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The European Financial Management was founded in 1994 by Dr. John Doukas to serve as a high quality refereed publication outlet that publishes significant new research as it relates to European corporations, financial institutions and capital markets. The EFM journal is published in five issues per year [January, March, June, September and November ] and its acceptance rate is about 3%. The June issue is based on the Keynote Address and a small set of articles selected from the papers presented at the Annual Meetings of the European Financial Management Association. The articles published in the EFM journal are indexed and abstracted in the Social Science Citation Index.


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Newly Accepted Papers




Bank Risk Dynamics Where Assets are Risky Debt Claims


Sharon Peleg and Alon Raviv


Abstract:
The structural approach views firm’s equity as a call option on the value of its assets, which motivates stockholders to increase risk. However, since bank assets are risky debt claims, bank equity resembles a subordinated debt. Using this assumption, and considering the strategic interaction between a bank and its debtor, we argue that risk shifting is limited to states in which the debtor is in financial distress. Furthermore,risk shifting increases with bankruptcy costs and decreases with bank capital. Thus, increasing a bank’s capital affects stability, not only through the additional capital buffer, but also by affecting the risk shifting incentive.


Keywords:Risk taking, Asset risk, Financial institutions, Stress test, Leverage


JEL Classification: G21, G28, G32, G38



The Market Liquidity Timing Skills of Debt-Oriented Hedge Funds


Baibing Li, Ji Luo and Kai-Hong Tee


Abstract:
We investigate the liquidity timing skills of debt-oriented hedge funds following the 2008 credit crisis, which demonstrated the importance of understanding liquidity conditions to manage the market exposure of investments. We base the analysis on the estimated co-movements of fixed income and equity market liquidity. Our findings, which are statistically robust, show evidence of liquidity timing ability in the fixed income market for all debt-oriented hedge fund strategy categories. Joint market liquidity timing skill, however, is only found in some categories. Our findings suggest that debt-oriented hedge fund managers use a sophisticated set of timing strategies in their investment managements.


Keywords:Fixed income market; hedge funds; liquidity timing skill; market exposure


JEL Classification: G1; G11; G23



Endogenous Credit Spreads and Optimal Debt Financing Structure in the Presence of Liquidity Risk


Eva Luetkebohmert, Daniel Oeltz and Yajun Xiao


Abstract:
We present a structural model that allows a firm to effectively manage its exposure to both insolvency and illiquidity risk inherent in its financing structure. Besides insolvency risk, the firm is exposed to rollover risk through possible runs by short-term creditors. Moreover, asset price volatilities are subject to macro-economic shocks and influence creditors' risk attitudes and margin requirements. Credit spreads are derived endogenously depending on the firm's total default risk. Equity holders have to bear the rollover losses. An optimal debt structure that maximizes the firm's equity value is determined by trading off lower financing costs and higher rollover risk.


Keywords:funding liquidity, optimal capital structure, rollover risk, structural credit risk models


JEL Classification: G01, G32, G33



Financial Flexibility and Investment Ability Across the Euro Area and the UK


Annalisa Ferrando, Maria-Teresa Marchica, and Roberto Mura


Abstract:
We use a very large sample of European private and public firms to show that financial flexibility attained through a conservative leverage policy is more important for private, small-medium-sized, and young firms and for firms in countries with less access to credit and weaker investor protection. Further, using the 2007 financial crisis as a natural experiment, we show that a higher degree of financial flexibility allows firms to reduce the negative impact of liquidity shocks on investment. Our findings support the hypothesis that financial flexibility improves companies’ ability to undertake future investment, despite market frictions hampering possible growth opportunities.


Keywords: low leverage, financial flexibility, investment, cross-country analysis


JEL Classification:G31, G32, D92



Announcement Effects of Contingent Convertible Securities: Evidence from the Global Banking Industry


Manuel Ammann, Kristian Blickle and Christian Ehmann


Abstract:
This paper investigates the announcement effects of CoCo bonds issued by global banks between January 2009 and June 2014. Using a sample of 34 financial institutions, we examine abnormal stock price reactions and CDS spread changes before and after the announcement dates. We find that the announcement of CoCos correlates with positive abnormal stock returns and negative CDS spread changes in the immediate post-announcement period. We explain these effects with a set of theories including the lowered probability of costly bankruptcy proceedings, a signaling framework based on pecking order theory and the cost advantage of CoCos over equity (tax shield).


