European Financial Management 2009 Archive

January 2009, VOL 15:1 March 2009, VOL 15:2 June 2009, VOL 15:3 September 2009, VOL 15:4 November 2009, VOL 15:5

European Financial Management, VOL 15:1 January 2009

The Subprime Panic


Understanding the ongoing credit crisis or panic requires understanding the designs of a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. I describe the relevant securities, derivatives, and vehicles to show: (1) how the chain of interlinked securities was sensitive to house prices; (2) how asymmetric information was created via complexity; (3) how the risk was spread in an opaque way; and (4) how trade in the ABX indices (linked to subprime bonds) allowed information to be aggregated and revealed. These details are at the heart of the origin of the Panic of 2007. The events of the panic are described.

Keywords: Banking panic, credit crisis, securitization, subprime mortgages, ABX index, credit derivatives

JEL Classification: G1,G2

Cash Flow Sensitivity of Investment

Armen Hovakimian and Gayane Hovakimian

Investment cash flow sensitivity is associated with both underinvestment when cash flows are low and overinvestment when cash flows are high. The accessibility of external capital is positively correlated with cash flows, intensifying investment cash flow sensitivity. Managers actively counteract the variations in internal and external liquidity by accumulating working capital when liquidity is high and draining it when liquidity is low. These results imply that cash flow sensitive firms face financial constraints, which are binding in low cash flow years. Traditional indicators of financial constraints, such as size and dividend payout, successfully distinguish firms that may potentially face constraints, but are less successful in distinguishing between periods of tight and relaxed constraints. These periods are much more clearly separated by the KZ index, which, on the other hand, is less successful in identifying firms that are likely to face liquidity constraints.

Keywords: Investment cash flow sensitivity, financial constraints, investment, managerial overconfidence

JEL Classification: G30, G31, G32

The Dark Side of International Cross-Listing: Effects on Rival Firms at Home

Michael Melvin and Magali Valero

We analyze the stock price impact of firmsҠU.S. cross-listing on home-market rival firms. Using an empirical event study approach we find negative cumulative average abnormal returns for the rival firms around both the listing and announcement of listing dates. The evidence suggests both positive and negative spillover effects on rival firms, where the dominant effect is that investors see rivals at a relative disadvantage to the cross-listing firm. As firms cross-list in the US and commit to the increased disclosure and investor protection associated with the US listing, they are better able to take advantage of growth opportunities relative to their non cross-listing counterparts, and this results in negative spillover effects on rival firms. Our results are consistent with the idea that firms cross-list as a means to reduce agency costs of controlling shareholders and thus are able to exploit growth opportunities as they have better access to external finance.

Keywords: Cross-listings; Rival firms; Growth opportunities

JEL Classification: G15

Are Venture Capitalists a Catalyst For Innovation?

Stefano Caselli, Stefano Gatti and Francesco Perrini

In this paper we test two hypotheses concerning the presence of innovation in venture capital investments and the growth of innovative venture backed firms. To examine these hypotheses we considereda sample of 37 Italian venture backed firms that went public on the Italian stock exchange between 1995 and 2004 and by a statistical matching procedure we picked 37 twin firms among the non-venture backed IPOs for the same period. Our evidence shows that innovation is an important factor during the selection phase but once the investment is made, the company does not promote continued innovation and concentrates all efforts to improve other economic and managerial aspects.

Keywords: growth, innovation projects, venture capital, propensity score

JEL Classification: L21, D21, D92, C14, C33

The Components of the Bid-Ask Spread: Evidence from the Athens Stock Exchange

Timotheos Angelidis and Alexandros Benos

We analyze the components of the bid-ask spread in the Athens Stock Exchange (ASE), which was recently characterized as a developed market. For large and medium capitalization stocks, we estimate the adverse selection and the order handling component of the spreads as well as the probability of a trade continuation on the same side of either the bid or the ask price, using the Madhavan et al. (1997) model. We extend it by incorporating the traded volume and we find that the adverse selection component exhibits U-shape patterns, while the cost component pattern depends on the stock price. For high priced stocks, the usual U-shape applies, while for low-priced ones, it is an increasing function of time, mainly due to the order handling spread component. Furthermore, the expected price change and the liquidity adjustment to Value-at-Risk that is needed are higher in the low capitalization stocks, while the most liquid stocks are the high priced ones. Moreover, by estimating the Madhavan et al. (1997) model for two distinct periods we explain why there are differences in the components of the bid-ask spread.

