European Financial Management 2006 Archive

January 2006, VOL 12:1 March 2006, VOL 12:2 June 2006, VOL 12:3 September 2006, VOL 12:4 November 2006, VOL 12:5

European Financial Management, VOL 12:1 January 2006

Share Repurchases, Dividends, and Executive Options: the Effect of Dividend Protection

Eva Liljeblom and Daniel Pasternack

We study the determinants of share repurchases and dividends in Finland. We find that higher foreign ownership serves as a determinant of share repurchases and suggest that this is explained by the different tax treatment of foreign and domestic investors. Further, we also find support for the signalling and a gency cost hypotheses for cash distributions. The fact that 41% of the option programmes in our sample are dividend protected allows us to test more directly the "substitution/managerial wealth" hypothesis for the choice of distribution method. When options are dividend protected, the relationship between dividend distributions and the scope of the options programme turns to a significantly positive one instead of the negative one documented in US data.

Keywords: Share repurchases, Executive options, Foreign owners

JEL Classification: G12, G32, G35

Optimal Portfolio Allocation Under Higher Moments

Eric Jondeau and Michael Rockinger

We evaluate how departure from normality may affect the allocation of assets. A Taylor series expansion of the expected utility allows to focus on certain moments and to compute the optimal portfolio allocation numerically. A decisive advantage of this approach is that it remains operational even for a large number of assets. While the mean-variance criterion provides a good approximation of the expected utility maximization under moderate non-normality, it may be ineffective under large departure from normality. In such cases, the three-moment or four-moment optimization strategies may provide a good approximation of the expected utility.

Keywords: Asset allocation, Stock returns, Non-normality, Utility function

JEL Classification: C22, C51, G12

Acquisitions: Private versus Public

Paul Draper and Krishna Paudyal

Takeovers of privately held companies represent more than 80% of all takeovers. Despite their significance, studies of such takeovers and their impact on the wealth of shareholders are rare. Using a very large, near exhaustive, sample of listed and privately held UK targets we examine the impact of such takeovers on the risk adjusted return of listed UK acquirers over the period 1981 to 2001. Acquirers of private firms earn significant positive returns during the period surrounding the bid announcement although the gains are dependent on target status, mode of payment, and the relative size of those involved. The much quoted conclusion, derived from the experiences of listed firm bidders, that the shareholders of acquiring firms fail to gain from takeovers, cannot be generalized. Acquiring a privately held company is an attractive option for maximizing shareholder wealth.

Keywords: Acquisitions, Target status, Managerial motives, Excess returns, Mode of payment

JEL Classification: G34

The Determinants Of Corporate Trade Credit Policies In A Bank-Dominated Financial Environment: The Case Of Finnish Small Firms

Jyrki Niskanen and Mervi Niskanen

This paper examines trade credit policies of small firms operating in a bank-dominated environment (Finland). We find that creditworthiness and access to capital markets are important determinants of trade credit extended by sellers. The level of purchases is positively correlated with the level of accounts payable. Larger and older firms and firms with strong internal financing are less likely to use trade credit, whereas firms with a high ratio of current assets to total assets, and firms subject to loan restructurings use it more. Negative loan decisions by financial interme-diaries increase and a close bank-borrower relationship decreases the probability that a firm does not take advantage of trade credit discounts.

Keywords: Trade Credit, Bank-dominated Financial Market, Small firms’ financial policies

JEL Classification: G30, G32

Stock Price and Volume Effects Associated with Compositional Changes in European Stock Indices

Cristina Vespro

This paper provides further evidence of price and volume effects associated with index compositional changes by analysing the inclusions (exclusions) from the French CAC40 and SBF120 indices, as well as the FTSE100. I find evidence supporting the price pressure hypothesis associated with index fund rebalancing, but weak or no evidence for the imperfect substitution, liquidity and information hypotheses. The results improve on recent evidence from the S&P500 index. The evidence for the FTSE100 additions shows, in particular, that markets learn about an imminent inclusion and incorporate this information into prices, even before the announcement date.