Keywords: contingent convertible securities, CoCo bonds, announcement effects, event study


JEL Classification: G01, G14, G21



Risk control: Who cares?


Nick Taylor


Abstract:
The performance of recently introduced risk-control indices is evaluated and tested with respect to a set of competing indices. Applying a method of moments methodology to these data reveals that the performance of strategies that track risk-control indices have economic and statistical significance to investors with realistic risk aversion parameter values. How- ever, this performance varies over time and appears to be determined by macroeconomic and liquidity conditions.


Keywords: Risk control, volatility, certainty equivalent return, method of moments


JEL Classification: G53, G11, G17



A Theoretical Model for the Term Structure of Corporate Credit based on Competitive Advantage


Myuran Rajaratnam, Bala Rajaratnam and Kanshukan Rajaratnam


Abstract:
We derive the term structure of Corporate Credit based on the Competitive Advantage of a firm and the tax deductibility of its interest payments. We consider the competitive advantage enjoyed by the firm as the central tenet of our model and capture its eventual demise in a probabilistic manner. We compensate the bond holder for expected losses and then provide an additional spread based on the tax deductibility of interest payments. Our simple intuitive model appears to overcome some of the well-known shortcomings of structural credit risk models.


Keywords: Term Structure, Corporate Credit, Competitive Advantage, Value-Investing, Credit Spread Puzzle


JEL Classification: EFM 340 Fixed Income; JEL G12 Bond Interest Rates



The Role of the Conditional Skewness and Kurtosis in VIX Index Valuation


Simon Lalancette and Jean-Guy Simonato


Abstract:
The CBOE VIX index is a widely recognised benchmark measure of expected stock market volatility. As shown in the literature, probability distributions other than Gaussian are key features required to describe the dynamics of the S&P 500, the variable that ultimately determines the VIX index level. As such, it is important to assess if deviations from the Gaussian distribution have important impacts on the VIX index level. We examine herein how a model articulated over a time-varying non-Gaussian distribution with conditional skewness and kurtosis can contribute to the overall explanation of the VIX dynamics.


Keywords:VIX, GARCH, skewness, kurtosis, risk-neutral valuation


JEL Classification: C58, G1



Dynamic Asset Allocation with Liabilities


Daniel Giamouridis, Athanasios Sakkas, Nikolaos Tessaromatis


Abstract:
We develop an analytical solution to the dynamic multi-period portfolio choice problem of an investor with risky liabilities and time varying investment opportunities. We use the model to compare the asset allocation of investors who take liabilities into account, assuming time varying returns and a multi-period setting with the asset allocation of myopic ALM investors. In the absence of regulatory constraints on asset allocation weights, there are significant gains to investors who have access to a dynamic asset allocation model with liabilities. The gains are smaller under the typical funding ratio constraints faced by pension funds.


Keywords:Strategic Asset Allocation,Dynamic Asset Allocation, Asset-Liability Management, Return Predictability, Myopic Investors


JEL Classification: G11, G12, G23



Bankers on the Board and CEO Incentives


Min Jung Kang and Young (Andy) Kim


Abstract:
Governance improvement measures often demand more financial experts on corporate boards. Directors from the lending bank require particular attention because the conflicts of interest between shareholders and debtholders would be severe. Hence, we examine whether commercial banker directors work in the best interests of shareholders in providing incentives to the CEO. We find that the CEO’s compensation VEGA is lower if an affiliated banker director is on the board, especially when the director is the chair of the compensation committee. Further, commercial banker directors increase debt-like compensation and make it more sensitive to performance and less sensitive to risk.


Keywords:bankers on board, financial expertise, conflicts of interest, governance, board of directors, CEO compensation


JEL Classification: G14



Due Diligence and Investee Performance


Douglas Cumming and Simona Zambelli


Abstract:
We estimate the economic value of due diligence (DD) in the context of private equity by investigating the relationship between DD and investee performance, while controlling for endogeneity. With the adoption of a novel dataset, we find evidence highly consistent with the view that a thorough DD is associated with improved investee performance. We also distinguish the role of different types of DD and show that the DD performed by fund managers has a more pronounced impact on performance. Instead, the DD mainly performed by external agents, i.e., consultants, lawyers and accountants, gives rise to puzzling results and imperfect matching.


Keywords:Due Diligence, Governance, Performance, Private Equity


JEL Classification: G23, G24, G28



Where will the “Silver Money” Go?


