European Financial Management 2005 Archive

January 2005, VOL 11:1 March 2005, VOL 11:2 June 2005, VOL 11:3 September 2005, VOL 11:4 November 2005, VOL 11:5

European Financial Management, VOL 11:1 January 2005

Financial Integration and EMU

Franklin Allen and Wei-Ling Song

This paper investigates the effect of European Monetary Union on the integration of the financial services industry within Europe using data on the announcements of M&A’s within the industry. We find some evidence that EMU has helped financial integration within the Euro area. In addition, financial institutions in EMU countries became more active in initiating integration between EMU and non-EMU partners, which also contributed to overall regional integration within Europe. The more active role of EMU institutions suggests that institutions residing in the Eurozone became stronger players in the corporate control market. However, EMU does not facilitate the entry of non-European institutions into Europe.

Keywords: Financial integration, financial institutions, mergers, euro

JEL Classification: G21, G34, F23

A Parimutuel Market Microstructure for Contingent Claims Trading

Jeffrey Lange and Nicholas Economides

Parimutuel principles are widely used as an alternative to fixed odds gambling in which a bookmaker acts as a dealer by quoting fixed rates of return on specified wagers. A parimutuel game is conducted as a call auction in which odds are allowed to fluctuate during the betting period until the betting period is closed or the auction “called”. The prices or odds of wagers are set based upon the relative amounts wagered on each risky outcome. In financial microstructure terms, trading under parimutuel principles is characterized by (1) call auction, non-continuous trading; (2) riskless funding of claim payouts using the amounts paid for all of the claims during the auction; (3) special equilibrium pricing conditions requiring the relative prices of contingent claims equal the relative aggregate amounts wagered on such claims; (4) endogenous determination of unique state prices; and (5) higher efficiency. Recently, a number of large investment banks have adopted a parimutuel mechanism for offering contingent claims on various economic indices, such as the U.S. Nonfarm payroll report and Eurozone Harmonized inflation. Our paper shows how the market microstructure incorporating parimutuel principles for contingent claims which allows for notional transactions, limit orders, and bundling of claims across states is constructed. We prove the existence of a unique price equilibrium for such a market and suggest an algorithm for computing the equilibrium. We also suggest that for a broad class of contingent claims, that the parimutuel microstructure recently deployed offers many advantages over the dominant dealer and exchange continuous time mechanisms.

Keywords: market microstructure, contingent claims, exchange, Parimutuel, Financial options, risk

JEL Classification: G10, G13, G14

The Capital Structure of Swiss Companies: An Empirical Analysis Using Dynamic Panel Data

Philippe Gaud, Elion Jani, Martin Hoesli and Andre Bender

In this paper, we analyze the determinants of the capital structure for a panel of 104 Swiss companies listed in the Swiss stock exchange. Dynamic tests are performed for the period 1991-2000. It is found that the size of companies and the importance of tangible assets are positively related to leverage, while growth and profitability are negatively associated with leverage. The sign of these relations suggest that both the pecking order and trade-off theories are at work in explaining the capital structure of Swiss companies, although more evidence exists to validate the latter theory. Our analysis also shows that Swiss firms adjust toward a target debt ratio, but the adjustment process is much slower than in most other countries. It is argued that reasons for this can be found in the institutional context.

Keywords: Capital structure, Dynamic panel data, Trade-off theory, Pecking order theory

JEL Classification: G32

Contrarian Profits and the Overreaction Hypothesis: The Case of the Athens Stock Exchange

Antonios Antoniou, Emilios C. Galariotis and Spyros I. Spyrou

This paper investigates the existence of contrarian profits and their sources for the Athens Stock Exchange (ASE). The empirical analysis decomposes contrarian profits to sources due to common factor reactions, overreaction to firm-specific information, and profits not related to the previous two terms, as suggested by Jegadeesh and Titman (1995). Furthermore, in view of recent evidence that common stock returns are related to firm characteristics such as size and book-to-market equity, the paper decomposes contrarian profits to sources due to factors derived from the Fama and French (1993, 1996) three-factor model. For the empirical testing, size-sorted sub-samples that are rebalanced annually are employed, and in addition, adjustments for thin and infrequent trading are made to the data. The results indicate that serial correlation is present in equity returns and that it leads to significant short-run contrarian profits that persist even after we adjust for market frictions. Consistent with findings for the US market, contrarian profits decline as one moves from small stocks to large stocks, but only when market frictions are considered. Furthermore, the contribution to contrarian profits due to the overreaction to the firm-specific component appears larger than the underreaction to the common factors.

