European Financial Management 2008 Archive

January 2008, VOL 14:1 March 2008, VOL 14:2 June 2008, VOL 14:3 September 2008, VOL 14:4 November 2008, VOL 14:5

European Financial Management, VOL 14:1 January 2008

Behavioral Finance: A Review and Synthesis

Avanidhar Subrahmanyam

I provide a synthesis of the behavioral finance literature over the past two decades. I review the literature in three parts, namely, (i) empirical and theoretical analyses of patterns in the cross-section of average stock returns, (ii) studies on trading activity, and (iii) research in corporate finance. Behavioral finance is an exciting new field because it presents a number of normative implications for both individual investors and CEOs. The papers reviewed here allow us to learn more about these specific implications.

Keywords: Behavioral Finance, Market Efficiency, Cross-Section of Stock Returns

JEL Classification: G00, G10, G11, G14, G31, G32, G34

Clustering in U.S. Stock Prices After Decimalization

David Ikenberry and James Weston

Early in 2001, U.S. equity markets transitioned from trading in discrete price fractions to a smoother decimal format with a tick size of one penny. Theory suggests in an unconstrained world, stock prices should be distributed uniformly, particularly if the cost of defeating time priority is low. This regime change provides a natural experiment to test whether investors instead prefer to trade at particular price points even when their choices are essentially unconstrained by regulation. Instead of uniformity, we find widespread evidence of price clustering at increments of five and ten cents (nickels and dimes); the overall magnitude of clustering is double in scale of what is otherwise expected. Previous studies which documented clustering around even-eighths argued that these patterns were a rational market response to trading impediments. We report consistent findings, but also find that the overall level of post-decimalization clustering is far more extensive than is reasonably explained by prior hypotheses. The evidence instead suggests a more fundamental human bias for prominent numbers as discussed in the psychology literature. Contrary to previous studies, we find no difference in price clustering, ceteris paribus, between the Nasdaq and NYSE after decimalization. Should regulators choose to revisit the notion of tick size, our evidence suggests that for many stocks there would be only minor impact between the transaction prices that prevail now and those that would occur if the tick size were increased to five cents.

Keywords: decimalization; investor behavior; price clustering.

JEL Classification: G12, G14

Wolf in Sheepӳ Clothing: The Active Investment Strategies Behind Index Performance

Angelo Ranaldo and Rainer Haberle

This paper argues that the commonly used market indices imply forms of active investment management in disguise. The selection and rebalancing rules make these indices highly exclusive and dynamic regarding their underlying components and significantly bias their performance. Any passive investment tracking these indices turns into an active strategy characterised by market timing and state-dependent performance. Evidence is provided that exclusive indices outperform (underperform) more inclusive peer indices in upward (downward) markets. The constitution and maintenance rules of exclusive indices correspond to a set of active trading and investment rules similar to momentum strategies.

Keywords: index performance, active / passive investment management, momentum strategies, index constituents; selection and rebalancing rules; performance measurement; Ԣuy-and-holdԠstrategy.

JEL Classification: G11

Overconfidence and Investor Size

Anders Ekholm and Daniel Pasternak

Recent research documents that institutional or large investors act as antagonists to other investors by showing opposite trading behavior following the disclosure of new information. Using an extremely comprehensive official transactions data set from Finland, we set out to explore the interrelation between investor size and behavior. More specifically, we test whether investor size is positively (negatively) correlated with investor reaction following positive (negative) news. We document robust evidence of that investor size affects investor behavior under new information, as larger investors on average react more positively (negatively) to good (bad) news than smaller investors. We furthermore find that the performance of smaller, or more overconfident, investors is in general hurt by their behavior.

Keywords: investor size; trading behavior; overconfidence

JEL Classification: G10 G12, G14

Adaptive Learning in an Expectational Difference Equation with Several Lags: Selecting among Learnable REE

Mikael Bask

It is demonstrated that adaptive learning in least squares sense may be incapable to satisfactorily reduce the number of attainable equilibria in a rational expectations model when focusing on the forward-solutions to the model. The model examined, as an illustration, is a basic asset pricing model for exchange rate determination that is augmented with technical trading in the currency market in the form of moving averages since it is the most commonly used technique according to questionnaire surveys. The forward-solutions to such a model are preferable to the backward-solutions that normally are utilized since announcement effects is an important feature in currency trade. Because of technical trading in foreign exchange, the current exchange rate depends on jmax lags of the exchange rate, meaning that the model has jmax+1 rational expectations equilibria, where several of them are adaptively learnable in least squares sense. However, since past exchange rates should not affect the current exchange rate when technical trading is absent in currency trade, it is possible to single out a unique equilibrium among the adaptively learnable equilibria that is economically meaningful.It is worth noting that the model examined can also be viewed as a model for stock price determination in which the forward-solutions to the model are preferable to the back-ward-solutions since the importance of announcement effects is a common characteristic for currency and stock markets.