Na Young Park


Abstract:
Using international country-level data, this paper shows that demographic ageing is likely to significantly expand the insurance industry. This expansion is driven by the increased need to secure earnings for post-retirement consumption, the desire to hedge against risks associated with increasing age, and the older generation’s risk aversion to increasing the demand for safer assets such as insurance and pension products. Moreover, such an expansion of the insurance industry is particularly apparent in financially liberalized countries. This is because risk and asset management associated with insurance and pension products could be facilitated and more effective in liberalized financial markets.


Keywords:demographic ageing, demographic change, financial liberalization, insurance industry, insurance markets


JEL Classification: G21, G28, G30



Financial Hedging and Firm Performance: Evidence from Cross-Border Mergers and Acquisitions


Zhong Chen, Bo Han and Yeqin Zeng


Abstract:
Using a sample of 1,369 cross-border acquisitions announced by Standard & Poor's 1500 firms between 2000 and 2014, we find strong evidence that derivatives users experience higher announcement returns than nonusers, which translates into a $193.7 million shareholder gain for an average-sized acquirer. In addition, we find that acquirers with hedging programmes have higher deal completion probabilities, longer deal completion times, and better long-term post-deal performance. We confirm our findings after employing an extensive array of models to address potential endogeneity. Overall, our results provide new insights into a link between corporate financial hedging and firm performance.


Keywords:Cross-border M&As; risk management; financial derivatives


JEL Classification: F31; G13; G32; G34



Relationship Lending and Firms Leverage: Empirical Evidence in Europe


Roberto Guida and Valentina Sabato


Abstract:
Using a novel measure of relationship lending based on the kind of information banks use to assess borrowers, we investigate the role of relationship lending in firms’ capital structure. Using a unique dataset of European manufacturing firms, we measure relationship lending based on three dimensions (closeness, soft information, exclusivity) and relate them to firms’ leverage. Overall our results support the hypothesis that supply factors matter. We find that the actual use of soft information increases leverage and only firms without soft information-intensive relationships increase their leverage through multiple relationships. However, the effect of relationship lending on leverage varies across countries.


Keywords:relationship lending; soft information; capital structure; leverage; financial systems


JEL Classification: D45, G15, G21, G32



How to Manage Long-term Financial Self-sufficiency of National Catastrophe Insurance Fund? The Feasibility of Three Bailout Programs


Jo-Yu Wang, Yang-Che Wu, Wen-Lin Wu, and Ming Jing Yang


Abstract:
This paper shows the feasibility that a natural catastrophe insurance fund (NCIF) may achieve financial self-sufficiency via three bailout programs, including pre-funding, loan-financing and equity-financing, to support the insurer during bad years. Under such programs, different accounting procedures of insurer and NCIF are developed to simulate their 30-year cash flows based on best-fitting loss model calibrated by global insured loss data. The numerical analysis indicates proposed programs can balance the financial revenue and expenditure of NCIF in the long term, and this conclusion implies the authority can develop similar scheme as NCIF to smooth the peak risk of natural catastrophes.


Keywords:natural catastrophe insurance fund, pre-funding bailout program, loan-financing bailout program, equity-financing bailout program


JEL Classification: G32; G11; C15



Retail Investor Attention and IPO Valuation


Hugh M. J. Colaco, Amedeo De Cesari, and Shantaram P. Hegde


Abstract:
Given restrictions placed on communication with prospective investors, retail investor attention can help firms/underwriters with the task of initially valuing an IPO. Using Google search volume to proxy for retail investor attention, we find that the presence of and an increase in retail attention following initial filing but prior to initial pricing are positively related to initial valuations. Our results are robust to alternative matching methods to identify our matched sample of non-IPO firms and to including several controls for institutional demand. We conclude that retail investor attention plays a critical role in the early stages of IPO valuation.


Keywords: initial public offering; equity valuation; retail investor; investor attention


JEL Classification: G30; G32



Extreme Returns in the European Financial Crisis


Andreas Chouliaras and Theoharry Grammatikos


Abstract:
We examine the transmission of financial shocks among the euro-periphery (Portugal, Ireland, Italy, Greece, Spain), the euro-core (Germany, France, the Netherlands, Finland, Belgium), and the major European Union (but not euro) countries (Sweden, the United Kingdom, Poland, the Czech Republic, Denmark). Using extreme returns on daily stock market data from 2004 until 2013, we find transmission effects for the tails of the returns distributions for the pre-crisis, US crisis and euro crisis periods from the euro-periphery to the non-euro and euro-core groups. During the crises, the shocks transmitted were more substantial, indicating significantly higher losses on extreme return days.