Keywords: Stock index revisions, Index composition, Price and Volume effects, Price Pressure

JEL Classification: G12, G14

European Financial Management, VOL 12:2 March 2006

The Effect of Crossing-Network Trading on Dealer Market's Bid-Ask Spreads

Carole Gresse

This article provides new insights into market competition between traditional exchanges and alternative trading systems in Europe. It investigates the relationship between the trading activity of a crossing network (CN) and the liquidity of a traditional dealer market (DM) by comparing data from the SEAQ quote-driven segment of the London Stock Exchange (LSE) and internal data from the POSIT crossing network. A cross-sectional analysis of bid-ask spreads shows that DM spreads are negatively related to CN executions. Risk-sharing benefits from CN trading dominate fragmentation and cream-skimming costs. Further, risk-sharing gains are found to be related to dealer trading in the CN.

Keywords: Crossing networks, Alternative trading systems, Dealer markets, Liquidity, Transaction costs, Risk sharing

JEL Classification: G19

The Determinants of Corporate Debt Maturity Structure: Evidence from France, Germany and UK

Antonios Antoniou, Yilmaz Guney, and Krishna Paudyal

We examine the determinants of the debt maturity structure of French, German and British firms. These countries represent different financial and legal traditions that may have implications on corporate debt maturity structure. Our model incorporates the factors representing three major theories (tax considerations, liquidity and signalling, and contracting costs) of debt maturity. It also controls for capital market conditions. The results confirm the applicability of most theories of debt maturity structure for the UK firms. However, the evidence from France and Germany are mixed. Therefore, the findings suggest that the debt maturity structure of a firm is determined by firm-specific factors and the country's financial systems and institutional traditions in which it operates.

Keywords: Dynamic Debt Maturity Structure, Panel Data, System-GMM

JEL Classification: G20, G32

European Foreign Exchange Risk Exposure

Aline Muller and Willem F. C. Verschoor

We find that about 13 percent of our sample of 817 European multinational firms experienced economically significant exposure effects to the Japanese yen, 14 percent to the U.S. dollar and 22 percent to the U.K. pound. Our evidence differs substantially from the U.S. experience and is robust across sub-sample periods, suggesting that a depreciating (appreciating) Euro against foreign currencies has a net negative (positive) impact on European stock returns. Short-term exposure seems to be relatively well hedged, where considerable evidence of long-term exposure is found. Firms with weak liquidity positions tend to have smaller exposures. Foreign exposure is found to increase with firm size.

Keywords: Exchange Risk, European multinational firms, Hedging policies, Intervaling, Long-term exposure

JEL Classification: F3, G12

Corporate Performance, Corporate Governance, and Top Executive Turnover in Finland

Benjamin Maury

This paper empirically investigates how corporate governance forces and firm performance affect top executive turnover in Finnish listed companies. I document an increase in CEO, top management, and board turnover in response to poor stock price performance and operating income losses. The sensitivity of the relation between stock price performance and CEO turnover is significantly higher in firms with a two-tier board structure (when the CEO is not the Chairman), but significantly lower when the CEO or a board member is the controlling shareholder. These results suggest that both the ownership structure and the board design have implications for the disciplining of managers.

Keywords: Corporate governance, Ownership structure, Board design, Two-tier board, Management turnover, Board turnover

JEL Classification: G3, G32, G38

An Integrated Framework of Corporate Governance and Firm Valuation

Stefan Beiner, Wolfgang Drobetz, Markus M. Schmid, and Heinz Zimmermann

Recent empirical research shows evidence of a positive relationship between the quality of firm-specific corporate governance and firm valuation. Instead of looking at one single corporate governance mechanism in isolation, we construct a broad corporate governance index and apply five additional variables related to ownership structure, board characteristics, and leverage to provide a comprehensive description of firm-level corporate governance for a representative sample of Swiss firms. To control for potential endogeneity of these six governance mechanisms, we develop a system of simultaneous equations and apply three-stage least squares (3SLS). Our results support the widespread hypothesis of a positive relationship between corporate governance and firm valuation.

Keywords: Corporate governance, Principal-agent problems, Ownership structure, Firm valuation, Endogeneity

JEL Classification: G12, G32, G34, G38

European Financial Management, VOL 12:3 June 2006

Improved Estimates of Correlation Coefficients And Their Impact on the Optimum Portfolios

Edwin J. Elton, Martin J. Gruber and Jonathan Spitzer

To implement mean variance analysis one needs a technique for forecasting correlation coefficients. In this article we investigate the ability of several techniques to forecast correlation coefficients between securities. We find that separately forecasting the average level of pair-wise correlations and individual pair-wise differences from the average improves forecasting accuracy. Furthermore, forming homogenous groups of firms on the basis of industry membership or firm attributes (eg. Size) improves forecast accuracy. Accuracy is evaluated in two ways: First, in terms of the error in estimating future correlation coefficients. Second, in the characteristics of portfolios formed on the basis of each forecasting technique. The ranking of forecasting techniques is robust across both methods of evaluation and the better techniques outperform prior suggestions in the literature of financial economics.