Keywords: asset pricing, exchange rates, heterogeneous agents, least squares learnability, rational expectations equilibria and technical trading.

JEL Classification: C62, F31 and G12

New Paradigms in Stock Market Indexing

Derek Jun, Burton G. Malkiel

Considerable recent interest has been shown in a new set of stock-market indices that are weighted by fundamental factors such as sales, earnings, dividends or book values, rather than by capitalization. In this paper, we analyze the performance of Fundamental Indexing٠(ԆIԩ. First, we show that the source of FIӳ recent excellent performance is not from its ability to systematically arbitrage mispricing in a noisy market but from increasing the portfolioӳ exposure to stocks with low price-to-book values and with small capitalizations. We find that FI does not produce a positive alpha when its excess returns are explained by the Fama-French three-factor model of CAPM beta, the value premium and the size premium. Second, we show that it is possible to construct a portfolio of exchange-traded funds with similar factor loadings that can replicate, and sometimes, even outperform FI. However, we caution investors not to expect consistent outperformance from portfolios tilted towards value and small-cap stocks. Historical data shows evidence of mean reversion in the performance of such strategies.

Keywords:Indexing, Fundamental Indexing, Fama-French Model, Small Cap Stocks, and Value Premium

JEL Classification:G11, G14

Why Have Debt Ratios Increased for Firms in Emerging Markets?

Todd Mitton

I study trends in capital structure between 1980 and 2004 in a sample of over 11,000 firms from 34 emerging markets. The average firm's market-value debt ratio rose by 15 percentage points over this quarter century. I study how this rise in leverage was influenced by firm-level factors and by the availability of debt financing at the country level. The central finding is that the increase in debt ratios can largely be attributed to changes in the characteristics of emerging market firms over this period. For the average firm, the most prominent determinants of capital structure ֠size, profitability, asset tangibility, and growth opportunities ֠all shifted in the direction implying a higher optimal level of debt. At the country level, increased financial development within the country is associated with lower debt ratios, but increased financial openness to foreign markets is associated with higher debt ratios.

Keywords: emerging markets; capital structure; financial development

JEL Classification: G32; G15

On the Equivalence Between the APV and the WACC Approach in a Growing Leveraged Firm

Mario Massari, Francesco Roncaglio and Laura Zanetti

While in a steady state framework the choice between the wacc approach (Modigliani-Miller, 1963) and the adjusted present value (APV) approach (Myers, 1974) is irrelevant since the two approaches provide the same result, however, in a growing firm context the wacc equation seems to be inconsistent with the APV result. In this paper we propose a simple model to evaluate the tax savings in a growing firm in order to show under which assumptions the two approaches lead to the same results. We demonstrate that the use of the wacc model in a steady-growth scenario gives rise to some unusual assumptions with regard to the discount rates to be used in calculating tax shields. We show that the widely used wacc formula, if used, as it is in most cases, in a growth context, implies that a) debt tax shield related to already existing debt are discounted using kd; b) debt tax shield related to new debt, due to companyӳ growth, are discounted, according to a mixed procedure, using both ku and kd. We discuss the inconsistency of such a discounting procedure and the preferred features of the APV approach.

Keywords: valuation techniques, growth, APV, WACC, tax-shields

JEL Classification: G31

Timing and Wealth Effects of German Dual Class Stock Unifications

Ingolf Dittmann and Niels Ulbricht

This paper studies the reasons and the costs of separating ownership from control by analyzing the decision of German dual class firms to consolidate their share structure from dual to single class equity between 1990 and 2001. We find that the firm value increases significantly by an average 4% on the announcement day. A significant part of the variation in abnormal returns can be explained by the ownership structure and by changes in liquidity. A logit analysis of the unification decision yields that firms are more likely to unify if their controlling shareholder loses only little voting power in a stock unification. Also, firms that are financially constrained are more likely to abolish dual class shares; these firms often issue additional shares after the stock unification..

Keywords: Capital structure; entrenchment; financial constraints; liquidity; ownership structure.