Keywords:Financial crisis, financial contagion, spillover, euro crisis, stock markets


JEL Classification: G01, G15



Determinants of Management Earnings Forecasts: The Case of Global Shipping IPOs


Wolfgang Drobetz, Dimitrios Gounopoulos, Andreas Merikas and Anna Merika


Abstract:
Firms that go public on global stock markets are not obliged to disclose earnings forecasts in their prospectuses. We use this fact to examine the shipping industry, where most firms issue earnings forecasts during the IPO process, and thus provide unique, international-level evidence. We find overall pessimistic forecasts of ship owners, primarily because of the industry’s uncer-tain and volatile environment. High ship owner participation after going public is associated with less accurate earnings forecasts. Our results further indicate that financial leverage, a listing in an emerging stock market, and global market conditions are other main factors responsible for in-accurate earnings forecasts.


Keywords:Earnings management, voluntary disclosure environment, forecast accuracy, IPOs


JEL Classification: D82, G14, G32, M41



CEO Personal Investment Decisions and Firm Risk


Wei Cen and John A. Doukas


Abstract:
We develop a novel approach of measuring CEO risk preferences, based on the personal allocation of their deferred compensation funds, and find CEOs holding more volatile deferred compensation portfolios lead riskier firms. We also use the 2008 financial crisis as a natural experiment to check the robustness of this new approach and find consistent evidence in support of a positive association between CEO risk-taking and firm risk. Moreover, the evidence shows that risk-taking CEOs pursue risky financial and investment policies. Our results, in accord with the behavioral consistency theory, demonstrate that CEOs act consistently across personal and professional choices.


Keywords: CEO Risk preferences; Firm risk; CEO Deferred compensation; Inside debt; Financial Crisis


JEL Classification: G30; G32; G34; M52



Cold Case File? Inventory Risk and Information Sharing during the pre-1997 Nasdaq Preopening


Laurence Lescourret


Abstract:
This paper shows that dealers in OTC markets might choose to share information about transient price pressures. Using data from the pre-1997 NASDAQ preopening, I find that the frequency and magnitude of non-positive spreads (the information-sharing vehicle) initiated by wholesalers (specialized marketmakers with a high exposure to inventory risk) are strongly related to opening price reversals and daily rading imbalances. This activity is more likely to occur on days of large liquidity shocks, and it is not observed for other dealers. Overall, the obligation to absorb price pressure at a yet unknown opening price might induce dealers to communicate the direction in which the opening price should move. The findings contain lessons for the design of today's OTC markets.


Keywords: OTC markets, Preopen, NASDAQ, Information Sharing, Price Reversals


JEL Classification: G12, G14, D82



How Useful is Basel III"s Liquidity Coverage Ratio? Evidence from U.S. Bank Holding Companies?


Brian Du


Abstract:
This paper approximates a construction of Basel III’s Liquidity Coverage Ratio (LCR) for U.S. bank holding companies. This study examines (i) the LCR’s marginal contribution to a firm’s systemic risk and (ii) whether the LCR can predict ex ante which banks are most exposed to systemic losses in a true systemic event. Panel regressions from 2002 to 2015 show that the LCR is associated with lower relative systemic risk, measured by ΔCoVaR, as proposed by Adrian and Brunnermeier (2016). The LCR may be used conjunctively with marginal expected shortfall to predict a firm’s systemic losses during the crisis of 2007-2008.


Keywords: Financial crisis; Banking; Systemic risk; Liquidity coverage ratio


JEL Classification: G01; G10; G18; G21



Maximum Diversication Strategies Along Commodity Risk Factors


Simone Bernardiy, Markus Leippoldz and Harald Lohrex


Abstract:
Pursuing risk-based allocation across a universe of commodity assets, we nd diversi ed risk parity (DRP) strategies to provide convincing results. DRP strives for maximum diversi cation along uncorrelated risk sources. A straightforward way to derive uncorrelated risk sources relies on principal components analysis (PCA). While the ensuing statistical factors can be associated with commodity sector bets, the corresponding DRP strategy entails excessive turnover because of the instability of the PCA factors. We suggest an alternative design of the DRP strategy relative to common commodity risk factors that implicitly allows for a uniform exposure to commodity risk premia.


