interpret, and remember.

Keywords: portfolio frontier, efficient frontier, capital market line, asset pricing

JEL Classification: G10, G11, G12

European Financial Management, VOL 9:3 September 2003

The Impact of Institutional Differences on Derivatives Usage: A Comparative Study of US and Dutch Firms

Gordon M Bobnar, Abe de Jong and Victor Marcae

This paper examines the influence of institutional differences on corporate risk management practices in the US and the Netherlands. We compare results to surveys in each country using a strategy that corrects for differences over industry and size classes across the Dutch and US samples. We document several differences in the firms’ uses and attitudes towards derivatives and attempt to attribute them to the differences in the institutional environments between the US and the Netherlands. We find that institutional differences appear to have an important impact on risk management practices and derivatives use across US and Dutch firms.

Keywords: risk management; derivatives; hedging; international finance

JEL classification: F30; G15; G32

Incorporating Collateral Value Uncertainty in Loss-Given-Default Estimates and Loan-to-Value Ratios

Esa Jokivuolle and Samu Peura

We present a model of risky debt in which collateral value is correlated with the possibility of default. The model is then used to study the expected loss given default, primarily as a function of collateral. The results obtained could prove useful for estimating losses given default in many popular models of credit risk which assume them constant. We also examine the problem of determining sufficient collateral to secure a loan to a desired extent. In addition to bank practitioners, regulators might find our analysis useful in reviewing banks' lending standards relative to current collateral values. In particular, the current proposals for The New (Basel) Capital Accord involve options for the use of banks' own loss given default estimates which might benefit from the analysis in this paper.

Keywords: credit risk, collateral, loss given default, loan-to-value, Basel II

JEL Classification: G13, G21

Price Differentials Between Classes of Dual-Class Stocks: Voting Premium or Liquidity Discount?

Robert Neumann

A series of papers suggest that private benefits can explain the price differentials between stock classes carrying different voting rights. However, in Denmark the premium is negative for several firms over long periods. This indicates that in the absence of takeover contests, where the voting right becomes crucial in a transfer of corporate control, the price differential in stock classes with identical dividend rights is more likely to reflect investors' liquidity risks. Whereas the existing literature tends to focus primarily on corporate control-related explanations, this paper documents the impact of liquidity on price spreads between dual-class shares.

Keywords: Dual-class shares; voting rights; Liquidity risk; Ownership structure

JEL Classification: G32, G34

Strategic Management of Cost efficiencies in Networks: Cross-country Evidence on European Branch Banking

Nayantara D. Hensel

This paper examines the role of cost efficiencies on efficient management of branch networks in the contemporary European commercial banking industry. The analysis, which could be generalized to other industries, indicates that larger banks are more likely to have heavily utilized branch networks than smaller banks and to exhibit fewer cost efficiencies from building more branches. The finding of this result within each country suggests the role of internal firm size regardless of competitive conditions. The similar cross-country finding suggests the impact of factors such as market structure/ concentration levels and type of non-price competition. Larger banks often generate less income per unit asset deployed. Cross-border efficiency might be improved by greater use of banks with under-used networks by banks with over-used networks.

Keywords: European banking; cost efficiencies; market structure

JEL Classification: L10, L89, L21, G21, F23, F36

Firm Defaults and the Correlation Effect

Hans Gersbach and Alexander Lipponer

We examine how the correlations of bank loan defaults depend on the correlations of asset returns and how correlations and diversification are affected by macroeconomic risks. We highlight the main properties of the relationship between asset re-turns and default correlations, illustrating how adverse macroeconomic shocks raise not only the likelihood of defaults, but also the correlation of defaults. The latter effect, called correlation effect, may account for more than 50% of the increase in the credit risk.

Keywords: Credit Portfolio Management, Default Correlations, Macroeconomic Shocks, Correlation Effect, Monte-Carlo Simulation

JEL Classification: F47, G11, G33


Paying People to Lie: The Truth About the Budgeting Process

Michael C. Jensen

This paper analyzes the counterproductive effects associated with using budgets or targets in an organization's performance measurement and compensation systems. Paying people on the basis of how their performance relates to a budget or target causes people to game the system and in doing so to destroy value in two main ways: 1. both superiors and subordinates lie in the formulation of budgets and therefore gut the budgeting process of the critical unbiased information that is required to coordinate the activities of disparate parts of an organization, and 2. they game the realization of the budgets or targets and in doing so destroy value for their organizations. Although most managers and analysts understand that budget gaming is widespread, few understand the huge costs it imposes on organizations and how to lower them.
My purpose in this paper is to explain exactly how this happens and how managers and firms can stop this counterproductive cycle. The key lies not in destroying the budgeting systems, but in changing the way organizations pay people. In particular to stop this highly counterproductive behavior we must stop using budgets or targets in the compensation formulas and promotion systems for employees and managers. This means taking all kinks, discontinuities and non-linearities out of the pay-for-performance profile of each employee and manager. Such purely linear compensation formulas provide no incentives to lie, or to withhold and distort information, or to game the system.
While the evidence on the costs of these systems is not extensive, I believe that solving the problems could easily result in large productivity and value increases?sometimes as much as 50 to 100% improvements in productivity. I believe the less intensive reliance on such budget/target systems is an important cause of the increased productivity of entrepreneurial and LBO firms. Moreover, eliminating budget/target-induced gaming from the management system will eliminate one of the major forces leading to the general loss of integrity in organizations. People are taught to lie in these pervasive budgeting systems because if they tell the truth they often get punished and if they lie they get rewarded. Once taught to lie in this system people generally cannot help but extend that behavior to all sorts of other relationships in the organization.