Keywords: Bid-Ask Spread, Asymmetry Information, Transaction Costs, Price Impact.

JEL Classification: D4, C1

The Size and Structure of the World Mutual Fund Industry

Sofia Ramos

This paper analyses the mutual fund industry for 20 countries using a new database of more than 50,000 mutual funds. The results suggest that more developed industries provide more benefits to investors as they diversify more internationally, charge lower annual charges and present more product sophistication. The results also have important policy implications by emphasizing the role of competition and contestability in industry development. Fewer barriers to entry are positively associated with a larger industry, and concomitantly with more efficiency in terms of returns and fees.

Keywords: Mutual Funds, Competition, Mutual Fund Industry, Entry Barriers.

JEL Classification: G15, G23

Competition between Exchanges: Euronext versus Xetra

Maria Kasch-Haroutounian and Erik Theissen

Exchanges in Europe are in a process of consolidation. After the failure of the proposed merger between Deutsche B򲳥 and Euronext, these two groups are likely to become the nu-clei for further mergers and co-operation with currently independent exchanges. A decision for one of the groups entails a decision for the respective trading platform. Against that back-ground we evaluate the attractiveness of the two dominant continental European trading sys-tems. Though both are anonymous electronic limit order books, there are important differ-ences in the trading protocols. We use a matched-sample approach to compare execution costs in Euronext Paris and Xetra. We find that both quoted and effective spreads are lower in Xetra. The differences are more pronounced for less liquid stocks. When decomposing the spread we find no systematic differences in the adverse selection component. Realized spreads, on the other hand, are significantly higher in Euronext. Neither differences in the number of liquidity provision agreements nor differences in the minimum tick size or in the degree of domestic competition for order flow explain the different spread levels. We thus conclude that Xetra is the more efficient trading system.

Keywords: Competition between exchanges, bid-ask spread

JEL Classification: G10, G15

The Value of Adjusting the Bias in Recommendations: International Evidence

German Lopez-Espinosa, Marina Balboa-Ramon and Juan Carlos Gomez-Sala

The financial literature has shown that both earnings forecasts and investment recommendations are optimistically biased. However, while the bias in earnings forecasts has decreased over time and even some recent studies show that they are no longer optimistic, in the case of investment recommendations this bias still remains relatively constant over time. Therefore, it seems that recommendations are less credible to investors than earnings forecasts. The vast majority of recommendation studies have been carried out at the country level. In this paper, we use an international context to study whether profitable investment strategies exist when adjusting the recommendation bias of each analyzed country. The adjustment we propose to correct this bias takes into account the differences across countries, and also varies in time to correct for the changes in bias over time within countries. Our empirical results show that there are in fact significant differences in the level of bias among countries, with the United States and the United Kingdom being the countries with the highest bias. Second, the adjusted consensus portfolios are more orthogonal to typical investment styles (Size, Book-to-Market and Attention) and we find that investors could implement a higher number of profitable investment strategies using this adjusted measure. In this line, the results show that the countries with the lowest bias obtain the highest risk adjusted abnormal returns. Third, our work entails a practical implication, as it shows the value embedded in a simple necessary adjustment in the global asset management context. This is an important result showing that profitable investment strategies exist when considering a global portfolio based on adjusted recommendations.

Keywords: Country-bias, adjusted consensus, international portfolio management, investment strategy

JEL Classification: G10, G14, G20, G24

European Financial Management, VOL 15:2 March 2009

Risk and Asset Management: Introduction

Lionel Martellini

The Performance of Characteristics-based Indices

Noel Amenc, Felix Goltz, Veronique Le Sourd

This paper analyses a set of characteristics-based indices that, it has been argued, outperform market cap-weighted indices. We analyse the performance of an exhaustive list of these indices and show that i) the outperformance over value-weighted indices may be negative over long time periods, and ii) there is no significant outperformance over equal-weighted indices. An analysis of the style and sector exposures of characteristics-based indices reveals a significant value tilt. When this tilt is properly adjusted for, the abnormal returns of these indices decrease considerably. Moreover, it is straightforward to construct portfolios with higher Sharpe ratios than characteristics-based indices through factor or sector tilts.

Keywords: market portfolio, value premium, performance measurement, characteristics-based indices

JEL Classification: G11, G12

Do Inflation-Linked Bonds Still Diversify?

