European Financial Management 2007 Archive

January 2007, VOL 13:1 March 2007, VOL 13:2 June 2007, VOL 13:3 September 2007, VOL 13:4 November 2007, VOL 13:5

European Financial Management, VOL 13:1 January 2007

Payout Policy Pedagogy: What Matters and Why

Harry DeAngelo, Linda DeAngelo

This paper argues that we should abandon MM (1961) irrelevance as the foundation for teaching payout policy, and instead emphasize the need to distribute the full value generated by investment policy (Ԧull payoutԩ. Because MMӳ assumptions restrict payouts to an optimum, their irrelevance theorem does not provide the appropriate prescription for managerial behavior. A simple example clarifies why the correct prescription is Ԧull payout,Ԡand why both payout and investment policy matter even absent agency costs (DeAngelo and DeAngelo (2006)). A simple life-cycle generalization explains the main stylized facts about the payout policies of U.S. and European firms.

Keywords:Dividends, Payout policy, Dividend puzzle

JEL Classification:G35, G32, H25.

Capital Cash Flows, APV and Valuation

Laurence Booth

This paper examines three different methods of valuing companies and projects: the adjusted Present Value (APV), capital cash flows (CCF) and weighted average cost of capital (WACC) methods. It develops the appropriate WACC and beta leveraging formulae appropriate for each valuation model, so that given a particular valuation model the correct APV and CCF values can be determined from the WACC value and vice versa. Further it goes on to show when the perpetuity formulae give poor estimates of the value of individual cash flows, even though the overall values are correct. The paper cautions that the APV and CCF models require more information than is currently known, such as the value of the corporate use of debt, and consequently can give misleading results, particularly in sensitivity analyses.

Keywords:Capital cash flows, APV, Valuation,

JEL Classification:G31, G32.

Examining the Relationships between Capital, Risk and Efficiency in European Banking

Yener Altunbas, Santiago Carbo, Edward P.M. Gardener, and Philip Molyneux

This paper analyses the relationship between capital, risk and efficiency for a large sample of European banks between 1992 and 2000. In contrast to the established US evidence we do not find a positive relationship between inefficiency and bank risk-taking. Inefficient European banks appear to hold more capital and take on less risk. Empirical evidence is found showing the positive relationship between risk on the level of capital (and liquidity), possibly indicating regulatorsҠpreference for capital as a mean of restricting risk-taking activities. We also find evidence that the financial strength of the corporate sector has a positive influence in reducing bank risk-taking and capital levels. There are no major differences in the relationships between capital, risk and efficiency for commercial and savings banks although there are for co-operative banks. In the case of co-operative banks we do find that capital levels are inversely related to risks and we find that inefficient banks hold lower levels of capital. Some of these relationships also vary depending on whether banks are among the most or least efficient operators.

Keywords: Bank capital, risk, efficiency, credit, European banks

JEL Classification: E5, E52, G21

The Validity of the Economic Value Added Approach: an Empirical Application

Dimitris Kyriazis and Christos Anastassis

This study investigates the relative explanatory power of the Economic Value Added model with respect to stock returns and firmsҠmarket value, compared to established accounting variables (e.g. net income, operating income), in the context of a small European developing market, namely the Athens Stock Exchange, in its first market-wide application of the EVA measure. Relative information content tests reveal that net and operating income appear to be more value relevant than EVA. Additionally, incremental information tests suggest that EVA unique components add only marginally to the information content of accounting profit. Moreover, EVA does not appear to have a stronger correlation with firmsҠMarket Value Added than the other variables, suggesting that-for our Greek dataset- EVA, even though useful as a performance evaluation tool, need not necessarily be more correlated with shareholderӳ value than established accounting variables.

Keywords: economic value added, residual income, market value added, relative information content, incremental information content

JEL Classification: G3, G31,M41

The Determinants of Financial Structure: New Insights from Business Start-ups

Nancy Huyghebaert and Linda Van De Gucht

Business start-ups lack prior history and reputation, face high failure risk, and have highly concentrated ownership. The resulting information and incentive problems, combined with entrepreneurial private benefits of control, affect initial financing decisions. This paper examines simultaneously the impact of these issues on leverage, debt mix and maturity. We find that start-ups with high adverse selection and risk shifting problems contract less bank debt but compensate with other debt sources. Start-ups in growing industries have lower leverage, but raise more bank debt. Entrepreneurs with large private control benefits contract less but longer term bank loans to lower the default probability.