Keywords: Portfolio management correlation , forecasting

JEL Classification: G11

Is Country Diversification Better than Industry Diversification?

Kent Hargis and Jianping Mei

In this paper, we develop a framework in which one can examine the source of industry and country diversification by examining their underlying return components. We find that the global cash flow factor explains on average 39% of the variation of country cash flows and global discount rates explain 55% of the variation of country discount rates. These are much less than the explanatory power of the two factors over industry cash flow and discount rate variations, which are 72% and 78% respectively. This suggests that global factors are much less important for return components at country level than at the industry level. As a result, both better diversification of expected returns and cash flows across countries determine the larger benefits of country diversification versus industry diversification. Moreover, emerging markets tend to have much smaller co-movements of both dividends and expected returns with those of the world, suggesting a lower degree of integration with the world goods and financial markets. Our results cast doubt on the prevailing wisdom that country diversification should be replaced by industry diversification.

Keywords: Return Decomposition, Time-varying Risk Premiums, and Market Integration

JEL Classification: G15

The Importance of Industry and Country Effects in the EMU Equity Markets

Miguel Almeida Ferreira and Miguel îgelo Ferreira

Most empirical studies find that country effects are larger than industry effects in stock returns, although industry effects have gained in importance recently. Our results support the dominance of country effects relative to industry and common effects in the EMU equity markets in the 1975-2001 period. However, there is an increasing importance of industry effect relative to country effect in the 1990s. In fact, industry effects is similar in magnitude to country effect in the post-euro period. The evolution of the ratio of country to industry effect is explained by the decrease in the cross-sectional variance of interest rate movements across EMU countries. Thus, there is evidence that nominal convergence has reduced the differences between national equity markets.

Keywords: International equity markets, Diversification, Volatility, EMU

JEL Classification: G11, G15

Herding in the German Mutual Fund Industry

Andreas Walter and Friedrich Moritz Weber

This paper analyses the trading activity of German mutual funds in the 1998ֲ002 period to investigate whether German mutual fund managers are engaged in herding behaviour. An-other objective of the study is to determine the impact of this herd-like trading on stock prices. Our results provide evidence of herding and positive feedback trading by German mutual fund managers. We show that a significant portion of herding detected in the German market is associated with spurious herding as a consequence of changes in benchmark index compo-sition. Investigating the impact of mutual fund herding on stock prices, we find that herding seems to neither destabilise nor stabilise stock prices.

Keywords: Mutual funds; Herding; Positive feedback trading; German stock market

JEL Classification: D7, G14, G23

Why and How UK Firms Hedge

Amrit Judge

This paper attempts to differentiate among the theories of hedging by using disclosures in the annual reports of 400 UK companies and data collected via a survey. I find, unlike many previous US studies, strong evidence linking the decision to hedge and the expected costs of financial distress. The tests show that this is mainly because my definition of hedging includes all hedgers and not just derivative users. However, when the tests employ the same hedging definition as previous US studies, financial distress cost factors still appear to be more important for this sample than samples of US firms. Therefore, a secondary explanation for the strong financial distress results might be due to differences in the bankruptcy codes in the two countries, which result in higher expected costs of financial distress for UK firms. The paper also examines the determinants of the choice of hedging method distinguishing between non-derivative and derivatives hedging. My evidence shows that larger firms, firms with more cash, firms with a greater probability of financial distress, firms with exports or imports and firms with more short-term debt are more likely to hedge with derivatives. Thus, differences in opportunities, in incentives for reducing risk and in the types of financial price exposure play an important role in how firms hedge their risks.