Marie Briere, Ombretta Signori

The diversifying power of inflation-linked (IL) bonds relative to traditional asset classes has changed significantly. In this paper, we study the dynamics of conditional volatilities and correlations for three asset classes, IL bonds, nominal bonds and equities, in the United States and Europe. Using a DCC-MVGARCH for the period 1997-2007, we highlight the change that took place in 2003. Although IL bonds once had definite diversification power, they are now highly correlated with nominal bonds and have reached similar volatility levels. As a result, the two asset classes are practically substitutable. This seems to be due to more stable inflation expectations and to a more liquid IL bond market. Although diversification was a valuable reason for introducing IL bonds in a global portfolio before 2003, this is no longer the case. Dynamic portfolio optimization using our estimates of conditional correlations and volatilities clearly demonstrates that the optimal weight of IL bonds in a portfolio decreased sharply in 2003 in favor of nominal bonds and equities.

Keywords: inflation-linked bonds, optimal allocation, portfolio choice, conditional volatility, conditional correlation

JEL Classification: G11, G12

Portfolio Performance Measurement: A No Arbitrage Bounds Approach

Dong-Hyun Ahn, H. Henry Cao, Stephane Chretien

This paper presents a new method to examine the performance evaluation of mutual funds in incomplete markets. Based on the no arbitrage condition, we develop bounds on admissible performance measures. We suggest new ways of ranking mutual funds and provide a diagnostic instrument for evaluating the admissibility of candidate performance measures. Using a monthly sample of 320 equity funds, we show that admissible performance values can vary widely, supporting the casual observation that investors disagree on the evaluation of mutual funds. In particular, we cannot rule out that more than 80% of the mutual funds are given positive values by some investors. Moreover, we empirically demonstrate that potential inference errors embedded in existing parametric performance measures can be of important magnitude.

Keywords: portfolio performance measurement, mutual funds

JEL Classification: G12, G23

Does Hedge Fund Performance Persist? Overview and New Empirical Evidence

Martin Eling

The contribution of this paper is to provide an overview and new empirical evidence on hedge fund performance persistence, which has been a controversial issue in the academic literature during the last several years. In the first step, we review recent studies and put them into a joint evaluation of hedge fund performance persistence. In the second step, the methodological framework developed in the overview is used to present new empirical evidence. We find different levels of performance persistence depending on the statistical methodology and the hedge fund strategy employed. In our study, performance persistence cannot be explained by the use of option-like strategies, but it can be partially explained by survivorship and backfilling bias. Differences among hedge fund strategies might be explained by return smoothing. Finally, we develop a rationale for choosing between different methodologies to measure performance persistence and conclude that the multi-period Kolmogorov-Smirnov test is the most useful for evaluating performance persistence of hedge funds.

Keywords: Performance Measurement, Performance Persistence, Hedge Funds

JEL Classification:

Insider Trading and Corporate Governance: The Case of Germany

Andr顂etzer and Erik Theissen

We analyze transactions by corporate insiders in Germany. We find that insider trades are associ-ated with significant abnormal returns. Insider trades that occur prior to an earnings announce-ment have a larger impact on prices. This result provides a rationale for the UK regulation that prohibits insiders from trading prior to earnings announcements. Both the ownership structure and the accounting standards used by the firm affect the magnitude of the price reaction. The position of the insider within the firm has no effect, which is inconsistent with the informational hierarchy hy-pothesis.

Keywords: Insider trading, directors' dealings, corporate governance

JEL Classification: G14, G30, G32

Predicting European Takeover Targets

Gurvinder Brar, Daniel Giamouridis, Manolis Liodakis

This article extends Palepu (1986) acquisition likelihood model by incorporating measures of technical nature, e.g. momentum, trading volume as well as a measure of market sentiment. We use the proposed model to predict takeover targets in a large sample of European and cross-border Merger and Acquisition deals and validate its performance on an in- and out-of ׳ample basis. The robustness of the proposed model is investigated across several dimensions. In addition we explore the ability of the model to form the basis of successful takeover timing investment strategies. The results of our empirical analysis suggest that the proposed model predicts European takeover targets with relatively high accuracy and is able to determine portfolios that earn significant returns which are not explained by conventional risk factors.

