European Financial Management 2010 Archive

January 2010, VOL 16:1 March 2010, VOL 16:2 June 2010, VOL 16:3 September 2010, VOL 16:4 November 2010, VOL 16:5

European Financial Management, VOL 16:1 January 2010

Property Derivatives for Managing European Real-Estate Risk

Frank J. Fabozzi, Robert J. Shiller and Radu Tunaru

Abstract: Although property markets represent a large proportion of total wealth in developed countries, the real-estate derivatives markets are still lagging behind in volume of trading and liquidity. Over the last few years there has been increased activity in developing derivative instruments that can be utilised by asset managers. In this paper, we discuss the problems encountered when using property derivatives for managing European real-estate risk. We also consider a special class of structured interest rate swaps that have embedded real-estate risk and propose a more efficient way to tailor these swaps.

Keywords:real-estate markets, property derivatives, balance guaranteed swaps

JEL Classification: G15, G20

The Cross-Section of Expected Stock Returns: What Have We Learnt from the Past Twenty-Five Years of Research?

Avanidhar Subrahmanyam

Abstract: I review the recent literature on cross-sectional predictors of stock returns. Predictive variables used emanate from informal arguments, alternative tests of risk-return models, behavioral biases, and frictions. More than fifty variables have been used to predict returns. The overall picture, however, remains murky, because more needs to be done to consider the correlational structure amongst the variables, use a comprehensive set of controls, and discern whether the results survive simple variations in methodology.

Keywords:market efficiency, cross-section of stock returns

JEL Classification: G12, G14

The CAPM is alive and well:A review and Synthesis

Haim Levy

Abstract: Mean-Variance (M-V) analysis and the CAPM are derived in the expected utility framework. Behavioral Economists and Psychologists (BE&P) advocate that expected utility is invalid, suggesting Prospect Theory as a substitute paradigm. Moreover, they show that the M-V rule, which is the foundation of the CAPM, is not always consistent with peoples' choices. Thus, BE&P cast doubt on the validity of expected utility paradigm and of the M-V rule, hence the CAPM is theoretically questionable. In addition, there is very little empirical support to the CAPM. We show in this study that the CAPM is theoretically valid even when one accepts the BE&P framework and even when expected utility is invalid. Moreover, within the BE&P framework there is a strong experimental support for the CAPM

Keywords:CAPM, M-V, expected utility, Prospect Theory

JEL Classification: D81, C91

Keeping Up with the Joneses: A Model and a Test of Collective Accounting Fraud

Nuno Fernandes and Jos顇uedes

Abstract This paper explains the variations in incidence of accounting fraud across economic settings by putting the behaviour and motivation of managers under the microscope. To safeguard their reputation in the managerial labour market, managers of firms that perform poorly are prone to fraudulently inflate earnings if they expect the economy to be strong, since that raises the likelihood of peers reporting high performance. A realised level of economic activity, on the other hand, counteracts this tendency on the part of managers to overstate earnings, by reducing the number of firms that actually perform poorly. We term these two effects the incentive effect and the need effect, respectively. The two effects yield a distinctive relationship between the incidence of accounting fraud and macroeconomic conditions. Specifically, the fraction of firms fraudulently overreporting earnings is positively related to expected economic performance and negatively related to realised economic performance. The incentive and need effects on collective fraud are examined empirically by relating proxies of the aggregate incidence of accounting fraud to expected and realised GDP growth rates. The results unambiguously support the predicted influence of macroeconomic performance.

Keywords: earnings manipulation, fraud, corporate governance

JEL Classification: G19, G30, G34, G38

Corporate Governance in China: A Step Forward

Yan-Leung Cheung, Ping Jiang, Piman Limpaphayom and Tong Lu

Recently, the presumed benefits of corporate governance have become one of the most contentious issues especially for emerging markets in Asia where institutional settings are quite different from other parts of the world. Using an internationally accepted benchmark (OECDӳ Principles of Corporate Governance, OECD, 2004), this study evaluates the progress of corporate governance practice of Chinese listed companies. A corporate governance index (CGI) is constructed to measure the quality of corporate governance practices of the 100 largest listed firms in China during 2004-2006. The results show that Chinese companies have been making progress in the corporate governance reform. The findings also show a positive relation between market valuation and overall corporate governance practices, as measured by the CGI, among these Chinese listed companies. Additional investigation reveals that the rights of shareholders are the main driver in the relationship.