JEL Classification: G32, G34

European Financial Management, VOL 14:2 March 2008

Economic Sentiment and Yield Spreads in Europe

Eva Ferreria , Maria-Isabel Martinez, Eliseo Navaroo and Gonzalo Rubio

According to Harvey (1988), the forecasting ability of the term spread on economic growth is due to the fact that interest rates reflect investorsҠexpectations about the future economic situation when deciding their plans for consumption and investment. Past literature has used ex-post data on output or consumption growth as proxies for their expected value. In this paper, we employ a direct measure of economic agentsҠexpectations, the Economic Sentiment Indicator elaborated by the European Commission, to test this hypothesis. Our results indicate that a linear combination of European yield spreads explains a surprising 93.7% of the variability of the Economic Sentiment Indicator. This ability of yield spreads to capture economic agent expectations may be the actual reason of the predictive power of yield spreads about future business cycle.

Keywords: Economic Sentiment Indicator; term structure of interest rates; yield spreads; principal components; expected economic growth?

JEL Classification: G12, E43

Corporate Sell-offs in the UK: Use of Proceeds, Financial Distress, and Long-Run Impact on Shareholder Wealth

Edward Lee and Stephen Lin

This study examines the long-run return performance following UK corporate sell-off announcements. We observe significant negative abnormal returns up to five years subsequent to sell-off announcements. Our finding is robust to various specifications, irrespective of the intended use of proceeds. We also find a significantly positive association between long-run abnormal returns and the magnitude of cash proceeds for sellers reducing corporate debt as well as for sellers with deeper financial distress or higher growth prospects. Overall, we find that UK corporate sell-offs are associated with declines in subsequent shareholder wealth.

Keywords: Sell-offs, financial distress, long-run performance

JEL Classification: G34

Dispersed Trading and the Prevention of Market Failure: The Case of the Copenhagen Stock Exchange

David C. Porter, Carsten Tanggaard, Daniel G. Weaver and Wei Yu

With augmented demands on power grids resulting in longer and larger blackouts combined with heightened concerns of terrorist attacks, trading institutions and policy makers have widened their search for systems that avoid market failure during these disturbing events. We provide insight into this issue by examining trading behavior at the Copenhagen Stock Exchange during a major blackout. We find that although market quality declined, markets remained functional and some price discovery occurred during the blackout period suggesting that the NOREX structure of interlinked trading systems combined with widely dispersed trading locations may be a viable means of protection against market failure during massive power disruptions or terrorist attacks.

Keywords: Power failure; fragmented markets; market failure

JEL Classification: G1; G14; G18

How Much Is Too Much: Are Merger Premiums Too High?

Antonios Antoniou, Philippe Arbour and Huainan Zhao

Is it too much to pay target firm shareholders a 50% premium on top of market price? Or is it too much to pay a 100% premium when pursuing mergers and acquisitions? How much is too much? In this paper, we examine how the extent of merger premiums paid impacts both the long-run and announcement period stock returns of acquiring firms. We find no evidence that acquirers paying high premiums underperform those paying relatively low premiums in three years following mergers, and the result is robust after controlling for a variety of firm and deal characteristics. Short term cumulative abnormal returns are moreover positively correlated to the level of the premium paid by acquirers. Our evidence therefore suggests that high merger premiums paid are unlikely to be responsible for acquirersҠlong-run post merger underperformance.

Keywords: Mergers and Acquisitions; Corporate Takeovers; Merger Premiums; Abnormal Returns; Event Study

JEL Classification: G14; G34

An Empirical Analysis of the Pricing of Bank Issued Options versus Options Exchange Options

Jenke Ter Horst and Chris Veld

Since 1998, large investment banks have become active as issuers of options, generally referred to as call warrants or bank-issued options. This has led to an interesting situation in the Netherlands, where simultaneously call warrants are traded on the stock exchange, and long-term call options are traded on the options exchange. Both entitle their holders to buy shares of common stock. We start with a direct comparison between call warrants and call options, written on the same stock and with the same exercise price, but where the call option has a longer time to maturity. In 13 out of 16 cases we find that the call warrants are priced higher, which is a clear violation of basic option pricing rules. In the second part of the analysis we use option pricing models to compare the pricing of call warrants and call options. If implied standard deviations from options are used to price the call warrants, we find that the call warrants are strongly overpriced during the first five trading days. The average overpricing is between 25 and 30 percent. Only a small part of the overpricing can be explained by rational arguments such as transaction costs. We suggest that the overvaluation can be explained by a combination of an active financial marketing by the banks and the framing effect.