Keywords: Takeovers; Prediction; Investment decisions

JEL Classification: G11; G34; C21

The Euro and the changing face of European Banking: Evidence from Mergers and Acquisitions

M. Ekkayokkaya , Krishna Paudyal and Phil Holmes

During the last fifteen years, the European banking industry has experienced considerable consolidation through mergers and acquisitions against the background of the introduction of the single currency and reductions in cross-border barriers. This paper investigates whether these changes impacted on announcement period gains of the banks acquiring targets by examining the pre-euro, run-up to the euro and post euro eras. Evidence suggests biddersҠgains have fallen with the development of economic and monetary union. It also reveals significant differences in the gains from acquisitions within and outside the eurozone. These results are consistent with increased competition among bidders and increased integration of the market in the eurozone area in the post-euro era. However, differing results relating to focused and diversifying bids suggest that the level of market integration is sector dependent.

Keywords: G21, G34

JEL Classification: European banking, integration, single currency, euro, acquisitions

European Financial Management, VOL 15:3 June 2009

Is CEO Pay Really Inefficient? A Survey of New Optimal Contracting Theories

Alex Edmans and Xavier Gabaix

Abstract Bebchuk and Fried (2004) argue that executive compensation is set by CEOs themselves rather than boards on behalf of shareholders, since many features of observed pay packages may appear inconsistent with standard optimal contracting theories. However, it may be that simple models do not capture several complexities of real-life settings. This article surveys recent theories that extend traditional frameworks to incorporate these dimensions, and show that the above features can be fully consistent with e ciency. For example, optimal contracting theories can explain the recent rapid increase in pay, the low level of incentives and their negative scaling with ?rm size, pay-for-luck, the widespread use of options (as opposed to stock), severance pay and debt compensation, and the insensitivity of incentives to risk.

Keywords:executive compensation, CEO incentives, optimal contracting

JEL Classification: D2, D3, G34, J3

The Impact of Managerial Entrenchment on Agency Costs: An Empirical Investigation Using UK Panel Data

Chrisostomos Florackis and Aydin Ozkan

Abstract This paper empirically investigates the relationship between managerial entrenchment and agency costs for a large sample of UK firms over the period 1999-2005. To measure managerial entrenchment, we use detailed information on ownership and board structures and managerial compensation. We develop a managerial entrenchment index, which captures the extent to which managers have the ability and incentives to expropriate wealth from shareholders. Our findings, which are based on a dynamic panel data analysis, show that there is a strong negative relationship between managerial entrenchment and our inverse proxy for agency costs, namely asset turnover ratio. There is also evidence that short-term debt and dividend payments work as effective corporate governance devices for UK firms. Finally, our findings reveal that agency costs are persistent over time. The results are robust to a number of alternative specifications, including varying measures of managerial entrenchment and agency costs.

Keywords: Agency costs; Managerial entrenchment; Corporate governance mechanisms; Panel data.

JEL Classification: G3; G32

The Co-movement of Credit Default Swap, Bond and Stock Markets: An Empirical Analysis

Lars Norden and Martin Weber

Abstract We analyze the relationship between credit default swap (CDS), bond and stock markets during 2000-2002. Focusing on the intertemporal co-movement, we examine monthly, weekly and daily lead-lag relationships in a vector autoregressive model and the adjustment between markets caused by cointegration. First, we find that stock returns lead CDS and bond spread changes. Second, CDS spread changes Granger cause bond spread changes for a higher number of firms than vice versa. Third, the CDS market is more sensitive to the stock market than the bond market and the strength of the co-movement increases the lower the credit quality and the larger the bond issues. Finally, the CDS market contributes more to price discovery than the bond market and this effect is stronger for US than for European firms.

Keywords: credit risk; credit spreads; credit derivatives; lead-lag relationship

JEL Classification: G10, G14, G21

Why Do Western European Firms Issue Convertibles Instead of Debt or Equity?

Marie Dutordoir and Linda Van De Gucht

Abstract Unlike their US counterparts, European convertible debt issuers tend to be large companies with small debt- and equity-related financing costs. Therefore, it is puzzling why these firms issue convertibles instead of standard financing instruments. This paper examines European convertible debt issuer motivations by estimating a security choice model that incorporates convertibles, straight debt, and equity. We find that European convertibles are used as sweetened debt, not as delayed equity. This motivation is reflected in the debt-like design of most European convertible issues.

Keywords: convertible debt; security choice; security design; Western Europe.