Keywords: corporate governance; China

JEL Classification:G3; G34

Interest Rate Risk Rewards in Stock Returns of Financial Corporations: Evidence from Germany

Marc-Gregor Czaja, Hendrik Scholz and Marco Wilkens

The interest rate sensitivity of stock returns of financial and non-financial corporations is a well-known phenomenon. However, only little is known about the part of total stock returns that is attributable to the compensation an investor receives for being exposed to interest rate risk when investing in equity securities. We pursue here a benchmark portfolio approach, constructing benchmark portfolios having the same interest rate risk exposure as a particular stock. By studying the time series of returns of these asset-specific benchmarks, we find: i) Regardless of the industry considered, the interest rate risk benchmarks of German corporations have mostly earned a signifͩcantly positive reward. ii) Returns of interest rate risk benchmarks of financial institutions exceeded significantly those of non-financial corporations. iii) An investor willing to bear nothing but the average interest rate risk of German financial institutions would have earned a mean return of about or even exceeding 70% of the corresponding total stock returns. iv) Returns of the interest rate risk benchmarks of the German insurance sector were significantly higher than those of German banks, which seems to contradict conventional market wisdom that insurances hedge interest rate risks.

Keywords: interest rate risk; risk rewards; Nelson-Siegel approach; German financial corporations; benchmark portfolio approach

JEL Classification: : G12; G21; G22

European Financial Management, VOL 16:2 March 2010

Conditional Asset Pricing and Stock Market Anomalies in Europe

Rob Bauer, Mathijs Cosemans and Peter C. Schotman

This study provides European evidence on the ability of static and dynamic specifications of the Fama-French (1993) three-factor model to price 25 size-B/M portfolios. In contrast to US evidence, we detect a small-growth premium and find that the size effect is still present in Europe. Furthermore, we document strong time variation in factor risk loadings. Incorporating these risk fluctuations in conditional specifications of the three-factor model clearly improves its ability to explain time variation in expected returns. However, the model still fails to completely capture cross-sectional variation in returns as it is unable to explain the momentum effect.

Keywords: conditional asset pricing, time-varying risk, stock market anomalies

JEL Classification: G12, G14

Passive Hedge Fund Replication ֠Beyond the Linear Case

Noel Amenc, Lionel Martellini, Jean-Christophe Meyfredi and Volker Ziemann

In this paper we extend Hasanhodzic and Lo (2007) by assessing the out-of-sample performance of various non-linear and conditional hedge fund replication models. We find that going beyond the linear case does not necessarily enhance the replication power. On the other hand, we find that selecting factors on the basis on an economic analysis allows for a substantial improvement in out-of-sample replication quality, whatever the underlying form of the factor model. Overall, we confirm the findings in Hasanhodzic and Lo (2007) that the performance of the replicating strategies is systematically inferior to that of the actual hedge funds.

Keywords: Hedge funds, passive replication, Kalman filter, conditional factor models.

JEL Classification: G10.

PIP Transactions, Price Improvement, Informed Trades and Order Execution Quality

Nabil Khoury, Stylianos Perrakis and Marko Savor

This study focuses on innovations in order execution processes within the context of the Boston Option Exchange (BOX). More specifically, it examines the impact of the Price Improvement Process (PIP) on options quoted, effective and realized proportional spreads. We consider the PIP as a mechanism that allows the market maker to ԩnternalizeԠthe transaction. We show that PIP transactions are associated with wider bid/ask proportional quoted spreads than non-PIP transactions, in spite of the temporary narrowing of the effective proportional spread during PIP. We identify informed traders by focusing on the direction of trade. Using an original data set, we show that PIP transactions follow signals in the form of buy/sell orders by informed traders. We also show that PIP is a mechanism that allows the market maker to internalize a position in the same direction as that of the informed trader. We conclude that PIP does not improve the efficiency of the market but simply allows the market maker to benefit at the expense of uninformed traders.