Keywords: financial marketing, framing, bank-issued options, long-term call options, call warrants

JEL Classification: G13 and G14

Regime Change and the Role of the International Markets on the Stock Return of small open Economies

Don Bredin and Stuart Hyde

We examine the inѵence of US, UK and German macroeconomic and Юancial variables on the stock returns of two relatively small, open European economies, Ireland and Denmark. Within a nonlinear frame- work, we allow for time variation via regime switching using a smooth transition regression (STR) model. We Юd that US (global) and UK and German (regional) stock returns are signiУant determinants of re- turns in both markets. Further, global information represented by oil and US asset price movements drive changes between states in each market. SigniУantly, the role of country-speciУ domestic variables is typically conЮed to a single state while global and regional variables pervade all states.

Keywords: Smooth transition, Regime switching

JEL Classification: G15, F30, F37, C32

Capital Structure and Assets: Effects of an Implicit Collateral

Christian Riis Flor

This paper analyzes a firmӳ capital structure choice when assets have outside value. Valuable assets implicitly provide a collateral and increase tax shield ex- ploitation. The key feature in this paper is asset value uncertainty, implying that it is unknown ex ante whether the equity holders ex post optimally sell the as- sets or re-optimize the capital structure. Ex ante, more uncertain asset value decreases leverage, but not firm value, and selling the assets becomes less likely. Firms should tend to invest in assets whose value is less correlated to changes in earnings and, in addition, asset sales are less likely when this correlation is low.

Keywords: Optimal capital structure; uncertain asset value; debt restructuring.

JEL Classification: G32, G33, G34

European Financial Management, VOL 14:3 June 2008

Non-Monotonicity of the Tversky-Kahneman Probability-Weighting Function A Cautionary Note

Jonathan Ingersoll

Cumulative Prospect Theory has gained a great deal of support as an alternative to Expected Utility Theory as it accounts for a number of anomalies in the observed behavior of economic agents. Expected Utility Theory uses a utility function and subjective or objective probabilities to compare risky prospects. Cumulative Prospect Theory alters both of these aspects. The concave utility function is replaces by a loss-averse utility function and probabilities are replaced by decision weights. The latter are determined with a weighting function applied to the cumulative probability of the outcomes. Several different probability weighting functions have been suggested. The two most popular are the original proposal of Tversky and Kahneman and the compound-invariant form proposed by Prelec. This note shows that the Tversky-Kahneman probability weighting function is not increasing for all parameter values and therefore can assign negative decision weights to some outcomes. This in turn implies that Cumulative Prospect Theory could make choices not consistent with first-order stochastic dominance.

Keywords: prospect theory; decision weights; probability-weighting function.

JEL Classification: C91; D10; D81; G19i>

Testing Conditional Asset Pricing Models Using a Markov Chain Monte Carlo Approach

Manuel Ammann and Michael Verhofen

We use Markov Chain Monte Carlo (MCMC) methods for the parameter estimation and the testing of conditional asset pricing models. In contrast to traditional approaches, it is truly conditional because the assumption that time variation in betas is driven by a set of conditioning variables is not necessary. Moreover, the approach has exact finite sample properties and accounts for errors-in-variables. Using S&P 500 panel data, we analyze the empirical performance of the CAPM and the Fama and French (1993) three-factor model. We find that time-variation of betas in the CAPM and the time variation of the coefficients for the size factor (SMB) and the distress factor (HML) in the three-factor model improve the empirical performance. Therefore, our findings are consistent with time variation of firm-specific exposure to market risk, systematic credit risk and systematic size effects. However, a Bayesian model comparison trading off goodness of fit and model complexity indicates that the conditional CAPM performs best, followed by the conditional three-factor model, the unconditional CAPM, and the unconditional three-factor model.

Keywords: Markov Chain Monte Carlo, Conditional Asset Pricing, Bayesian Analysis

JEL Classification: G12

Have European Stocks Become More Volatile?

Colm Kearny and Valerio Poti

We examine the dynamics of idiosyncratic risk, market risk and return correlations in European equity markets using weekly observations from 3515 stocks listed in the 12 Euro area stock markets over the period 1974-2004. Similarly to Campbell, Lettau, Malkiel and Xu (2001), we find a rise in idiosyncratic volatility, implying that it now takes more stocks to diversify away idiosyncratic risk. Contrary to the United States, however, market risk is trended upwards in Europe and correlations are not trended downwards. Both the volatility and correlation measures are pro-cyclical, and they rise during times of low market returns. Market and average idiosyncratic volatility jointly predict market wide returns, and the latter impact upon both market and idiosyncratic volatility. This has asset pricing and risk management implications.