JEL Classification:G14; G32

Market Feedback, Investment Constraints, and Managerial Behavior

Paula Hill and David Hillier

Abstract This paper examines the joint role of market feedback and investment constraints on managerial behavior. Using a sample of UK fixed price initial public offerings, we show that underperformance of share returns at the IPO significantly affects managerial investment decisions in the period after the offering. Firms with better investment opportunities and proportionately lower fixed (higher intangible) assets are more sensitive to negative market feedback. Over the longer term, the more responsive firms perform significantly better than their non-responsive counterparts. The findings contribute to the debate on the informational advantage of managers over investors and present strong evidence that the market, on aggregate, can provide a superior assessment of a firmӳ opportunities. Managers who are able to respond to negative market feedback can significantly improve their firmӳ future prospects.

Keywords:Market Feedback; Managerial Behavior; Investment; Financing; Book to Market;

JEL Classification:G32

Foreign Currency Derivatives versus Foreign Currency Debt and the Hedging Premium

Ephraim Clark and Amrit Judge

Abstract This paper compares the effect on firm value of different foreign currency (FC) financial hedging strategies identified by type of exposure (short or long term) and type of instrument (forwards, options, swaps and foreign currency debt). We find that hedging instruments depend on the type of exposure. Short term instruments such as FC forwards and/or options are used to hedge short term exposure generated from export activity while FC debt and FC swaps into foreign currency (but not into domestic currency) are used to hedge long term exposure arising from assets located in foreign locations. Our results relating to the value effects of foreign currency hedging indicate that foreign currency derivatives use increases firm value but there is no hedging premium associated with foreign currency debt hedging, except when combined with foreign currency derivatives. Taken individually, FC swaps generate more value than short term derivatives.

Keywords:International Finance; Risk Management; Foreign Currency Hedging; Foreign Currency Derivatives; Foreign Currency Debt; Foreign Currency Swaps.

JEL Classification: G15; G30; G32

What Drives Private Equity Returns?-Fund Inows, Skilled GPs, and/or Risk?

Christian Diller and Christoph Kaserer

Abstract This paper analyzes the determinants of returns generated by mature European private equity funds. It starts from the presumption that this asset class is characterized by illiquidity, stickiness, and segmentation. Given this presumption, Gompers and Lerner (2000) have shown that venture deal valuations are driven by overall fund inflows into the industry that yield the putative 'money chasing deals' phenomenon. It is the aim of this paper to show that this phenomenon explains a significant part of the variation in private equity funds' returns. This is especially true for venture funds, as they are a ected more by illiquidity and segmentation than buy-out funds. In the context of a WLS-regression approach the paper reports a highly signifi- cant impact of total fund in ows on fund returns. It can also be shown that private equity funds' returns are driven by GP's skills as well as stand-alone investment risk. In a bootstrapping context we can show that most of these results are quite stable.

Keywords: Private equity funds; performance measurement; venture capital; buyout; IRR; PME; 'money chasing deals' phenomenon .

JEL Classification:G24

A Retrospective Evaluation of the European Financial Management (1995-2008)

Kam C. Chan, Chih-Hsiang Chang and Y. Ling Lo

Abstract We provide a retrospective evaluation of the European Financial Management (EFM) from 1995-2008. In 14 years, EFM has published a total of 333 articles, with 564 authors from 399 academic and non-academic institutions. The authors and institutions represent 26 different countries. Two interesting results emerge from this analysis. First, although EFM is a young finance journal, it has achieved a highly respectable status among all finance journals. In fact, EFM has surpassed a number of well-established finance journals in its research impact. Second, consistent with its mission, EFM has published articles whose authors have European affiliations and research content. Nonetheless, we find that EFM is the publication outlet of authors outside the European region as well. The rising readership and variety of articles published suggest that EFM is a general finance journal that has done very well in serving the interests of the finance profession for the last 14 years.

Keywords: journal evaluation; Google; citations

JEL Classification:G00

European Financial Management, VOL 15:4 September 2009

Initial Public Offerings: Introduction

Guest Editor: Tim Jenkinson

Universal Banking, Asset Management, and Stock Underwriting

William C. Johnson and Marietta-Westberg

This paper examines institutions that underwrite IPOs and have asset management divisions from 1993 through 1998. We provide evidence that these firms use asset management funds as vehicles to help them earn more equity underwriting business. We also show that asset managers affiliated with IPO underwriters use their superior information about their own institutionӳ IPOs to earn annualized market adjusted returns 7.6% above asset managers of firms who did not underwrite the IPO. Superior future returns by asset managers who trade affiliated IPOs are dependent on the information environment for the IPO and the underwriter reputation rank.