Keywords: market microstructure, bid-ask spreads, options markets, market efficiency

JEL Classification: G13, G14

The Sophisticated and the Simple: the profitability of contrarian strategies

Gishan Dissanaike and Kim-Hwa Lim

A variety of variables have been used to form contrarian portfolios, ranging from relatively simple measures, like book-to-market, cash flow-to-price, earnings-to-price and past returns, to more sophisticated measures based on the Ohlson model and residual income model (RIM). This paper investigates whether: (i) contrarian strategies based on RIM perform better or worse than those based on the Ohlson model; (ii) contrarian strategies based on more sophisticated valuation models (e.g. Ohlson and RIM) perform much better than the relatively simpler ranking variables that have been used so extensively in the finance literature. Given that the RIM and Ohlson models require greater information inputs and technical know-how, and make different implicit assumptions on future abnormal earnings, it is important to ascertain if they offer significantly greater contrarian profits to outweigh the increased costs that they entail. Indeed, our surprising finding is that simple cash flow-to-price measures appear to do almost as well as the more sophisticated alternatives. One would have expected the sophisticated models to significantly outperform the simple cash flow to price model for the reasons given by Penman (2007).

Keywords: ; evaluation, market efficiency

JEL Classification: M41, G12, G14

Conference Calls and Stock Price Volatility in the Post-Reg FD Era

Alberto Dell Acqua, Francesco Perrini and Stefano Caselli

Past research has documented that the utilization of conference calls is greater in the high tech sector than in other industries. Do high tech firms benefit from that? This study attempts to answer this question by examining the impact of ԰ost-Reg FDԠconference calls on the price volatility of high tech firms listed in the US market. We find evidence that more open conference calls results in lower idiosyncratic volatility.

Keywords: stock volatility, conference calls, high tech stocks, voluntary disclosure

JEL Classification: G14, G32.

Large Shareholders, the Board of Directors and the Allocation of Cash Proceeds from Corporate Asset Sell-offs

Ali Ataullah, Ian Davidson and Hang Le

Recent finance literature suggests that managers of divesting firms may retain cash proceeds from corporate asset sell-offs in order to pursue their own objectives, and, therefore, shareholdersҠgains due to these deals are linked to a distribution of proceeds to shareholders or to debtholders. We add to this literature by examining the role of various corporate governance mechanisms in the context of the allocation of sell-off proceeds. Specifically, we examine the impact of directorsҠshare-ownership and stock options, board composition and external large shareholdings on (1) shareholdersҠabnormal returns around asset sell-off announcements, and (2) managersҠdecision to either retain or distribute (to shareholders or to debtholders) sell-off proceeds. We find that non-executive directorsҠand CEOӳ share-ownership and stock options are related to shareholdersҠgains from sell-offs for firms that retain proceeds. However, corporate governance mechanisms are not significantly related to shareholdersҠgains for firms that distribute sell-off proceeds. Furthermore, we find that the likelihood of a distribution of proceeds, relative to the retention decision, is increasing in large institutional shareholdings, executive and non-executive directorsҠshare-ownership and non-executive representation in the board.

Keywords: asset sell-offs, large shareholders, institutional investors, boards of directors, board composition

JEL Classification: G32, G34, G35

Why Do Price Limits Exist in Stock Markets? A Manipulation-Based Explanation

Kenneth A. Kim and Jungsoo Park

Numerous stock market regulators around the world impose daily price limits on individual stock price movements. We derive a simple model that shows that price limits may deter stock market manipulators. Based on our modelӳ implications, we predict that regulators impose price limit rules for markets where the likelihood of manipulation is high. We present empirical evidence consistent with this hypothesis. Our study is the first to formally propose a manipulation-based rationale for the existence of price limits in stock markets.