Keywords: Idiosyncratic risk, correlation, portfolio management, asset pricing.

JEL Classification: C32, G11, G12, G12, G15.

The Determinants of Foreign Currency Hedging: Does Foreign Currency Debt Induce a Bias?

Ephraim Clark and Amrit Judge

In this paper we use UK data to present strong empirical evidence that explains the mixed results in previous studies with respect to the effect of financial distress on the demand for corporate hedging. We build on recent studies that have identified a strong link between foreign currency (FC) debt use and leverage. Given this relationship, we show that using leverage variables as proxies for financial distress and the failure to distinguish between FC debt users and non-users causes misleading inference. More specifically, when we partition our sample of FC hedgers into firms that use and do not use foreign debt, we show that leverage variables are significantly related to the FC hedging decision for firms that use FC debt either in isolation or in combination with FC derivatives but not for firms that only use FC derivatives. This suggests that FC debt users are influencing these results. However, we also find that other financial distress cost proxies with no obvious link to FC debt use are significant determinants in the corporate demand for FC hedging, including derivatives use.

Keywords: Corporate hedging; foreign currency hedging; derivatives; financial distress; foreign currency debt.

JEL Classification: F30, G32, G33

Minority Protection and Dividend Policy in Finland

Seppo Kinkki

This paper highlights some theoretical arguments and empirical results on whether legal-based minority protection affects corporate cash dividends in Finland. The Company Act in Finland states that shareholders having one tenth of all shares can demand a so-called minority dividend, which is half of the profit of the fiscal year, yet not more than 8% of the equity. Minority dividend, as in Finland, is rarely used in EU countries. I find, that minority protection is a better influence over managerial control than controlling shareholders having absolute voting power. When there is no controlling shareholder and coalition costs are lowest, minority protection in Finland is better than minority protection in mandatory dividend countries. Combining strong shareholder rights (as in the USA) and minority dividend (as in Finland) could decrease agency costs both vertically and horizontally.

Keywords: dividends, minority protection, agency problems

JEL Classification: G32, G35

Predicting Agency Rating Migrations with Spread Implied Rating

Jiaming Koo and Simone Varotto

Rating agencies are known to be prudent in their approach to rating revisions, which results in delayed rating adjustments. For a large set of eurobonds we derive credit spread implied ratings and compare them with agency ratings. Our results indicate that spread implied ratings often anticipate the future movement of agency ratings and hence can help track credit risk in a more timely manner. This finding has important implications for risk managers in banks who, under the new Basel 2 regulations, have to rely more on credit ratings for capital allocation purposes, and for portfolio managers who face rating-related investment restrictions.

Keywords: Credit rating, Spread implied rating, Credit risk

JEL Classification: C20, G11, G23, G33

Asymmetric Volume-Return Relation and Concentrated Trading in LIFFE Futures

Tribhuvan N. Puri and George C. Philippatos

This study demonstrates that intraday volume and return on LIFFE interest rate and currency futures exhibit an asymmetric volume-return relationship characterized by significantly larger volume associated with negative returns than with non-negative returns. This finding is unlike the stylized asymmetric relation often observed in equity markets, where the volume on price rise is larger than the volume on price decline. The asymmetric relationship in LIFFE futures is also found to be dynamic as the direction of asymmetry can reverse during the day. It has been argued in the past that a costly short sale restriction that requires a higher transaction cost on a short position than on a long position is responsible for the asymmetric effect in equity markets. Since such a restriction is absent in futures markets, they should not exhibit any asymmetric volume behavior. Based on the results of this research, the costly short sale hypothesis is rejected. An alternative explanation of the asymmetric relation observed in futures is presented based on recent information models that take into consideration asymmetrically-informed traders, their dispersion of beliefs, quality and quantity of the information signal, and how the traders process it. The paper also confirms a strong U-shape trading pattern in 15-minute volume, but no such pattern is identified in intraday returns.

Keywords: LIFFE futures, volume-return asymmetric relationship, costly short-sale constarint, dispersion of beliefs,information quality, trading pattern, market microstructure.