JEL Classification: G24

Competitive IPOs

Tim Jenkinson and Howard Jones

Abstract Competition between investment banks for lead underwriter mandates in IPOs is fierce, but having committed to a particular bank, the power of the issuer is greatly reduced. Although information revelation theories justify giving the underwriters influence over pricing and allocation, this creates the potential for conflicts of interest. In this clinical paper we analyse an interesting innovation that has been used in recent European IPOs whereby issuers separate the preparation and distribution roles of investment banks, and keep competitive pressure on the banks throughout the issue process. These 'competitive IPOs' allow the issuer greater control and facilitate more contingent fee structures that help to mitigate against 'bait and switch.' But unlike more radical departures from traditional bookbuilding ֠such as auctions ֠the competitive IPO is an incremental market-based response to potential conflicts of interest that retains many of the advantages of investment banks' active involvement in issues.

Keywords:IPO, bookrunners, syndicate, underpricing

JEL Classification: G3, G24

Conflicts of Interest and Research Quality of Affiliated Analysts in the German Universal Banking System: Evidence from IPO Underwriting

Wolfgang Bessler and Matthias Stanzel

Abstract The quality of equity research by financial analysts is a prerequisite for an efficient capital market. This study investigates the quality of earnings forecasts and stock recommendations for initial public offerings (IPOs) in Germany. The empirical study includes 12,605 earnings forecasts and 6,209 stock recommendations of individual analysts for the time period from 1997 to 2004. The focus of this study is on analyzing the potential conflicts of interest that arise when the analyst is affiliated with the underwriter of an IPO. In a universal banking system these conflicts of interest are usually more pronounced and therefore interesting to investigate. The empirical findings for the German financial market suggest that earnings forecasts and stock recommendations of the analysts belonging to the lead-underwriter are on average inaccurate and biased, indicating some conflicts of interest. Moreover, the stock recommendations of the analysts that are affiliated with the lead-underwriter are often too optimistic resulting in a significant long-run underperformance for the investor. In contrast, unaffiliated analysts provide better earnings forecasts and stock recommendations that would have resulted in a superior performance for the investor

Keywords:initial public offerings, analyst behavior, conflicts of interest, research quality, earnings forecasts and stock recommendations

JEL Classification: G14; G24

How much does investor sentiment really matter for equity issuance activity?

Francois Derrien and Ambrus Kecskes

We study the extent to which investor sentiment matters for aggregate equity issuance activity. We focus on firms that are susceptible to investor sentiment and for which accurate measures of economic fundamentals are available. While sentiment on its own matters for equity issuance, it matters relatively little once we control for accurately measured fundamentals. Collectively, proxies for sentiment explain roughly 10 percentage points of the time-series variation of equity issuance beyond the roughly 40 percent explained by fundamentals. We conclude that investor sentiment does not seem to matter very much for aggregate equity issuance activity.

Keywords: IPOs; capital demands; economic fundamentals; investor sentiment

JEL Classification: G32

Security Choice and Corporate Governance

Brett Olsen and John Howe

Abstract The most efficient corporate governance structure will vary by firm depending on the costs and benefits of different governance mechanisms. For IPO firms, warrants might act as a substitute for other governance mechanisms (Schultz, 1993). Alternatively, warrants might serve as a signal of high quality, and thus effectively governed, firms (Chemmanur and Fulghieri, 1997), in which case they would act as a complement to other governance mechanisms. We test these competing hypotheses by examining a sample of unit IPO firms (firms issuing warrants with shares) matched to a comparable sample of shares-only firms and show that warrants act as a substitute for other governance mechanisms. The research is also of interest because it shows an interaction between the financing decisions of firms and their corporate governance that has not been documented previously.

Keywords:corporate governance, agency costs, IPOs, warrants, board of directors

JEL Classification: G34, L22

Why do European Firms Go Public?

Franck Bancel and Usha Mittoo

Abstract We survey chief financial officers (CFOs) from 12 European countries regarding the determinants of going public and exchange listing decisions. Most CFOs identify enhanced visibility and prestige and financing for growth as the most important benefits of an IPO, but other motivations for IPOs differ significantly across firms, countries and legal systems. We find strong support for the IPO theories that emphasize financial and strategic considerations, such as enhanced reputation and credibility, and financial flexibility as a major advantage of an IPO. At the same time, we find moderate support for theories that focus on exit strategy, balance of power with creditors, external monitoring, and mergers and acquisitions motivations. European CFOsҠviews on the major benefits of an IPO are generally similar to those of U.S. managers as reported in Brau and Fawcett (2006), but differ significantly on outside monitoring; outside monitoring is considered a major benefit by European CFOs but a major cost by U.S. CFOs. Our evidence suggests that the decision to go public is a complex one, and cannot be explained by one single theory because firms seek multiple benefits in going public. These motivations are influenced by the firmӳ ownership structure, size and age as well as by the home countryӳ institutional and regulatory environment.