Keywords: Overreaction, Delayed reaction, Contrarian Profits, Multifactor Models, and Emerging Stock Markets

JEL Classification: G1

Use of the Proceeds and Long-Term Performance of French SEO Firms

Pierre Jeanneret

This paper examines the long-term stock performance of French SEO with rights by looking at the intended use of the proceeds. Firms that raise equity for pure capital structure motives are separated from the ones that use the SEO proceeds to finance specific investment projects. Issuers in the fist category are concerned about preserving their financial flexibility and they are expected to evolve in a capital structure irrelevancy framework. On the other hand, issuers in the second category are more inclined to be sensitive to adverse selection problems or agency conflicts and thus, they should be more exposed to under-reaction on the long-run. According to a matching firm methodology, “Financing New Investment” issuers underperform their benchmark at a rate of 4 % to 8 % per year over a 36-month horizon while “Capital Structure” issuers do not show any abnormal performance. These results are robust according to alternative Beta pricing models. In addition, managers of both issuer’s types time the SEO after a period of positive abnormal performance in order to sell overpriced securities. However, only the “Financing New Investment” sample experiences a performance reversal; the abnormal returns decreasing gradually from the issue on, to become significantly negative 24 months after the event.

Keywords: Seasoned equity offerings, long-term event study, abnormal performance, under-reaction, use of the proceeds, window of opportunity p>JEL Classification: G14, G32

European Financial Management, VOL 11:2 March 2005

Are Euro Area Small Cap Stocks an Asset Class? Evidence from Mean-Variance Spanning Tests

Giovanni Petrella

In this paper we perform regression-based tests for mean-variance spanning in order to detect the effect of investing in euro area small capitalization stocks on the minimum variance frontier, and apply different measures to assess the extent of diversification gains. Empirical analysis shows that euro area small and mid cap stocks, as classified by size quartile and quintile rankings, arise as truly autonomous asset classes. This result is robust to different methodologies used to form size-based portfolios, and holds relative to both euro area large cap stocks and other international asset classes, US small capitalization stocks included.

Keywords: asset allocation; portfolio diversification; small cap stocks

JEL Classification: G11, G15

Socialism and Intrafirm Asset Allocation

Petra Joerg, Claudio Loderer and Lukas Roth

We rely on a survey of Swiss firms to document deviation from first-best for reasons of internal “fairness” when allocating resources. This “socialist” practice is more widespread in smaller than in larger firms. It ignores the reputation and past performance of the managers who apply for funding, but takes into account their hierarchical position and their past use of resources. Socialism is only partially explained by concerns about empire building and managerial optimism, and it is not meant to benefit shareholders.

Keywords: Capital budgeting, Internal socialism, Empire building, Managerial optimism, Performance

JEL Classification: G31, L22, M14

An Intertemporal International Asset Pricing Model: Theory and Empirical Evidence

Jow-ran Chang, Vihang Errunza, Ked Hogan and Mao-wei Hung

We extend Campbell's (1993) model to develop an intertemporal international asset pricing model (IAPM). We show that the expected international asset return is determined by a weighted average of market risk, market hedging risk, exchange rate risk and exchange rate hedging risk. These weights sum up to one. Our model explicitly separates hedging against changes in the investment opportunity set from hedging against exchange rate changes as well as exchange rate risk from intertemporal hedging risk. A test of the conditional version of our intertemporal IAPM using a multivariate GARCH process supports the asset pricing model. We find that the exchange rate risk is important for pricing international equity returns and it is much more important than intertemporal hedging risk.

Keywords: International Finance, Asset Pricing, Currency Risk, Intertemporal

JEL Classification: G11, G12, G15

Liability Risk for Outside Directors: A Cross-Border Analysis

Bernard Black, Brian Cheffins and Michael Klausner

Much has been said recently about the risky legal environment in which outside directors of public companies operate, especially in the United States, but increasingly elsewhere as well. Our research on outside director liability suggests, however, that directors' fears are largely unjustified. We examine the law and lawsuit outcomes in four common law countries (Australia, Canada, Britain, and the United States) and three civil law countries (France, Germany, and Japan). The legal terrain and the risk of "nominal liability" (a court finds liability or the defendants agree to a settlement) differ greatly depending on the jurisdiction. But nominal liability rarely turns into "out-of-pocket liability," in which the directors pay personally damages or legal fees. Instead, damages and legal fees are paid by the company, directors' and officers' (D&O) insurance, or both. The bottom line: outside directors of public companies face only a tiny risk of out-of-pocket liability. We sketch the political and market forces that produce functional convergence in outcomes across countries, despite large differences in law, and suggest reasons to think that this outcome might reflect sensible policy.