JEL Classification: G10,G13, G15

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

JEL Classification: G11

European Financial Management, VOL 14:4 , September 2008

Trust in Financial Markets

Colin Mayer

This paper examines contemporaneous and historical evidence on the structure of ownership and control of corporate sectors in developed countries to draw lessons for development of financial markets. It records the critical role that equity markets played in the ownership and financing of corporations at the beginning of the 20th century. It notes that this occurred in the absence of formal systems of regulation and that equity markets functioned on the basis of informal relationships of trust. These were sustained through local stock markets in the UK, banks in Germany, and business coordinators and family firms in Japan. The paper explores the concept of trust that is required to promote the development of financial markets.

Keywords: Corporate ownership, control, investor protection, trust

JEL Classification: O16

Social Networks and Corporate Governance

Avanidhar Subrahmanyam

We analyze frameworks that link corporate governance and firm values to governing boardsҠsocial networks and innovations in technology. Because agents create social networks with individuals with whom they share commonalities along the dimensions of social status and income, among other attributes, CEOs may participate in board membersҠsocial networks, which interferes with the quality of governance. At the same time, social connections with members of a board can allow for better evaluation of the membersҠabilities. Thus, in choosing whether to have board members with social ties to management, one must trade off the benefit of members successfully identifying high ability CEOs against the cost of inadequate monitoring due to social connections. Further, technologies like the Internet and electronic mail that reduce the extent of face-to-face networking cause agents to seek satisfaction of their social needs at the workplace, which exacerbates the impact of social networks on governance. The predictions of our model are consistent with recent episodes that appear to signify inadequate monitoring of corporate disclosures as well as with high levels of executive compensation. Additionally, empirical tests support the modelӳ key implication that there is better governance and lower executive compensation in firms where networks are less likely to form.


JEL Classification:

Debt, Equity, and Hybrid Decoupling: Governance and Systemic Risk Implications

Henry T.C. Hu, Bernard Black

We extend here our prior work, which focused on equity decoupling (Hu and Black, 2006, 2007, 2008), by providing a systematic treatment of debt decoupling and an initial exploration of hybrid decoupling. Equity decoupling involves unbundling of economic, voting, and sometimes other rights customarily associated with shares, often in ways that permit avoidance of disclosure and other obligations. Debt decoupling involving the unbundling of the economic, contractual control rights, and legal and other rights normally associated with debt, through credit derivatives and securitization. Corporations can have empty and hidden creditors, just as they can have empty and hidden shareholders. Ԉybrid decouplingԠacross standard equity and debt categories is also possible. Debt decoupling can pose risks at the firm level for what can be termed Ԥebt governanceԠ -- the overall relationship between creditor and debtor, including creditors' exercise of contractual and legal rights with respect to firms and other borrowers. Widespread debt decoupling can also involve externalities and therefore creates systemic financial risks; we explore those risks.

Keywords: equity decoupling; debt decoupling; hybrid decoupling; vote buying; equity swaps; credit default swaps; CDOs; securitization; systemic risk

JEL Classification: : G18; G32; G34; K22

Cited in FT (Jan 27, 2007)

The Impact of Corporate Governance on Executive Compensation

Stephen G. Sapp

This paper examines the relationship between the compensation of the top five executives at a set of over 400 publicly listed Canadian firms and various internal and external corporate governance-related factors. The media is full of stories suggesting a relationship between large executive compensation packages and failures in governance at various levels within organizations, but there exists little formal analysis of many of these relationships. Our analysis provides empirical evidence supporting some of these assertions, refuting others and documenting new relationships. We find that variances in internal governance related to differences across firms in the characteristics of the CEO, compensation committee and board of directors do influence both the level and composition of executive compensation, especially for the CEO. Considering external measures of corporate governance, we find that different types of shareholders and competitive environments impact executive compensation. We do not find that either the internal or external governance characteristics dominate.

Keywords: Executive compensation; corporate governance

JEL Classification: G32; M52

The Evolution of Corporate Governance and Firm Performance in Emerging Markets:The Case of Sellier and Bellot

Tomas Jandik and Craig G. Rennie

This paper investigates the evolution of corporate governance and firm performance in transition economies. It focuses on barriers that impeded adoption of optimal corporate governance at Czech ammunition manufacturer Sellier and Bellot (S&B) following voucher privatization in 1993. Exogenously imposed diffuse ownership, combined with legal, capital market, and accounting deficiencies, contributed to poor corporate governance and weak firm performance.This study shows how legal, capital market, and accounting deficiencies hinder corporate governance evolution; it demonstrates monitoring and incentive mechanisms can create value in transition economies; it suggests effective privatization not only involves rapid ownership transfer but careful accounting and securities regulation and legal protection.