Keywords: going public, European firms, IPO, survey, financing, exit, ownership

JEL Classification: F30, G32, G34, G30

European Financial Management, VOL 15:5 November 2009

Tranching and Rating

Michael Brennan, Julia Hein and Ser-Huang Poon

Abstract: In this paper we analyze the source and magnitude of marketing gains from selling structured debt securities at yields that reflect only their credit ratings, or specifically at yields on equivalently rated corporate bonds. We distinguish between credit ratings that are based on probabilities of de- fault and ratings that are based on expected default losses. We show that subdividing a bond issued against given collateral into subordinated tranches can yield significant profits under the hypothesized pricing sys- tem. Increasing the systematic risk or reducing the total risk of the bond collateral increases the profits further. The marketing gain is generally increasing in the number of tranches and decreasing in the rating of the lowest rated tranche.

Keywords:G12, G13, G14, G21, G24

JEL Classification: credit ratings, collateralized debt obligations, expected loss rate, default probability, systemic risk.

Risk Management Lessons from the Credit Crisis

Philippe Jorion

Abstract: Risk management, even if flawlessly executed, does not guarantee that big losses will not occur. Big losses can occur because of business decisions and bad luck. Even so, the events of 2007 and 2008 have highlighted serious deficiencies in risk models. For some firms, risk models failed because of known unknowns. These include model risk, liquidity risk, and counterparty risk. In 2008, risk models largely failed due to unknown unknowns, which include regulatory and structural changes in capital markets. Risk management systems need to be improved and place a greater emphasis on stress tests and scenario analysis. In practice, this can only be based on position-based risk measures that are the basis for modern risk measurement architecture. Overall, this crisis has reinforced the importance of risk management.

Keywords:risk management, financial crisis, risk models, stress test

JEL Classification: D81,G11,G16 ,G21, G32

A Generalization of the Mean-Variance Analysis

Valeri Zakamouline and Steen Koekebakker

In this paper we consider a decision maker whose utility function has a kink at the reference point with different functions below and above this reference point. We also suppose that the decision maker generally distorts the objective probabilities. First we show that the expected utility function of this decision maker can be approximated by a function of mean and partial moments of distribution. This ԭean-partial momentsԍ utility generalizes not only mean-variance utility of Tobin and Markowitz, but also meansemivariance utility of Markowitz. Then, in the spirit of Arrow and Pratt, we derive an expression for a risk premium when risk is small. Our analysis shows that a decision maker in this framework exhibits three types of aversions: aversion to loss, aversion to uncertainty in gains, and aversion to uncertainty in losses. Finally we present a solution to the optimal capital allocation problem and derive an expression for a portfolio performance measure which generalizes the Sharpe and Sortino ratios. We demonstrate that in this framework the decision makerӳ skewness preferences have first-order impact on risk measurement even when the risk is small.

Keywords: mean-variance utility, quadratic utility, mean-semivariance utility, risk aversion, loss aversion, risk measure, probability distortion, partial moments of distribution, risk premium, optimal capital allocation, portfolio performance evaluation, Sharpe ratio.

JEL Classification: D81, G11

Quantifying the Interest Rate Risk of Banks: Assumptions Do Matter

Oliver Entrop, Marco Wilkens and Alexander Zeisler

Abstract: This paper analyzes the robustness of the standardized framework proposed by the Basel Committee on Banking Supervision (2004b) to quantify the interest rate risk of banks. We generalize this framework and study the change in the estimated level of interest rate risk if the strict assumptions of the standardized framework are violated. Using data on the German universal banking system, we find that estimates of the interest rate risk are very sensitive to the frameworkӳ assumptions. We conclude that the results obtained using the standardized framework in its current specification should be treated with caution when used for supervisory and risk management purposes.

Keywords:interest rate risk, Basel Capital Accord, banking supervision, standardized interest rate shock

JEL Classification: G18, G21