Keywords: Corporate hedging; Risk management; Derivatives; Financial distress costs

JEL Classification: G32, G33

Competition and Concentration in the New European Banking Landscape

Christos Staikouras and Anastasia Koutsomanoli-Filippaki

This paper measures the degree of concentration and competition in the enlarged European Union (EU) banking environment over the period 1998-2002. In the empirical part we opt for a methodology as proposed by Panzar and Rosse based on a non-structural estimation of market competition. Our results suggest that European banks were operating under conditions of monopolistic competition and that bank interest income in the 10 new EU member states were earned under conditions of higher competition than those that existed in the old EU banking countries. The opposite result was observed for total operating revenues. Smaller banks earn interest income in a less competitive environment than larger banks, while the opposite is observed for total revenues.

Keywords: European banks; banking structure; competition; concentration; Panzar-Rosse methodology

JEL Classification: G21, L10, P20

European Financial Management, VOL 12:4 September 2006

Has Finance Made the World Riskier?

Raghuram G. Rajan

Developments in the financial sector have led to an expansion in its ability to spread risks. The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households. On net, this has made the world much better off. Concurrently, however, we have also seen the emergence of a whole range of intermediaries, whose size and appetite for risk may expand over the cycle. Not only can these intermediaries accentuate real fluctuations, they can also leave themselves exposed to certain small probability risks that their own collective behavior makes more likely. As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past. The paper discusses the implications for monetary policy and prudential supervision. In particular, it suggests market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk.

Keywords: financial development, financial-sector-induced turmoil, risk and derivatives

JEL Classification:G20, G21, G22

Is it the Law or the Lawyers? Investment Covenants Around the World

Douglas Cumming and Sofia Johan

This paper introduces a new dataset from 50 private investment funds from 17 countries around the world. We analyse the frequency of use of investment covenants imposed by institutional investors governing the activities of private investment fund managers in areas pertaining to investment decisions, investment powers, types of investments, fund operations, and limitations on liability. While the data indicate a role for country legality in affecting the frequency of use of fund covenants, the data further indicate that the presence of legally trained managers has a more pronounced role in affecting the use of covenants. As private equity and venture capital investment increases across Europe and elsewhere, our results indicate that legal practice factors will matter more than the legal setting for the establishment of covenants governing new funds.

Keywords: Empirical Contracts; Private Equity; Law and Finance

JEL Classification: G24, G28, G31, G32, G35

An Analysis of Changes in Board Structure During Corporate Governance Reforms

David HIllier and Patric McColgan

This study examines the evolution of company board structure during a period of corporate governance reform. Using data over a time period following the publication of the Cadbury Report (1992) we present evidence of an increase in the independence of UK boards, as measured by an increased willingness to employ independent non-executive directors, and to separate the positions of the CEO and the Chairman of the Board. In examining the determinants of these changes, we find that boards change more readily in response to changes in managerial control, equity issuance and corporate performance than changes in the firm-specific operating environment of companies.

Keywords: Board size; board composition; firm-specific characteristics; owner-specific characteristics.

JEL Classification:G32, G34, G38

Bidder CEO and Other Executive Compensation in UK M and As

Jerry Coakley and Stavroula Iliopoulou

This paper investigates the impact of M&As on bidder (CEO and other) executive compensation employing a unique sample of 100 completed bids in the UK over the 1998-2001 period. Our findings indicate that less independent and larger boards award CEOs significantly higher bonuses and salary following M&A completion both for the full sample and for the UK and US sub-samples. UK CEOs and executives are rewarded more for the effort exerted in accomplishing intra-industry or large mergers than for diversifying or small mergers and their cash pay is unaffected by other measures of their managerial skill or performance. US bidders are rewarded at higher levels than their UK counterparts and their remuneration is related only to measures of CEO dominance over the board of directors. Overall our findings offer support for the managerial power rather than the agency theory perspective on managerial compensation.

Keywords: Executive compensation; managerial power; agency theory.

JEL Classification: G34; J33

The Importance of Corporate Foreign Debt in Managing Exchange Rate Exposures in Non-Financial Companies

Tom Aabo

This empirical study of the exchange rate exposure management of Danish non-financial firms listed on the Copenhagen Stock Exchange shows that debt denominated in foreign currency (Ԧoreign debtԩ is a very important alternative to the use of currency derivatives. The results show that the relative importance of foreign debt is positively related to (1) the extent of foreign subsidiaries, (2) the relative value of assets in place, and (3) the debt ratio. The pivotal role of time horizon is emphasized. These findings are important to firms in other countries with open economies.