Keywords:capital structure; information and incentive problems; private benefits of control; start-ups.

JEL Classification:C31, G21, G32

Measuring Value-at-Risk in Project Finance Transactions

Stefano Gatti, Alvaro Rigamotti, Francesco Saita and Mauro Senati

Despite the remarkable importance of project finance in international financial markets, no quantitative models to measure and quantify the risk associated with a deal for the projectӳ lenders have been developed yet. The topic has recently become crucial, since the New Basle Capital Accord gives banks a choice of whether to adopt simpler (but possibly higher) standard capital requirements or to develop internal rating models for project finance transactions. The paper proposes how Monte Carlo simulations may be used to derive a Value at Risk estimate for project finance deals and discusses the critical issues that must be considered when developing such a model.

Keywords: Project finance, Value at Risk, credit risk management

JEL Classification: C15, C65, G31, G33

A New Econometric Model of Index Arbitrage

Nick Taylor

This paper introduces a new econometric model of the mispricing associated with (contemporaneous) differences between spot and futures prices. Like existing models, this model assumes that the level of arbitrage activity is positively related to the magnitude of absolute mispricing. However, unlike existing models, the new model assumes that a parameter governing a key feature of this relationship varies over time. Specifically, several versions of a smooth transition model of mispricing are introduced that each allow the shape of the transition function to be determined by a set of explanatory variables. Using high frequency data from the S&P 500 spot and futures market, the results show that the nature of the non-linearity in mispricing corresponds to arbitrageur behavior that varies (in a periodic fashion) over the trading day. This is evinced by the superior fit of the new model of mispricing, in comparison to the results based on existing econometric models of mispricing. Finally, the observed periodicity in arbitrageur behavior indicates that arbitrageurs prefer to trade during certain periods within the trading day ֠a result that contradicts the findings obtained when using existing econometric models of mispricing.

Keywords:Index arbitrage, smooth transition, intraday periodicity.

JEL Classification:C22; C41; G14.

European Financial Management, VOL 13:2 March 2007

Conditional Performance of Hedge Funds : Evidence from Daily Returns

Hossein Kazami, and Ying Li

Using daily returns on a set of hedge fund indices, we study (i) the properties of the indices' conditional density functions and (ii) the presence of asymmetries in conditional correlations between hedge fund indices and other investments and between hedge fund indices themselves. We use the SNP approach to obtain estimates of conditional densities of hedge fund returns and then proceed to examine their properties. In general, a nonparametric GARCH(1,1) model appears to provide the best fit for all strategies. We find that the conditional third and fourth moments are significantly affected by changes in the current volatility of returns on hedge fund indices. We examine changes in the conditional probability of tail events and report significant changes in the probability of extreme events when the conditioning information changes. These results have important implications for models of hedge fund risk that rely on probability of tail events. We formally test for the presence of asymmetries in conditional correlations to determine if there is contagion between hedge funds and other investments and between various hedge fund indices in extreme down markets versus extreme up markets. We generally do not find strong evidence in support of asymmetric correlations.

Keywords: Hedge funds; contagion; conditional volatility; skewness.

JEL Classification: G11, G12, G23

Capacity Constraints and Hedge Fund Strategy Returns

Naranyan Naik, Tarun Ramodorai and Maria Stromqvist

Hedge funds have generated significant absolute returns (alpha) in the decade between 1995 and 2004. However, the level of alpha has declined substantially over this period. We investigate whether capacity constraints at the level of hedge fund strategies have been responsible for this decline. For four out of eight hedge fund strategies, capital inflows have statistically preceded negative movements in alpha, consistent with this hypothesis. We also find evidence that hedge fund fees have increased over the same period. Our results provide support for the Berk and Green (2004) rational model of active portfolio management.