Keywords: price limits, stock market manipulation, stock market volatility

JEL Classification: G10; G15; G18

European Financial Management, VOL 16:3 June 2010

A High-Frequency Investigation of the Interaction between Volatility and DAX Returns

Philippe Mass and Martin Wallmeier

One of the most noticeable stylized facts in finance is that stock index returns are negatively correlated with changes in volatility. The economic rationale for the effect is still controversial. The competing explanations have different implications for the origin of the relationship: Are volatility changes induced by index movements, or inversely, does volatility drive index returns? To differentiate between the alternative hypotheses, we analyze the lead-lag relationship of option implied volatility and index return in Germany based on Granger causality tests and impulse-response functions. Our dataset consists of all transactions in DAX options and futures over the time period from 1995 to 2005. Analyzing returns over 5-minute intervals, we find that the relationship is return-driven in the sense that index returns Granger cause volatility changes. This causal relationship is statistically and economically significant and can be clearly separated from the contemporaneous correlation. The largest part of the implied volatility response occurs immediately, but we also observe a smaller retarded reaction for up to one hour. A volatility feedback effect is not discernible. If it exists, the stock market appears to correctly anticipate its importance for index returns.

Keywords: implied volatility; granger causality; leverage effect; feed-back effect; asymmetric volatility

JEL Classification: G10; G12; G13

Internal capital markets and capital structure: bank versus internal debt

Nico Dewaelheyns and Cynthia Van Hulle

We argue that domestic business groups are able to actively optimize the internal/external debt mix across their subsidiaries. Novel to the literature, we use bi-level data (i.e. data from both individual subsidiary financial statements and consolidated group level financial statements) to model the bank and internal debt concentration of non-financial Belgian private business group affiliates. As a benchmark, we construct a size and industry matched sample of non-group affiliated (stand-alone) companies. We find support for a pecking order of internal debt over bank debt at the subsidiary level which leads to a substantially lower bank debt concentration for group affiliates as compared to stand-alone companies. The internal debt concentration of a subsidiary is mainly driven by the characteristics of the groupӳ internal capital market. The larger its available resources, the more intra-group debt is used while bank debt financing at the subsidiary level decreases. However, as the groupӳ overall debt level mounts, groups increasingly locate bank borrowing in subsidiaries with low costs of external financing (i.e. large subsidiaries with important collateral assets) to limit moral hazard and dissipative costs. Overall, our results are consistent with the existence of a complex group wide optimization process of financing costs.

Keywords: internal capital markets; capital structure; debt source concentration; ownership structure; bank debt

JEL Classification: G32, G21

Impact of Imperfect Information on the Optimal Exercise Strategy for Warrants

Christian Koziol

In this paper, we determine the optimal exercise strategy for corporate warrants if investors suϥr from imperfect information and we evaluate the impact of this friction on the value of a warrant. For this purpose, we address both exercises at maturity, where imperfect information about the вm value is present, and exercises before maturity which are impacted by imperfect information about the size of the dividend. We model imperfect information so that all warrant holders know that they obtain biased signals of the true state without observing the signals of other warrant holders. The optimal exercise strategy follows from a complex game among warrant holders in which every individual warrant holder must account for the potential signals of the other warrant holders and their resulting exercise decisions. The main Юdings are that due to imperfect information warrant holders optimally start to exercise their warrants later than without imperfect information. Moreover, a simple block exercise strategy is always an equilibrium strategy for a high degree of imperfect information before maturity, even though a partial exercise can be the unique strategy without imperfect information. Remarkably, imperfect information does not necessarily result in a lower warrant value. As long as a warrant holder has a signal that allows for correct exercise decisions, then imperfect information enhances the warrant value due to suboptimal exercises by other investors.

Keywords: warrant exercise; block exercise; imperfect information;global games

JEL Classification: G13, C70

A Dynamic Approach to Accounts Receivable: A Study Of Spanish Smes

Pedro J. GarcTeruel and Pedro Martz-Solano

The main objective of this paper is to extend the literature on the granting of trade credit. The focus is to test whether the accounts receivable decisions follow a model of partial adjustment. To do that, we use a sample of 2,922 Spanish SMEs. Using a dynamic panel data model and employing the GMM method of estimation we control for unobservable heterogeneity and for potential endogeneity problems. The results reveal that firms have a target level of accounts receivable and take decisions in order to achieve that level. In addition, we find that sales growth (if positive), the size of the firms, their capacity to generate internal funds and get short term financing, and economic growth are important in determining trade credit granted by firms.