Keywords: Corporate governance; Ownership structure; Capital markets; Corporation and securities law; Transition economies; Czech Republic

JEL Classification: : G32; G34; K22

Corporate Restructuring and Bondholder Wealth

Luc Renneboog and Peter G. Szilagyi

This paper provides an overview of existing research on how corporate restructuring affects the wealth of bondholders. Restructuring is defined as any transaction that affects the firmӳ underlying capital structure. Thus, it reaches well beyond asset restructuring and includes transactions such as leveraged buyouts, security issues and exchanges, and the issuance of stock options. We identify significant gaps in the literature, emphasize the potential differences between bondholder wealth changes in market- and stakeholder-oriented governance systems, and provide valuable insights into methodological advances. Many issues obviously remain, as empirical evidence is still incomplete and focuses almost exclusively on the US. In stakeholder-oriented regimes, the potential for research remains constrained by the lesser development of bond markets that disclose information on creditor wealth shocks. Still, on-going debt securitization should now allow for the investigation of at least some critical issues. This is imperative, as the position of creditors in the firm differs substantially across governance systems despite the gradual convergence of these regimes across the world.

Keywords: bondholder wealth; corporate restructuring; mergers and acquisitions; event studies; bond returns.

JEL Classification: G12, G14, G34, G35

Corporate Real Estate Sale and Leaseback Effect: Empirical Evidence from Europe

Tomi Gronlund, Antti Louko, and Mika Vaihekoski

Corporate real estate disposals have increased in Europe during the past few years. In this research paper, we study market reactions of publicly traded European companiesҠreal estate sale and leaseback announcements during 1998ֲ004. This study is one of the first ones to study the sale and leaseback impact on corporate value with a pan-European data. We find that the sale and leaseback announcements have on average positive impact to firmӳ value which is in line with the previous studies. However, we also find that the positive effect is mainly caused by the deals with high transaction value to company market value ratio. Smaller transactions do not create on average any abnormal returns. Our results support the hypothesis that the positive sale and leaseback announcement effect is a consequence of revealed hidden value of the companyӳ assets. Thus, sale and leaseback can also be seen as a mechanism for revealing the hidden value of companyӳ assets to the market.

Keywords: real estate; sale and leaseback; hidden value; tax savings; event study

JEL Classification: G14

European Financial Management, VOL 14:5 November 2008

Psychological Bias as a Driver of Financial Regulation

David Hirshleifer

I propose here the psychological attraction theory of financial regulationشhat regulation is the result of psychological biases on the part of political participantsضoters, politicians, bureaucrats, and media commentators; and of regulatory ideologies that exploit these biases. Some key elements of the psychological attraction approach are: salience and vividness, omission bias, scapegoating and xenophobia, fairness and reciprocity norms, overconfidence, and mood effects. This approach further emphasizes emergent effects that arise from the interactions of individuals with psychological biases. For example, availability cascades and ideological replicators have powerful effects on regulatory outcomes

Keywords: Investor psychology; regulation; salience; omission bias; scapegoating; xenophobia; fairness; reciprocity; norms; mood; availability cascades; overconfidence; evolutionary psychology; memes; ideology; replicators

JEL Classification: G0; G28; H0; H1; H10

The Long-Term Effect of the Sarbanes-Oxley Act on Cross-Listing Premia

Kate Litvak

This paper uses a triple difference approach to assess whether the adoption of the Sarbanes-Oxley Act predicts long-term changes in cross-listing premia of affected foreign firms. I measure cross-listing premia as the difference between the Tobinӳ q of a cross-listed company and a non-cross-listed company from the same country matched on propensity to cross-list (first difference). I find that average premia for firms cross-listed on levels 2 or 3 (subject to SOX) declined in the year of SOX adoption (2002) and remained significantly below their pre-SOX level through year-end 2005 (second difference). Firms listed on levels 2 or 3, which are subject to SOX, experienced larger declines in premia than firms listed on levels 1 or 4, which are not subject to SOX (third difference). The estimated decline is 0.15-0.20 depending on specification. Riskier firms and firms from high-disclosing and high-GDP countries suffered larger post-SOX declines. Firm size predicts smaller declines in premia in well-governed countries. Faster-growing firms in poorly-governed countries experienced smaller declines in premia. The results are robust to the use of different before-and-after periods; the use of annual, quarterly, or monthly data; the use of individual companiesҠTobinӳ qӳ instead of matched pairs, and different regression specifications. The overall evidence is consistent with the view that SOX negatively affected cross-listed premia, and particularly hurt riskier firms and firms from well-governed countries, while perhaps helping high-growth firms from poorly-governed countries. At the same time, after-SOX, level-23 firms continue to enjoy a substantial premium, estimated at about 0.32.