Keywords:Hedge funds; capacity constraints; alpha; factor models; performance fees; flows

JEL Classification:G11, G12, G23

Hedge Fund Indices: Reconciling Investability and Representativity

Felix Goltz, Lionel Martellini, and Mathieu Vaissi鼯strong>

Following a growing concern among investors about the quality of hedge fund index return data, this paper addresses the question whether designing hedge fund indices that fulfil the usual requirements (in particular representative and investable) is or not a feasible task, given a variety of features that are specific to that industry. To test whether or not investability should necessarily come at the cost of representatitivity, we use a well-known methodology in asset pricing literature based on the concept of factor replicating portfolios. Our results suggest that it is actually possible to construct representative indices based on a limited number of funds that are open to new investments, except perhaps in the case of equity market neutral strategies, provided that i) these funds are suitably selected and ii) a portfolio is constructed with the objective of replicating the common trend in hedge fund returns for a given strategy. A range of robustness tests are performed that show that high correlation of the factor replicating portfolios with the common factor of returns for each strategy is remarkably stable with respect to modifying the number of funds in the replicating portfolio or changing the frequency of rebalancing.

Keywords: hedge funds, factor replicating portfolios, hedge fund indices.

JEL Classification: G11, G12, G23

The Style Consistence of Hedge Funds

R. Gibson and S.Gyger

This study examines the style classification and the style consistency of hedge funds using a new proprietary database over the period May 1989 to April 1999. First, a hard clustering procedure is applied to classify hedge funds into homogeneous groups. It is shown that the methodology is robust and can be used to build stable hedge funds indexes. The method performs equally well as the principal component analysis in explaining in- and out-of-sample cross-sectional hedge fundsҠreturns. Second, we extend hard to fuzzy cluster memberships, relaxing the full assignment of the funds to individual clusters. We apply the fuzzy clustering methodology to estimate hedge fundsҠprobabilistic exposure to various styles. We introduce three consistency indicators to quantify the hedge fund managersҠstyle opportunism levels. We finally document that there is no evidence that style consistency leads to superior hedge fundsҠperformance.

Keywords: Hedge funds; style classification; style consistency; cluster analysis.

JEL Classification: G11

The Performance of Hedge Fund Strategies and the Asymmetry of Return Distributions

Bill Ding and Hany A. Shawky

We present hedge fund performance estimates that adjust for stale prices, Fama-French risk factors and Skewness. We contrast these new performance estimates with traditional performance measures. Using three-factor models to adjust for staleness in prices and to incorporate Fama-French factors along with the Harvey-Siddique (2000) two-factor model that incorporates Skewness, we find that for the period 1990-2003, all hedge fund categories achieve above average performance when measured against an aggregate market index. More significantly, however, when we estimate performance at the individual hedge fund level, we discover that only 40 to 47% of the funds are shown to achieve an above average performance over that time period depending on the model used. These results have important implications for investors, endowments and pensions when they choose hedge fund managers.

Keywords: Hedge funds, Skewness, Coskewness, Performance

JEL Classification: G29.

Hedge Fund Risk Measures: A Cross-Sectional Approach

Bing Liang and Hyuna Park

This paper analyzes the risk-return trade-off in the hedge fund industry. We compare semi-deviation, value-at-risk (VaR), Expected Shortfall (ES) and Tail Risk (TR) with standard deviation at the individual fund level as well as the portfolio level. Using the Fama and French (1992) methodology and the combined live and defunct hedge fund data from TASS, we find that the left-tail risk captured by Expected Shortfall (ES) and Tail Risk (TR) explains the cross-sectional variation in hedge fund returns very well, while the other risk measures provide statistically insignificant or marginally significant results. During the period between January 1995 and December 2004, hedge funds with high ES outperform those with low ES by an annual return difference of 7%. We provide empirical evidence on the theoretical argument by Artzner et al. (1999) that ES is superior to VaR as a downside risk measure. We also find the Cornish-Fisher (1937) expansion is superior to the nonparametric method in estimating ES and TR.