Keywords: accounts receivable, trade credit, SMEs, partial adjustment model, endogeneity

JEL Classification: G31, G32

Diversification, Refocusing and Firm Value

Gonul Colak

At any point in time a firm faces three restructuring choices: diversify, refocus, or do nothing. This study analyzes the causes and the consequences of these actions in a unified framework using the appropriate methodologies. Various factors, such as firmӳ characteristics and multinational nature, its industryӳ characteristics, its exchange and index inclusion, and divested (or acquired) segment(s)Ҡindustry conditions, are considered as the determinants of the diversifying and the refocusing decisions. The estimation results from the corresponding multinomial logit model suggest that refocusing occurs generally due to firm-specific reasons, and diversification due to outside factors, such as industry and economic conditions. Added or dropped segmentӳ industry profitability, its relationship to the core business of the firm, and its relatedness to the businesses of the conglomerateӳ other segments have a nontrivial effect on either decision. In a related analysis, the paper explicitly models and estimates the valuation consequences that are sustained by the firm after it undertakes a refocusing or a diversification action. To isolate the changes in firmӳ value that are due to these decisions only, a 2SLS estimation is used to control for endogeneity that arises because the factors that affect a firmӳ value are likely to have also induced the firm to make the corresponding decision. The novelty of my approach is in its inclusion of variables measuring the consequences due to both actions, the diversification and the refocusing, in the same valuation equation. Contrary to some earlier findings, I find no evidence of Ҥiversification discountҠor Ҳefocusing premium.ҠThe choice of this paper to analyze all corporate restructuring decisions in a unified framework yields valuable business insights into the reasons for undertaking such corporate events.

Keywords: diversification discount; refocusing; excess value; simultaneity bias

JEL Classification: G10, G30, G34, G39

Dividends and Market Signaling: An Analysis of Corporate Insider Trading

Esther del Brio and Alberto de Miguel

This study tests the multiple-signal theory of dividends of John and Lang (1991) in the context of a European market. Our evidence shows that investors are more sensitive to insider trading signals than to signaled changes in existing dividends. In effect, the insider sales signal is universally understood as bad news. After controlling for the quality of a firmӳ investment opportunities, investors are found to penalize dividend outflows by mature firms that exhibit more informed insider sales activity. Finally, we offer an innovative exploration of the role of earnings announcements in market reaction to the dividend signal.

Keywords: dividend announcements, insider trading, information-based signaling theory of dividends, cash flow signaling theory, earnings announcements.

JEL Classification: G14; G35

European Financial Management, VOL 16:4 September 2010

p> Intra-Dealer Integration

Laurent Germain, Brian Kluger, David Stolin, Crina Pungulescu and Daniel Weaver

This paper examines the quotation behavior of dealers who made markets in the same stocks on both NASDAQ and either EASDAQ or the LSE. Whereas previous studies examine international integration at the market level, we examine integration at the dealer level. In other words, do dealers within the same market-making firm use information from their arm on the opposite side of the Atlantic in forming their own quotes? We find that while there is some evidence of integration at the market level, integration is hard to detect at the dealer level. The results are largely unaffected by differences in fungibility between our two samples.

Keywords:intra-dealer integration; price discovery; cointegration; fungibility

JEL Classification: G1, G14, G15

The effect of venture capital financing on the sensitivity to cash flow of firmӳ investments

Fabio Bertoni, Massimo G. Colombo and Annalisa Croce

This work studies the effect of venture capital (VC) financing on firmsҠinvestments in a longitudinal sample of 379 Italian unlisted new-technology-based firms (NTBFs) observed over the 10-year period from 1994 to 2003. We distinguish the effects of VC financing according to the type of investor: independent VC (IVC) funds and corporate VC (CVC) investors. Previous studies argue that NTBFs are the firms most likely to be financially constrained. The technologyשntensive nature of their activity and their lack of a track record increase adverse selection and moral hazard problems. Moreover, most of their assets are firm-specific or intangible and hence cannot be pledged as collateral. In accordance with this view, we show that the investment rate of NTBFs is strongly positively correlated with their current cash flows. We also find that after receiving VC financing, NTBFs increase their investment rate independently of the type of VC investor. However, the investments of CVC-backed firms remain sensitive to shocks in cash flows, whereas IVC-backed firms exhibit a low and statistically not significant investmentףash flow sensitivity that we interpret as a signal of the removal of financial constraints.