Credit Rationing, Customer Relationship and the Number of Banks: an Empirical Analysis

Eric de Bodt, Frederic Lobez and Jean-Christophe Statnik

The recent important transformations of the banking sector, especially through numerous mergers and acquisitions, both in Europe and in the USA, have raised serious concerns for the financing of small businesses (SBS). Indeed, SBS are known to be heavily dependent of this financing channel but to be rather opaque. It has long been thought that banks classically solved this problem by developing long term customer relationships. But will the new large banks, born from the current restructuring process, be able to continue to play this role? If not, what strategy should SBS develop to compose their bank pool in order to avoid, as much as possible, credit rationing? These questions are at the heart of our analysis. We show that there is no unique rule: all depends on the degree of SBS opacity and the kind of bank the SBS are working with.

Keywords: Credit Rationing, Customer Relationship, Bank Pool

JEL Classification: G10, G18, G28, G38

European Financial Management, VOL 11:3 June 2005

Do Insider Trading Laws Work?

Arturo Bris

This paper presents the first comprehensive global study of insider trading laws and their first enforcement. In a sample of 4,541 acquisitions from 52 countries, I find that insider trading enforcement increases both the incidence, and the profitability of insider trading. The expected total insider trading gains increase. Consequently, laws that proscribe insider trading fail to eliminate insider profits. However, harsher laws work better at reducing the incidence of illegal insider trading.

Keywords: Insider trading, Takeovers, Market regulation

JEL Classification: G38, G34, G15

European Momentum Strategies, Information Diffusion, and Investor Conservatism

John A. Doukas and Phillip J. McKnight

In this paper we conduct an out-of-sample test of two behavioral theories that have been proposed to explain momentum in stock returns. We test the gradual-information-diffusion model of Hong and Stein (1999) and the investor conservatism bias model of Barberis, Shleifer and Vishny (1998) in a sample of 13 European stock markets during the period 1988 to 2001. These two models predict that momentum comes from the (i) gradual dissemination of firm-specific information and (ii) investors failure to update their beliefs sufficiently when they observe new public information. The findings of this study are consistent with the predictions of the behavioral models of Hong and Stein s (1999) and Barberis et al. (1998). The evidence shows that momentum is the result of the gradual diffusion of private information and investors psychological conservatism reflected on the systematic errors they make in forming earnings expectations by not updating them adequately relative to their prior beliefs and by undervaluing the statistical weight of new information.

Keywords: Short-term momentum returns, Gradual dissemination of information, Investor psychological conservatism

JEL Classification: G1, G11, G14

Who Controls US?

Yoser Gadhoum, Larry H.P. Lang and Leslie Young

Berle and Means asserted that US corporations typically have dispersed shareholders; their evidence did not support this conclusion. Today, 59.74 percent of US corporations have “controlling shareholders” who hold at least 10 percent of the shares; 24.57 percent are controlled and managed by a family; 16.33 percent are controlled by a widely-held financial institution; 13.55 percent are controlled through family trusts. In all size ranges, the US has more corporations controlled by families than by financial institutions. In almost all size ranges, it has a higher percentage of family-controlled corporations than any of next four largest economies.

Keywords: Corporate Governance, Ownership Structure

JEL Classification: G32

The Performance of U.K. International Unit Trusts

Jonathan Fletcher and Andrew Marshall

We evaluate the performance of U.K. unit trusts with international equity objectives between January 1985 and December 2000 relative to domestic benchmark strategies. We use performance measures based on Jensen (1968), Ferson and Schadt (1996), and the Chen and Knez (1996) law of one price (LOP). We find more favorable trust performance using the Jensen and Ferson and Schadt measures relative to the LOP measure. There is evidence of inferior performance by some international trusts using the unconditional LOP measure. The charges and investment sector of the trust also has an impact on the performance of the trusts using the LOP measure.

Keywords: International investment, Fund performance

JEL Classification: G10, G12

Noise and the Trading Mechanism: The Case of SETS

Patricia Chelley-Steeley

On October 20, 1997, the London Stock Exchange introduced a new trading systemcalled SETS. This system was to replace the dealer system SEAQ, which had been inoperation since 1986. Using the iterative sum of squares test introduced by Inclan andTiao(1994), we investigate whether there was a change in the unconditional variance ofopening and closing returns, at the time SETS was introduced. We show that for theFTSE-100 stocks traded on SETS, on the days following its introduction, there was awidespread increase in the volatility of both opening and closing returns. However, nosynchronous volatility changes were found to be associated with the FTSE-100 index orFTSE-250 stocks. We conclude therefore that the introduction of the SETS tradingmechanism caused an increase in noise at the time the system was introduced.