Keywords: Budgeting, Budgets, Compensation, Performance Measurement, Gaming, Lying, Loss of Integrity, Truthfulness, Sandbagging, Motivation, Productivity, Incentives, Control Systems, Accounting Irregularities, Fraud, Goldbricking, Channel Stuffing, Cooking the Books, Managing Earnings, Managing the Numbers

European Financial Management, VOL 9:4 December 2003

Differences between European and American IPO Markets

Jay R. Ritter

This brief survey discusses recent developments in the European initial public offering (IPO) market. The spectacular rise and fall of the Euro NM markets and the growth of bookbuilding as a procedure for pricing and allocating IPOs are two important patterns. Gross spreads are lower and less clustered than in the U.S. Unlike the U.S., some European IPOs, especially those in Germany, have when-issued trading prior to the final setting of the offer price. Current research includes empirical studies on the valuation of IPOs and both theoretical and empirical work on the determinants of short-run underpricing.

Choice of Selling Mechanism at the IPO: The Case of the French Second Market

Sigrid Vandemaele

This study examines the choice of flotation mechanism within the framework of the French Second Market. Between 1983 and 1996, a firm that opted for a quotation on the Second Market, had the choice between (i) an auction-like procedure (there were two variants) and (ii) a fixed-price introduction procedure. Several interesting results are presented. First, the choice for an auction-like procedure appears to be positively related to firm valuation uncertainty at the IPO. Second, the likelihood of opting for an auction-like procedure decreases as the reputation of the investment bank guiding the flotation increases. Third, the likelihood of opting for an auction is increasing in the number of secondary shares sold by venture capitalists and investment banks.

Keywords: IPO; Contract Choice

JEL Classification: G32

Privatization Initial Public Offerings: The Polish Experience

Ranko Jelic and Richard Briston
University of Birmingham, Birmingham Business School, Birmingham, UK

The Polish government has preferred gradual direct sales to privatisation initial public offerings (PIPOs) by a 2.8 to 1 margin. Evidence suggests that the government has attempted to manage the timing of PIPOs. We, however, find no evidence of underpricing of PIPOs to a greater degree than that found for issues in the private sector. Both domestic and international investors in PIPOs earned predominantly positive returns up to 36 months after listing. The difference between PIPOs and private sector IPOs average returns is statistically significant only for international investors.

Keywords: Privatisation, IPOs, Economies in Transition

JEL Classification: G18, G32, P31

Takeover Defenses and IPO Firm Value In the Netherlands

Peter Roosenboom and Tjalling van der Goot
Tilburg University and Center, University of Amsterdam

The central question of this study involves the relation between the use of takeover defenses and IPO firm value. We report that management frequently uses takeover defenses before taking the firm public. The use of takeover defenses is primarily motivated by managerial entrenchment. IPO investors anticipate potential conflict of interests with mangement and reduce the price they pay for the IPO shares if takeover defenses are adopted. Although managers internalize this cost of takeover defenses to the degree they own pre-IPO stock, they are likely to gain through private control benefits. Non-management pre-IPO owners lose. Their shares are worth less, but different from managers, they do not get offsetting private control benefits. We infer that managers use takeover defenses to protect private control benefits at non-management pre-IPO owners’ expense.

Keywords: initial public offering, takeover defense, firm valuation

JEL Classification: G32, G34

Should Firms Going Public Enjoy Tax Benefits? An Analysis of the Italian Experience in the '90s

Arioso Giudici and Stefano Paleari

In Italy tax benefits are granted to firms going public. However, dDoes such tax relief really reduce the corporate tax burden ? In this workburden? In this study we tackle the issue, by considering 21 industrial firms that were listed on the Italian Exchange from 1995 to 1997, enjoying1997 and enjoyed a temporary tax rate cut-off. We find that the increase in the taxable income reported by these firms largely counterbalances the effect of the tax relief. We conclude that a tax rate cut-off may not necessarily provoke a reduction in the tax burden for newly listed firms, since in the short runterm they report larger earnings compared towith privately-owned companies. We claim that this ‘induced’ effect is mainly due to: the significant improvement ofthe operating performance in the year of the listing, tolisting; the reduction of the debt tax shield, to the increase in investments as well as to more transparency in accounting.shield; an increase in investment and more accounting transparency. Our findings suggest that tax relievesrelief for IPO firms does not necessarily provoke a loss of revenues for the Government.mean a loss of revenue for the government.

Keywords: Initial public offerings; Italian stock exchange; Tax relief; Corporate income tax

JEL Classification: G10, H20