Keywords: hedge funds, expected shortfall, tail risk, conditional VaR, Cornish-Fisher expansion

JEL Classification: G11, G12, C31

European Financial Management, VOL 13:3 June 2007

Investor Attention and Time-Varying Comovements

Lin Peng, Wei Xiong and Tim Bollerslev

This paper analyzes the effect of an increase in market-wide uncertainty on information flow and asset price comovements. We use the daily realized volatility of the 30-year treasury bond futures to assess macroeconomic shocks that affect market-wide uncertainty. We use the ratio of a stockӳ idiosyncratic realized volatility with respect to the S&P 500 futures relative to its total realized volatility to capture the asset price comovement with the market. We find that market volatility and the comovement of individual stocks with the market increase contemporaneously with the arrival of market-wide macroeconomic shocks, but decrease significantly in the following five trading days. This pattern supports the hypothesis that investors shift their (limited) attention to processing market-level information following an increase in market-wide uncertainty and then subsequently divert their attention back to asset-specific information.

Keywords: Time-Varying Comovement, Information Flow, Volatility Dynamics, Attention Constraints

JEL Classification: G12, G14

Is the Aggregate Investor Reluctant to Realize Losses?
Evidence from Taiwan

Brad M. Barber, Yi-Tsung Lee, Yu-Jane Liu, Terrance Odean

We ask whether the typical investor and the aggregate investor exhibit a bias known as the disposition effect, the tendency to sell investments are held for a profit at a faster rate than investments held for a loss. We analyze all trading activity on the Taiwan Stock Exchange (TSE) for the five years ending in 1999. Using a dataset that contains all trades (over one billion) and the identity of every trader (nearly four million), we find that in aggregate, investors in Taiwan are about twice as likely to sell a stock if they are holding that stock for a gain rather than as loss. Eighty-four percent of all Taiwanese investors sell winners at a faster rate than losers. Individuals, corporations, and dealers are reluctant to realize losses, while mutual funds and foreigners, who together account for less than five percent of all trades (by value), are not.


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All Guts, No Glory: Trading and Diversification among Online Investors

Anders Anderson

I explore cross-sectional portfolio performance in a sample containing 324,736 transactions conducted by 16,831 Swedish investors at an Internet discount brokerage firm during the period May 1999 to March 2002. On average, investors hold undiversified portfolios, show a strong preference for risk, and trade aggressively. I measure performance using a panel data model, and explain the cross-sectional variation using investorsҠturnover, portfolio size and degree of diversification. I find that turnover is harmful to performance due to fees, and is therefore more predominant among investors with small portfolios. I argue that the degree of diversification is a proxy for investor skill, and it has a separate and distinct positive effect on performance. Investors underperform the market by about 8.5% per year on average, of which half can be attributed to trading costs.

Keywords: Investor behavior; performance evaluation; panel data models.

JEL Classification: G11, D14, C33

Valuation in the US Commercial Real Estate

Eric Ghysels, Alberto Plazzi and Rossen Valkanov

We consider a log-linearized version of a discounted rents model to price commercial real estate as an alternative to traditional hedonic models. First, we verify a key implication of the model, namely, that cap rates forecast commercial real estate returns. We do this using two different methodologies: time series regressions of 21 US metropolitan areas and mixed data sampling (MIDAS) regressions with aggregate REITs returns. Both approaches confirm that the cap rate is related to fluctuations in future returns. We also investigate the provenance of the predictability. Based on the model, we decompose fluctuations in the cap rate into three parts: (i) local state variables (demographic and local economic variables); (ii) growth in rents; and (iii) an orthogonal part. About 30% of the fluctuation in the cap rate is explained by the local state variables and the growth in rents. We use the cap rate decomposition into our predictive regression and find a positive relation between fluctuations in economic conditions and future returns. However, a larger and significant part of the cap rate predictability is due the orthogonal part, which is unrelated to fundamentals. This implies that economic conditions, which are also used in hedonic pricing of real estate, cannot fully account for future movements in returns. We conclude that commercial real estate prices are better modeled as financial assets and that the discounted rent model might be more suitable than traditional hedonic models, at least at an aggregate level.