Keywords: Trading Mechanism, Noise, SETS, Opening and Closing Returns

JEL Classification: G16

European Financial Management, VOL 11:4 September 2005

Understanding Regulation

Andrei Shleifer*

Keywords: Government Regulation; Regulation of Securities Markets

JEL Classification: G21

* Keynote Address at the 2004 European Financial Management Association Meetings, Basel, Switzerland, June 2004

A Reconsideration of Tax Shield Valuation

Enrique R. Arzac and Lawrence R. Glosten

A quarter-century ago, Miles and Ezzell (1980) solved the valuation problem of a firm that follows a constant leverage ratio L = D/S. However, to this day, the proper discounting of free cash flows and the computation of WACC are often misunderstood by scholars and practitioners alike. For example, it is common for textbooks and fairness opinions to discount free cash flows at WACC with beta input S = [1+(1–)L]u, although the latter is not consistent with the assumption of constant leverage. This confusion extends to the valuation of tax shields and the proper implementation of adjusted present value procedures. In this paper, we derive a general result on the value of tax shields, obtain the correct value of tax shields for perpetuities, and state the correct valuation formulas for arbitrary cash flows under a constant leverage financial policy.

Keywords: Tax Shield Valuation, WACC, APV, Cost of Capital, Leveraged Beta

JEL Classification: G13, G30, G31, G32, G33

A Conditional Assessment of the Relationships Between the Major World Bond Markets

Delroy M. Hunter and David P. Simon

This paper uses a bivariate GARCH framework to examine the lead-lag relations and the conditional correlations between 10-year US government bond returns and their counterparts from the UK, Germany, and Japan. We find that while mean and volatility spillovers exist between the major international bond markets, they are much weaker than those between equity markets. The results also indicate that the correlations between the US and other major bond market returns are time varying and are driven by changing macroeconomic and market conditions. However, in contrast to the finding that the benefits of international diversification in equity markets evaporate during high-stress periods, we find that the benefits of diversification across major government bond markets do not decrease during periods of extremely high bond market volatility or following extremely negative US and foreign bond returns.

Keywords: International bonds, conditional correlation, bond correlation, diversification benefits

JEL Classification: G15

Is Investment-Cash Flow Sensitivity Caused by Agency Costs or Asymmetric Information? Evidence from the UK

Grzegorz Pawlina and Luc Renneboog

We investigate the investment-cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow-sensitive. Is this sensitivity a result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium? We find that investment-cash flow sensitivity results mainly from the agency costs of free cash flow. The magnitude of the relationship depends on insider ownership in a non-monotonic way. Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring. Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets. We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.

Keywords: Investment-cash flow sensitivity; Ownership and control; Asymmetric information; Liquidity constraints; Agency costs of free cash flow; Large shareholder monitoring; Shapley values.

JEL Classification: D92, G31, G32

Equity Issuance, CEO Turnover and Corporate Governance

David Hiller, Linn Scott, Patrick McColgan

There is substantial evidence on the effect of external market discipline on chief executive turnover decisions in poorly performing companies. In this study we present evidence on the role of institutional monitoring in these decisions through the equity issuance process. We find that firms which undertake equity offerings are associated with an increased rate of forced CEO turnover that is focused on the managers of poorly performing companies. At the same time, equity offerings increase the likelihood of a new CEO being appointed from outside the current management team. We also provide evidence that independent boards are more likely to forcibly remove CEOs from their position, although this is not conditional on poor performance.

Keywords: : CEO Turnover, Equity Issuance, Board Structure.

JEL Classification: G32

European Financial Management, VOL 11:5 November 2005

Rain or Shine: Where is the Weather Effect?

William N. Goetzmann and Ning Zhu

There is considerable empirical evidence that emotion influences decision-making. In this paper, we use a database of individual investor accounts to examine the weather effects on traders. Our analysis of the trading activity in five major U.S. cities over a six-year period finds virtually no difference in individuals propensity to buy or sell equities on cloudy days as opposed to sunny days. If the association between cloud cover and stock returns documented for New York and other world cities is indeed caused by investor mood swings, our findings suggest that researchers should focus on the attitudes of market-makers, news providers or other agents physically located in the city hosting the exchange. NYSE spreads widen on cloudy days. When we control for this, the weather effect becomes smaller and insignificant. We interpret this as evidence that the behavior of market-makers, rather than individual investors, may be responsible for the relation between returns and weather. .