Keywords: investments, new-technology-based firms, financial constraints, venture capital, corporate venture capital.

JEL Classification: G32, D92, G23

The Consequences of Issuing Convertible Bonds: Dilution and/or Financial Restructuring?

Roland Gillet and Hubert de La Bruslerie

Historically, most convertible bond (CB) issues have been converted to equity sooner or later. The announcement of a CB issue will bring about a future dilution of the firmӳ capital, and is often followed by a drop in share price. However, a CB issue by itself creates future value for the shareholders if it enables the firm to make profitable investments. It can also issue a positive signal regarding the restructuring of the firmӳ financial liabilities and its attempts to optimise its financial structure. These positive effects, if they occur, will develop gradually after the issue, and cannot be identified by a simple short-term event analysis of a CB issue announcement. In this paper, we test the significance of the dilution effect, coupled with a possible value creation effect, using data from the French stock market. We introduce a comparison between dilutive convertibles and nondilutive exchangeable bonds. By integrating different corrections and by selecting a window of analysis over a longer period after the announcement of the issue, we show that the negative cumulative average abnormal returns generally observed in previous studies become non-significant. This absence of global incidence is indicative of large differences in individual behaviour by issuers of CBs, and leads us to take into account the strategic choices linked to the issue of a CB. Two goals, often described as ҩnvestment financingҠor Ҧinancial restructuringҬ may exist when issuing, and may appear to explain the size of the abnormal returns.

Keywords: convertible bonds, debt leverage, corporate financing decision, stock market efficiency, event studies.

JEL Classification: G14, G32

The Impact of Terrorist Attacks on International Stock Markets

Dirk Brounen and Jeroen Derwall

We examine the effects of terrorist attacks on stock markets, using a dataset that covers all significant events and that directly relate to the major economies of the world. Our event study suggests that terrorist attacks produce mildly negative price effects. We compare these price reactions to those from an alternative type of unanticipated disaster, earthquakes, and find that price declines following terror attacks are more pronounced. However, in both cases prices rebound within the first week of the aftermath. We also compare price responses internationally and for separate industries, and find that reactions are strongest for local markets and for industries that are directly affected by the attack. Our results suggest that financial markets react strongly to terror events but then recover swiftly and soon return to business as usual. The September 11th attacks turn out to be the only event that caused long-term effects on financial markets, especially in terms of industriesҠsystematic risk.

Keywords: event study, terrorist attacks, earthquakes, abnormal returns

JEL Classification: G14,G15

Liquidity and Optimal Market Transparency

Ariadna Dumitrescu

In this paper I explore some of the consequences of greater market transparency for market performance in the presence of a strategic specialist. Although numerous studies have dealt with this issue, previous work has only considered either fully transparent or fully opaque markets. My model allows for different levels of transparency, and therefore sheds light on how transparency affects market performance. I show that an intermediate level of transparency can improve market performance relative to the more extreme cases of full transparency or no transparency at all.

Keywords: market liquidity, market transparency, strategic specialist.

JEL Classification: D82, G12, G14

Business Cycles and Net Buying Pressure in the S&P 500 Futures Options

Kam C. Chan, Carl R. Chen and Peter P. Lung

We analyze the cyclical behavior and intraday pattern of net buying pressure in S&P 500 futures options market. The results suggest that net buying pressure of puts is counter-cyclical and the net buying pressure is more intense during contraction periods. The trading profits for put options during contraction periods thus far exceed those during expansion periods. Net buying pressure also exhibits intraday pattern and trading profits in the early trading sessions are higher than those for the rest of the day. In addition, we show that an hourly-basis hedging yields smaller profits than a daily-basis hedging, which suggests that the trading profits based on daily-basis hedging may contain risk premium associated with discretely rebalanced Բisk-freeԠoption portfolios.