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A Breakdown of the Valuation Effects of International Cross-Listing

Arturo Bris, Salvatore Cantale and George Nishiotis

It is well known that cross-listing domestic stocks in foreign exchanges has significant valuation effects on the listed company's shares. Using a sample of firms with dual shares, we explore the differential effects of cross-listing on prices and we are able to separate the different sources of the benefits of cross-listing. These sources include market segmentation, liquidity, and the bonding of controlling shareholders to lower expropriation of firm resources. \ Our results show that even though the market segmentation and bonding effects are both statistically significant, the economic significance of segmentation is more than double that of bonding. Furthermore, we document an economically and statistically significant increase in the liquidity of both share classes after the listing. Overall, our results explain why less and less firms are willing to list in the U.S.: Sarbanes Oxley has increased the cost of adopting better governance while its benefits are not substantial; and market segmentation has decreased significantly in the last years.


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Acquisitions, Overconfident Managers and Self-Attribution Bias

John A. Doukas and Dimitris Petmezas

We examine whether acquisitions by overconfident managers generate superior abnormal returns and whether managerial overconfidence stems from self-attribution. Self-attribution bias suggests that overconfidence plays a greater role in higher order acquisition deals predicting lower wealth effects for higher order acquisition deals. Using two alternative measures of overconfidence (1) high order acquisition deals and (2) insider dealings we find evidence supporting the view that average stock returns are related to managerial overconfidence. Overconfident bidders realize lower announcement returns than rational bidders and exhibit poor long-term performance. Second, we find that managerial overconfidence stems from self-attribution bias. Specifically, we find that high-order acquisitions (five or more deals within a three-year period) are associated with lower wealth effects than low-order acquisitions (first deals). That is, managers tend to credit the initial success to their own ability and therefore become overconfident and engage in more deals. In our analysis we control for endogeneity of the decision to engage in high-order acquisitions and find evidence that does not support the self-selection of excessive acquisitive firms. Our analysis is robust to the influence of merger waves, industry shocks, and macroeconomic conditions.

Keywords: Managerial Overconfidence, Self-Attribution Bias, Mergers and Acquisitions, Corporate Governance, Short-term and Long-term Performance.

JEL Classification: G14, G30, G34

Bank Mergers and Diversification: Implications for Competition PolicyALBERT

Banal-Estanol and Marco Ottaviani

This paper analyses competition and mergers among risk averse banks. We show that the correlation between the shocks to the demand for loans and the shocks to the supply of deposits induces a strategic interdependence between the two sides of the market. We characterize the role of diversification as a motive for bank mergers and analyse the consequences of mergers on loan and deposit rates. When the value of diversification is sufficiently strong, bank mergers generate an increase in the welfare of borrowers and depositors. If depositors have more correlated shocks than borrowers, bank mergers are relatively worse for depositors than for borrowers.

Keywords: risk aversion; imperfect competition; bank mergers; welfare of depositors and borrowers.

JEL Classification: D43, G21, G32, G34

European Financial Management, VOL 13:4 September 2007

The Economics of IPO Stabilization, Syndicates and Naked Shorts

Tim Jenkinson and Howard Jones

Stabilization is the bidding for and purchase of securities by an underwriter immediately after an offering for the purpose of preventing or retarding a fall in price. Stabilization is price manipulation, but regulators allow it within strict limits - notably that stabilization may not occur above the offer price. For legislators and market authorities, a false market is a price worth paying for an orderly market. This paper compares the rationale for regulatorsҠallowing IPO stabilization with its effects. It finds that stabilization does have the intended effects, but that underwriters also seem to have other motives to stabilize, including favouring certain aftermarket sellers and enhancing their own reputation and profits. A puzzling aspect of stabilization is why underwriters create Үaked shortҠpositions which are loss-making to cover when, as is usual, the aftermarket price rises to a premium. We set up a model to show that the lead underwriter may profit from a naked short at the expense of the rest of the syndicate given the way commissions are apportioned between them. We argue that a naked short mitigates the misalignment of interests which stabilization causes between issuer and lead underwriter, although it does so at the expense of the non-lead underwriters.

Keywords: IPO, stabilization, syndicates

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Do European Primarily Internet Banks Show Scale and Experience Efficiencies?