Keywords: : Weather Effect, Market Efficiency, Order Flow, Volatility, Individual Behavior .

JEL Classification: G12, G14

Divergence of Opinion Surrounding Extreme Events

Tim Loughran and Jennifer Marietta-Westberg

This paper examines the stock market performance of a large sample of new issues (IPOs and SEOs) following an extreme price movement during the first three years after the offering. Strong underperformance follows either a positive or negative (at least +/ 15%) one day return event. This poor performance cannot be explained by the Fama-French four-factor methodology, or by the generally low stock returns of growth firms. Unlike recent issuers, non-issuers report no poor performance following a similar extreme event using the four-factor methodology. The extreme event date shows very high levels of turnover, a measure of divergence of opinion. Finally, there is a strong negative linkage between higher levels of divergence of opinion and subsequent stock performance. .

Keywords: :

JEL Classification:

Does the Precision of News Affect Market Underreaction? Evidence from Returns Following Two Classes of Profit Warnings.

George Bulkley and Renata Herrerias

We evaluate whether the market reacts rationally to profit warnings by testing for subsequent abnormal returns. Warnings fall into two classes: those that include a new earnings forecast, and those that offer only the guidance that earnings will be below current expectations. We find significant negative abnormal returns in the first three months following both types of warning. There is also evidence that underreaction is more pronounced when the disclosure is less precise. Abnormal returns are significantly more negative following disclosures that offer only qualitative guidance than when a new earnings forecast is included.

Keywords: : Profit warnings; Market efficiency; Anomalies.

JEL Classification: G12; G14

Can Companies Influence Investor Behavior through Advertising? Super Bowl Commercials and Stock Returns

Frank Fehle, Sergey Tsyplakov and Vladimir Zdorovtsov

Recent research shows that mood and attention may affect investors choices. In this paper we examine whether companies can create such mood and attention effects through advertising. We choose a natural experiment by investigating price reactions and trading activity for firms employing TV commercials in nineteen Super Bowl broadcasts over the 1969 - 2001 period. We find significant positive abnormal returns for firms which are readily identifiable from the ad contents, which is consistent with the presence of mood and attention effects. For recognizable companies with the number of ads greater than the sample mean, the event is followed by an average abnormal one day return of 45 basis points. The effect appears to persist in the short term with the 20-day post-event cumulative abnormal returns for such firms averaging two percent. We find significant abnormal net buying activity for small trades in shares of recognized Super Bowl advertisers indicating that small investors tend to be the ones most attracted by the increased publicity.

Keywords: : Investor Behavior, Advertising.

JEL Classification: G12, G14.

Does Overconfidence Affect Corporate Investment? CEO Overconfidence Measures Revisited

Ulrike Malmeddier and Geoffrey Tate

This article presents the growing research area of Behavioral Corporate Finance in the context of one specific example: distortions in corporate investment due to CEO overconfidence. We first review the relevant psychology and experimental evidence on overconfidence. We then summarize the results of Malmendier and Tate (2005a) on the impact of overconfidence on corporate investment. We present supplementary evidence on the relationship between CEOs press portrayals and overconfident investment decisions. This alternative approach to measuring overconfidence, developed in Malmendier and Tate (2005b), relies on the perception of outsiders rather than the CEO s own actions. The robustness of the results across such diverse proxies jointly corroborates previous findings and suggests new avenues to measuring executive overconfidence.

Keywords: Behavioral Corporate Finance, CEO overconfidence, corporate investment

JEL Classification: G14, G31, G32, D80

On the Stability of the Cross-Section of Expected Stock Returns in the Cross-Section: Understanding the Curious Role of Share Turnover

Avanidhar Subrahmanyam

In this paper, we shed further light on cross-sectional predictors of stock return performance. Specifically, we explore whether the cross-section of expected stock returns is robust within stock groups sorted by past monthly return. We find that the book/market and momentum effects are remarkably robust to sorting on past returns. However, share turnover is negatively related to future returns for stocks with abnormally low stock price performance in the recent past, but positively related to returns for well-performing stocks. This casts doubt on the use of turnover as a liquidity proxy, but is consistent with turnover being a proxy for momentum trading which pushes prices in the direction of past price movements. Our results are robust to both NYSE/AMEX and Nasdaq stocks, and also robust to stratifying the sample by time period.

Keywords: Market efficiency, trading activity

JEL Classification: G12, G14