Keywords: Net buying pressure; Volatility smile; Microstructure; Market cycle

JEL Classification: G13

The Risk Microstructure of Corporate Bonds: A Case Study from the German Corporate Bond Market

Manfred Fruhwirth, Paul Schneider, and Leopold Sogner

Abstract: This article presents joint econometric analysis of interest rate risk, issuer-specific risk (credit risk) and bond-specific risk (liquidity risk) in a reduced-form framework. We estimate issuer-specific and bond-specific risk from corporate bond data in the German market. We find that bond-specific risk plays a crucial role in the pricing of corporate bonds. We observe substantial differences between different bonds with respect to the relative influence of issuer-specific vs. bond-specific spread on the level and the volatility of the total spread. Issuer-specific risk exhibits strong autocorrelation and a strong impact of weekday effects, the level of the risk-free term structure and the debt to value ratio. Moreover, we can observe some impact of the stock market volatility, the respective stockӳ return and the distance to default. For the bond-specific risk we find strong autocorrelation, some impact of the stock market index, the stock market volatility, weekday effects and monthly effects as well as a very weak impact of the risk-free term structure and the specific stockӳ return. Altogether, the determinants ofthe spread components vary strongly between different bonds/issuers.

Keywords: credit risk, Duffie/Singleton framework, liquidity risk, Markov chain Monte Carlo estimation

JEL Classification: C51, G12, E43

The Banking Relationshipӳ Role in the Choice of the Targetӳ Advisor in Mergers and Acquisitions

Gianfranco Forte, Giuliano Iannotta and Marco Navone

We analyze the factors influencing the target companiesҠchoice of bank advisor in mergers and acquisitions. We first examine the choice of hiring an advisor, which is non-trivial as in our sample target companies do not hire an advisor in one-third of transactions. We also analyze the choice to hire, as advisor, a bank with a strong prior relationship with the company (i.e. the main bank). Using data on 473 European M&A transactions completed in the 1994ֲ003 period, we find evidence that the decision to hire an advisor depends on three main factors: i) the intensity of the previous banking relationship, ii) the reputation of the bidder companyӳ advisor, and iii) the complexity of the deal. We also investigate the impact of a bank advisor on shareholdersҠwealth. We find that the abnormal return of target companiesҠshareholders increases with the intensity of the previous banking relationship, thus indicating a ԣertification roleԠof investment banks.

Keywords: relationship banking, investment banking, mergers, acquisitions

JEL Classification: G21

European Financial Management, VOL 16:5 November 2010

Do Firms Decouple Corporate Governance Policy and Practice?

Nasha Ananchotikul, Roy Kouwenberg and Visit Phunnarungsi

We test whether Thai listed firms with higher levels of good governance policy adoption are less likely to violate listing rules and laws designed to protect shareholders. Our results suggest that firms on average implement, substantively as opposed to symbolically, recommended governance policies, as violations occur less frequently among firms with higher governance policy adoption scores. However, we also find evidence of symbolic governance among a small group of Դalk-onlyԠfirms that issue statements about governance while lagging in the adoption of policies related to shareholder rights and the board of directors

Keywords:corporate governance, violations, fraud, cheap talk

JEL Classification: G3, G38, K42

Shareholder Activism through Proxy Proposals ֠The European Perspective

Peter Cziraki, Luc Renneboog and Peter Szilagyi

This paper is the first to investigate the corporate governance role of shareholder-initiated proxy proposals in European firms. Proposal submissions in Europe remain infrequent compared to the US, especially in Continental Europe. In the UK proposals typically relate to a proxy contest seeking board changes, while in Continental Europe they are more focused on specific governance issues. There is some evidence that proposal sponsors are valuable monitors, because the target firms tend to underperform and have low leverage. Sponsors also consider the ownership structure of the firm, because proposal probability increases in the targetӳ ownership concentration and the equity stake of institutional investors. While proposals enjoy limited voting success across Europe, they are relatively more successful in the UK. The outcomes are strongest for proposals targeting the board but are also affected by the target characteristics including the CEOӳ pay-performance sensitivity. Proposals are met with a significant negative abnormal return of -1.23%, when they are voted upon at general meetings. The low voting support gathered by proposals and the strongly adverse market reaction suggest that shareholders of European companies use proposals as an emergency brake rather than a steering wheel.