Javier Delgado, Iganacio Hernando and Maria J. Nieto

Empirical evidence shows that Internet banks worldwide have underperformed newly chartered traditional banks mainly because of their higher overhead costs. European banks have not been an exception in this regard. This paper analyses, for the first time in Europe, whether this is a temporary phenomenon and whether Internet banks may generate scale economies in excess of those available to traditional banks. Also do they (and their customers) accumulate experience with this new business model, allowing them to perform as well or even better than their peers, the traditional banks?. To this end, we have generally followed the same analytical framework and methodology used by DeYoung (2001, 2002, forthcoming) for Internet banks in the USA although the limitations in the availability of data, as well as the existence of different regulatory frameworks and market conditions, particularly in the retail segment, in the 15 European Union countries have required some modifications to the methodology. The empirical analysis confirms that, as is the case for US banks, European Internet banks show technologically based scale economies, while no conclusive evidence exists of technology based learning economies. As Internet banks get larger, the profitability gap with traditional banks shrinks. To the extent that Internet banks are profitable, European authorities may encourage a larger number of consumers to use this delivery channel, by tackling consumersԠsecurity concerns. This would allow Internet banks to capture more of the potential scale efficiencies implied in our estimations.


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Exchange Rates and the Conversion of Currency-Specific Risk Premia

Astrid Eisenberg and Markus Rudolf

How do the risk factors that drive asset prices influence exchange rates? Are the parameters of asset price processes relevant for specifying exchange rate process? Most international asset pricing model focus on the analysis of asset returns given exchange rate processes. Little work has been done on the analysis of exchange rate dependent on the asset returns. This paper uses an international stochastic discount factor (SDF) framework to analyze the interplay between asset prices and exchange rates. So far, this approach has only been implemented in international term structure model. We find that exchange rates serve to convert currency-specific discount factors and currency-specific theory (IAPT). Our empirical investigation of exchange rates and stock markets of four countries presents evidence for the conversation of currency-specific is premia by exchange rates.

Keywords:stochastic discount factor,international asset pricing, international arbitrage pricing theroy, factor risk premium, price of risk conversion

JEL Classification: F21, F31, G12, G15

The Performance of Local versus Foreign Mutual Fund Managers

Roger Otten and Dennis Bams

Previous literature on the home bias indicates that informational disadvantages contribute to an over-investing in domestic assets. The general idea is that local investors outperform foreign investors because they have superior access to information on local firms. In this paper we re-examine the latter argument by looking at mutual funds. More specifically we examine the performance of US equity funds (locals) versus UK equity funds (foreigners) both investing in the US equity market. For that purpose we construct a survivorship bias controlled database of 2,531 mutual funds during 1990-2000. After controlling for tax treatment, fund objectives, management expenses, investment style and time-variation in betas, we find no significant difference in risk-adjusted performance between US and UK mutual funds. We do however find a home bias for the UK funds.

Keywords: Mutual Funds, Home Bias, Performance evaluation

JEL Classification: G12, G20, G23

Managerial Stock Options and the Hedging Premium

Niclas Hagelin, Martin Holmen, John Knopf and Bengt Pramborg

Previous studies have found mixed evidence on whether hedging increases firm value. Some studies have shown that managerial incentives may influence firm hedging. In this paper we provide evidence that when hedging is based upon incentives from managersҠoptions, firm value decreases.

Keywords: hedging; managerial incentives; firm value.

JEL Classification: G32, F31

UK evidence on the characteristics versus covariance debate

Edward Lee, Weimin Liu and Norman Strong

We evaluate the Fama-French three-factor model in the UK using the approach of Daniel and Titman (1997) to determine whether characteristics or covariance risk better explains the size and value premiums. Across all three factors, we find that return premiums bear little relationship to the corresponding loadings. We show that small and value stocks earn higher returns irrespective of their return covariance. Our study contributes to the existing literature by reporting original findings on the Fama-French three factor model in the UK and by reporting results that complement existing evidence from similar studies in the US and Japan.

Keywords: value, size, factor loadings, return predictability

JEL Classification: G10, G12, G15, G30

Irrevocable Commitments and Going Private

Mike Wright, Charlie Weir and Andrew Burrows

This paper adds to growing interest in public to private buy-outs and mechanisms to ensure bid success. Using a unique, hand-collected dataset of 155 public to private buy-outs we provide one of the first examinations of the determinants of irrevocable commitments. Irrevocable commitments involve undertakings given by existing shareholders to agree to sell their shares to the bidder before the bid to take the company private is announced. We find that, for management buy-outs, the level of irrevocable commitments is increased by the bid premium, the reputation of the private equity backer and board shareholdings. The level of irrevocable commitments is reduced by rumours of a takeover bid and bid value. We therefore find evidence that management and private equity firmsҠactivity prior to the bidӳ announcement can have an important impact on the process of going private.