Keywords: exchange rate exposure management; financial hedging; foreign debt

JEL Classification: F23, F31, G15

European Financial Management, VOL 12:5 November 2006

The Role of Investment, Financing and Dividend Decisions in Explaining Corporate Ownership Structure: Empirical Evidence from Spain

Julio Pindado and Chabela De La Torre

This paper analyses the determinants of ownership structure by focusing on the role played by investment, financing and dividend decisions. The use of the Generalized Method of Moments allows us to provide new evidence on this important corporate governance topic, since it controls for the endogeneity problem. Our most relevant findings show that: i) increases in debt lead insiders to limit the risk they bear by reducing their holdings; ii) monitoring by large outside owners substitutes for the disciplinary role of debt; and iii) both inside and outside owners are encouraged to increase their stakes in the firm in view of higher dividends. Our results hold after controlling for equity issues and share repurchases.

Keywords: Ownership structure, investment, financing and dividend decisions, agency costs, panel data.

JEL Classification:G31, G32, G35.

The Impact of Corporate Governance on Closed-End Funds

Gordon Gemmill and Dylan C. Thomas

This study uses a large sample of UK-listed closed-end funds to examine whether governance has an impact on two indicators of fund performance: the level of fund-management fees and the discount at which a fund trades. Fees are under the control of the directors, and we find that they are inversely related to fund returns, even after allowing for differences across investment sectors. Fees are, on average, higher if a fund has a large board, few directors from outside the fund-family, many directors from within the fund-family, and low ownership by the management company. Discounts for funds are wider if the management company or any blockholder has a significant long-term stake, suggesting that investors are wary of entrenched management. The results suggest that boards are frequently compromised in their duty to shareholders by their dependence on fund-management companies.

Keywords: closed-end funds, corporate governance, fund management expenses, discounts

JEL Classification:G30, G34.

Corporate Governance and Information Efficiency in Security Markets

Charlie X. Cai, Kevin Keasey and Helen Short

Abstract This paper investigates a neglected topic in corporate governance research; namely, do governance characteristics affect the market reaction to news? The topic is important given the emphasis by governance regulations and codes of best practice on the need for greater transparency of corporate activities. For the first time in the corporate governance literature, we show that corporate governance characteristics (particularly the presence of founding family directors and gender diverse boards) affect the market reaction to company specific news. The results of the paper point to the analysis of the impact of governance characteristics on the market reaction to news being a new and complementary research agenda within corporate governance.

Keywords: Corporate Governance, Market Reaction to News

JEL Classification:G34, G14

Management Going-concern Disclosures: Impact of Corporate Governance and Auditor Reputation

Jinnn-Yang Uang, David B. Citron, Sudi sudarsanam and Richard J Taffler

Abstract The U.K. regulatory requirements relating to going-concern disclosures require directors to report on the going-concern status of their firms. Such directors have incentives not to report fairly in the case of financially-distressed firms. We expect effective corporate governance mechanisms will encourage directors to report more truthfully in such situations. This paper tests this proposition explicitly using a large sample of going-concern cases over the period 1994-2000. We find that whereas auditorsҠgoing-concern opinions predict the subsequent resolution of going-concern uncertainties directorsҠgoing-concern statements convey arbitrary and unhelpful messages to users. However, robust corporate governance structures and high auditor reputation constrain directors to be more truthful in their going-concern disclosures, bringing these more into line with the more credible auditor opinions.

Keywords: corporate governance; going concern; financial distress; Cadbury disclosure

JEL Classification:G33, G34, G38, M42

Valuation Effects of Short Sale Constraints: The Case of Corporate Takeovers

George Alexandridis, Antonios Antoniou and Huainan Zhao

We examine the relation between the degree of short sale constraints for acquiring firmsҠequity and post takeover stock performance. We find that negative long-run abnormal returns appear to decline (in economic and statistical terms) as the extent and persistence of institutional block-holder ownership increase, after accounting for the size, book-to-market and method of payment effects. In the spirit of Miller (1977), such evidence implies that the degree of short sale constraints serves as an important determinant of acquiring firmsҠshort-run overpricing. It appears that the presence of concentrated institutional presence mitigates and in most cases eliminates, through effective arbitrage, any short-run overpricing that may be responsible for the long-run underperformance of acquirers, preserving in this way efficiency in the takeover markets.

Keywords: short sale constraints; institutional ownership; mergers and acquisitions; long-term wealth effects.

JEL Classification:G14, G23, G34