Keywords:shareholder activism; shareholder proposals; corporate governance; sample selection

JEL Classification: G34

Pay me Right: Reference Values and Executive Compensation

Aleksandra Gregoric, Saso Polanec and Sergeja Slapnicar

This paper examines the importance of reference values for executive compensation contracts. We rely on a quasi-experimental setting (the adoption of pay guidelines), and a well-defined measure of individual-specific reference values to provide evidence on how a change in CEO reference compensation leads to subsequent changes of actual pay. We find that executive compensation adjusts gradually towards the new reference values, and that the speed of the adjustment depends on the corporate governance characteristics: the firm ownership structure, the role of the State and of the employees in the firm decision making. These results provide empirical support for theoretical models of bargaining that take into account reference values.

Keywords:CEO compensation, pay guidelines, reference values, corporate governance, CEO power

JEL Classification: G30, G34

Do Corporate Governance Motives Drive Hedge Fund and Private Equity Fund Activities?

Ann-Kristin Achleitner, Andr顂etzer and Jasmin Gider

We document empirical evidence that both hedge fund (HF) and private equity fund (PE) investments are driven by corporate governance improvements, but address different types of agency conflicts. Whereas HFs focus on firms without a controlling shareholder, in particular family shareholders, PEs invest in firms with low managerial ownership. Both appear to address free cash flow problems differently. Aiming at increasing dividends, HFs tend to use commitment devices that can be implemented over a short horizon. PEs are inclined to longer-term strategies: they target firms that are particularly well suited for leverage increases because of low expected financial distress costs

Keywords:private equity, hedge funds, corporate governance

JEL Classification: G34

Hedge Fund Regulation and Misreported Returns

Douglas Cumming and Na Dai

This paper introduces a cross-country law and finance analysis of the misreporting behavior in the hedge fund industry in terms of smoothing returns so that a fund consistently generates positive returns. We find strong evidence that international differences in hedge fund regulation are significantly associated with the propensity of fund managers to misreport monthly returns. We find a positive association between wrappers and misreporting, particularly for funds that do not have a lockup provision. Also, we find some evidence that misreporting is less common among funds in jurisdictions with minimum capitalization requirements and restrictions on the location of key service providers. We assess the robustness of our finds to a number of specifications, including, different specifications of misreporting bin widths, subsets of the data by fund type, as well as specifications controlling for collinearity and selection effects and other robustness checks. We show misreporting significantly affects capital allocation, and calculate the wealth transfer effects of misreporting and relate this wealth transfer to differences in hedge fund regulation.

Keywords:Hedge Funds, Regulation, Misreported Returns, Law and Finance

JEL Classification: G23, G24, G28, K22, M43


Greenspan's Retrospective of Financial Crisis and Stochastic Optimal Control

Jerome Stein

Alan Greenspan argues that the crisis was unpredictable and inevitable, given the ԥxcessiveԠleverage of the financial intermediaries. I focus upon the housing sector, which has been at the origin of the financial crisis because the value of the financial derivatives ultimately depended upon the ability of the mortgagors to repay their debts. The uncertainty concerns the capital gains ֠housing price appreciation ֠and the rate of interest. I explain why the application of stochastic optimal control (SOC) is an effective approach to determine the optimal degree of leverage, the optimum and excessive risk and the probability of a debt crisis. I show that the theoretically derived early warning signal of a crisis is the excess debt ratio, equal to the difference between the actual and optimal ratio. The excess debt of households starting from 2004-05 indicated that a housing crisis was most likely.

Keywords:Greenspan, Capital requirements, Stochastic Optimal Control, Warning Signals of crisis, Optimal Leverage and Debt ratios, bubbles

JEL Classification: C61, G11, G12, G14