Keywords: Public to private transactions, irrevocable commitments

JEL Classification: G34

Stock Concentration, Trading Cost and the Profitability of Momentum Trading Strategies: Further Evidence from the UK

Sam Ageyei-Ampomah

This paper examines the post-cost profitability of momentum trading strategies in the UK over the period 1988 ֠2003 and provides direct evidence on stock concentration, turnover and trading cost associated with the strategy. We find that after factoring out transaction costs the profitability of the momentum strategy disappears for shorter horizons but remains for longer horizons. Indeed, for ranking and holding periods up to 6-months, profitable momentum returns would not be available to most average investors as the cost of implementation outweighs the possible returns. However, we find post-cost profitability for ranking and /or holding periods beyond 6 months as portfolio turnover and its associated cost reduces. We find similar results for a sub-sample of relatively large and liquid stocks.

Keywords: : Momentum strategy, Transaction costs, Portfolio Turnover, Market Efficiency

JEL Classification: G10, G11, G14

European Financial Management, VOL 13:5 November 2007

Optimal Microstructures

Maureen O'Hara

Keynote Address at the European Financial Management Association meetings (EFMA), Madrid, Spain July 2006

Keywords: Microstructure, liquidity, bond markets, ambiguity, algorithmic trading /p>

JEL Classification: G10, G14, D02

On the Magnet Effect of Price Limits

David Abad and Roberto Pascual

The "magnet" or "gravitational" effect hypothesis asserts that, when trading halts are rule-based, investors concerned with a likely impediment to trade advance trades in time. This behavior actually pushes prices further towards the limit. Empirical studies about the magnet effect are scarce, most likely because of the unavailability of data on rule-based halts. In this paper, we use a large database from the Spanish Stock Exchange (SSE), which combines intraday stock specific price limits and short-lived rule-based call actions to stabilize prices, to test this hypothesis. The SSE is particularly well suited to test the magnet effect hypothesis since trading halts are price-triggered and, therefore, predictable to some extent. Still, the SSE microstructure presents two particularities: (i) a limit-hit triggers an automatic switch to an alternative trading mechanism, a call auction, rather than a pure halt; (ii) the trading halt only lasts 5 minutes. We find that, even when prices are within a very short distance to the price limits, the probability of observing a limit-hit is unexpectedly low. Additionally, prices either initiate reversion (non limit-hit days) or slow down gradually (limit-hit days) as they come near the intraday limits. Finally, the most aggressive traders progressively become more patient as prices approach the limits. Therefore, both the price patterns and the trading behavior reported near the limits do not agree with the price limits acting as magnetic fields. Consequently, we conclude that the switching mechanism implemented in the SSE does not induce traders to advance their trading programs in time.

Keywords: Price limits, non-discretionary trading halts, magnet effect, rule-based auctions, electronic order driven markets

JEL Classification: G1, G14, D44

Operating Performance of Newly Privatized Firms in Central European Transition Economies

Wolfgang Aussenegg and Ranko Jelic

This study examines the operating performance of privatized firms in three Central European Transition Economies between 1990 and 1998. Overall, we find no evidence of a significant improvement in operating performance for the first six years after privatization. Contrary to the increasing empirical evidence for non-transition economies, our privatized firms experi-ence no improvement in profitability, capital investments, efficiency, and output, a significant drop in employment, as well as a significant increase in leverage. The most important deter-minants of the performance changes following privatization were country effects, timing of the privatization sales, industry classification, and state ownership after privatization. Our findings are consistent with the empirical evidence that the transition process proved to be more difficult than expected and that, although necessary, privatizations do not necessarily produce equal efficiency gains in transition economies (Megginson, 2005; Havrylyshyn and McGettigan, 1999).