Keywords: Sarbanes-Oxley Act; International Listings; Securities Regulation; Corporate Governance

JEL Classification: G3; G14; G18; G38; K22

Corporate Governance When Managers Set Their Own Pay

Pablo Ruiz-Verdu

This paper presents a model of the firm in which the manager has discretion over his own compensation, constrained only by the threat of shareholder intervention. The model addresses two main questions. How does shareholder power affect managers' compensation and their incen- tives to maximize firm value? And what is the optimal level of shareholder power? Expectedly, the model shows that increasing shareholder power leads to lower managerial pay. Greater shareholder power, however, also weakens the manager's incentives to maximize value and may even lead to lower profits for shareholders. There might, thus, be too much, as well as too little, shareholder power. The model characterizes the optimal level of shareholder power and yields predictions about the relation between shareholder power, managerial pay, performance, and firm characteristics.

Keywords: Executive compensation, corporate governance, shareholder power, managerial power.

JEL Classification: G30, G34, D86, L20, M52.

Which Factors Affect Bond Underwriting Fees? The Role of Banking Relationships

Marco Navone, Giuliano Iannotta

The question of which factors are relevant in determining bond underwriting fees is empirically investigated by analyzing 2,202 bond issues completed by European firms during the 1993 ֠2003 period. Four major results emerge from the analysis. First, the introduction of the single currency in 1999 has generated an increase in competition among banks, and, as a result, a reduction in underwriting fees. Second, a strong relationship with the issuerӳ main bank reduces the level of underwriting fees. Third, new issuers are charged with lower underwriter fees relative to firms that have completed issues without building any strong relationship with a bank. Fourth, higher reputation banks charge lower underwriting fees. The implications of these findings are also discussed.

Keywords: Undewriting, Relationship, European bonds.

JEL Classification: G20, G24, L14

Required Rates of Return for Corporate Investment Appraisal in the Presence of Growth Opportunities

Jo Danbolt, Ian R. C. Hirst, Eddie Jones

Traditional methods of estimating required rates of return overstate hurdle rates in the presence of growth opportunities. We attempt to quantify this effect by developing a simple model which: (i) identifies those companies that have valuable growth opportunities; (ii) splits the value of shares into ҡssets-in-placeҠand ҧrowth opportunitiesһ and (iii) splits the equity B into i>B
for ҡssets-in-placeҠand ҧrowth opportunitiesҮ We find growth opportunities for UK companies over the 1990-2004 period to average 33% of equity value. Incorporating the effect of growth opportunities, the average cost of capital for investment purposes falls by 1.1 percentage points.

Keywords: Cost of capital, Beta, Growth opportunities, Assets-in-place

JEL Classification: G31

The Lead-Lag Relationship Between Cash And Stock Index Futures In A New Market

Manolis G. Kavussanos, Ilias D. Visvikis and Panayotis Alexakis

This paper investigates the lead-lag relationship in daily returns and volatilities between price movements of the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 stock index futures and the underlying cash indices in the relatively new futures market of Greece. Empirical results show that there is a bi-directional relationship between cash and futures prices. However, futures lead the cash index returns, by responding more rapidly to economic events than stock prices. This speed is much higher in the more liquid FTSE/ATHEX-20 market. Moreover, results indicate that futures volatilities spill information over to the corresponding cash market volatilities in both investigated futures markets, but volatilities in the cash markets have no effect on the volatilities of futures markets. Overall, it seems that new market information is disseminated faster in the futures market compared to the stock market. This implies that the futures markets can be used as price discovery vehicles, providing further evidence that derivatives markets contribute to completing and stabilising capital markets in Greece. A further finding of this study is that futures volume and disequilibrium effects between cash and futures prices are important variables in the explanation of volatilities in cash and futures markets.

Keywords: stock index futures markets, price discovery, Granger causality, VECM-GARCH, GIR analysis, volatility spillovers.

JEL Classification: G13, G14, C32