Keywords: Privatization, Operating Performance, Transition Economies, Self-selection

JEL Classification: G32, P34, P52

Cross-sectional Tests of Conditional Asset Pricing Models: Evidence from the German Stock Market

Andreas Schrimpf, Michael Schr򤥲 and Richard Stehle

We study the performance of conditional asset pricing models and multifactor models in explaining the German cross-section of stock returns. We focus on several variables, which (according to previous research) are associated with market expectations on future market excess returns or business cycle conditions. Our results suggest that the empirical performance of the Capital Asset Pricing Model (CAPM) can be improved when allowing for time-varying parameters of the stochastic discount factor. A? conditional CAPM using the term spread explains the returns on our size and book-to-market sorted portfolios about as well as the Fama-French three-factor model and performs best in terms of the Hansen-Jagannathan distance. Structural break tests do not necessarily indicate parameter instability of conditional model specifications. Another major finding of the paper is that the Fama-French model ֠despite its generally good cross-sectional performance ֠is subject to model instability. Unconditional models, however, do a better job than conditional ones at capturing time-series predictability of the test portfolio returns.

Keywords: Cross-Section of Stock Returns, Conditional Asset Pricing Models, Multifactor Models, Hansen-Jagannathan Distance, Value Premium

JEL Classification: G12

The Effect of Socially Responsible Investing on Portfolio Performance

Peer Osthoff and Alexander Kempf

More and more investors apply socially responsible screens when building their stock portfolios. This raises the question whether these investors can increase their performance by incorporating such screens into their investment process. To answer this question we implement a simple trading strategy based on socially responsible ratings from the KLD Research & Analytics: Buy stocks with high socially responsible ratings and sell stocks with low socially responsible ratings. We find that this strategy leads to high abnormal returns of up to 8.7% per year. The maximum abnormal returns are reached when investors employ the best-in-class screening approach, use a combination of several socially responsible screens at the same time, and restrict themselves to stocks with extreme socially responsible ratings. The abnormal returns remain significant even after taking into account reasonable transaction costs.

Keywords: Socially responsible investing, portfolio management, trading strategy

JEL Classification: G11, G12, G20, G23, M14

Volatility-Spillover Effects in European Bond Markets

Charlotte Christiansen

Volatility spillover from the US and aggregate European bond markets into individual European bond markets using a GARCH volatility-spillover model is analysed. Strong statistical evidence of volatility spillover from the US and aggregate European bond markets is found. For EMU countries, the US volatility-spillover effects are rather weak (in economic terms) whereas the European volatility-spillover effects are strong. The bond markets of EMU countries have become much more integrated after the introduction of the euro, and in recent years they have become close to being perfectly integrated. The main driver of the integration appears to be convergence in interest rates.

Keywords: Euro Introduction; Government Bonds; Integration of Bond Markets; International Bond Markets; Volatility Spillover

JEL Classification: C32; E43; F36; G12; G15

Corporate Raiders, Performance and Governance in Europe

Ettore Croci

I analyze 136 block purchases made by corporate raiders in Europe between 1990 and 2001. Contrary to the hypothesis that these investors expropriate the target companies, there is a positive market reaction to the first public announcement of these purchases. In the long-run, raiders earn an abnormal profit when they sell their stakes. When they still held their positions at the end of the sample period, abnormal returns were insignificant. RaidersҠactivities do not improve operating performance. The findings are consistent with superior stock picking ability among these investors, but do not support the hypothesis that raiders are governance champions.

Keywords: corporate control; corporate raiders; Europe; event study; corporate governance.

JEL Classification: G34.

Capital Structure Swaps and the Intrinsic Wealth of Long-term Shareholder

Thomas J. O'Brien , Linda Schimd Klein and Jamfes I. Hilliard

We show how capital structure swaps can increase the wealth of a firmӳ long-term shareholders when a firmӳ debt or equity is misvalued. We review the conventional rule that a firm should issue equity and use the proceeds to retire outstanding debt (an equity-for-debt swap) when equity is overvalued, or repurchase equity with proceeds of new debt (a debt-for-equity swap) when equity is undervalued. We also analyze the more complex case where a firmӳ debt and equity are both undervalued, showing the optimal swap may be to issue undervalued equity, contrary to the conventional rule.

Keywords: capital structure, swaps, debt, equity, asymmetric information

JEL Classification: G30/G32