Keywords: Commodity Strategies, Risk-Based Portfolio Construction, Risk Parity, Diversi - cation


JEL Classification: G11; D81



Do Managerial Practices Matter in Innovation and Firm Performance Relation? New Evidence from the UK


Ilayda Nemlioglu and Sushanta Mallick


Abstract:
The innovation and firm performance relation remains a puzzle, as all types of innovation are not equally beneficial. Besides, better-managed firms tend to perform better. Integrating these two strands of literature, we examine whether managerial practices explain this relationship using data from UK firms during 1992-2014. We find that firms which focus on R&D activities jointly with better managerial practices benefit favorably. During post-crisis period, higher intangibles are only beneficial when combined with R&D activity. Also firms with better managerial practices and innovative activities exhibit a positive effect of higher leverage. Finally, an inverse U-shaped result supports the Schumpeterian theory of creative destruction.


Keywords: firm performance, firm profitability, financial crisis, leverage, intangible assets, R&D intensity, innovation, managerial practices, panel data models


JEL Classification: JEL-codes: G01 (financial crisis), G1 (general financial markets), G3 (corporate finance), O3 (innovation, R&D and technological change, intellectual property rights), O32 (management of technological innovation and R&D), O34 (intellectual property& intellectual capital), C33 (panel data models)



Market-based Estimates of Implicit Government Guarantees in European Financial Institutions


Lei Zhao


Abstract:
I exploit the price differential of credit default swap (CDS) contracts written on debts with different levels of seniority to measure the implicit government guarantees enjoyed by European financial institutions from 2005 to 2013. I determine that the aggregate guarantee increases substantially during the recent financial crises and peaks at an average of 89 bps in 2011. My analysis suggests that the extent of implicit support depends on the type of financial institutions and there exists a Eurozone effect. Further investigation of feedback relationship shows that the guarantee implicitly offered by a government positively “Granger causes” the sovereign’s default risk.


Keywords:Credit default swap, financial crisis, financial institutions, implicit government guarantees, too-big-to-fail


JEL Classification: G01, G21, G28



The Contagion versus Interdependence Controversy between Hedge Funds and Equity Markets


Tae Yoon Kim and Hee Soo Lee


Abstract:
This study considers the ‘contagion versus interdependence’ controversy between hedge funds and equity markets. We find that contagion effects break down the established interdependence between them and conditional return smoothing could play a key role in the contagion process by increasing or decreasing the contagion likelihood during crisis and prosperity. It is noted that the return smoothing tends to produce a biased pattern of returns during crisis and a decreased amount of return during prosperity. These findings are obtained by linking single equation error correction model to factor model and carrying out quantile regression, Z-test and Wald–Wolfowitz runs test.


Keywords:hedge funds; contagion; interdependence; conditional return smoothing, single equation error correction model; factor model


JEL Classification: G01, C22, C58



The Manipulation Potential of Libor and Euribor


Alexander Eisl, Rainer Jankowitsch, and Marti G. Subrahmanyam


Abstract:
The London Interbank Offered Rate (Libor) and the Euro Interbank Offered Rate (Euribor) are two key benchmark interest rates used in a plethora of financial contracts. The integrity of the rate-setting processes has been under intense scrutiny since 2007. We analyze Libor and Euribor submissions by the individual banks and shed light on the underlying manipulation potential for the actual and several alternative rate-setting procedures. We find that such alternative fixings could significantly reduce the effect of manipulation. We also explore related issues such as the sample size and the particular questions asked of the banks in the rate-setting process.


Keywords:Money markets, Libor, Euribor, manipulation, collusion


JEL Classification: G01, G14, G18



Asset Pricing Puzzles in an OLG Economy with Generalized Preferences


Amadeu DaSilva and Mira Farka


Abstract:
We seek to explain a number of asset pricing anomalies–the equity premium puzzle, the risk-free rate puzzle, and portfolio allocation puzzle–in a parsimonious overlapping generations model (OLG) with two key features: borrowing constraint and Epstein-Zin-Weil (1989) preference. The model is able to simultaneously match asset pricing moments and individual portfolio decisions using reasonable values of parameters governing behavior. We find that the main driver of savings behavior, equity returns and asset allocation is the relative difference between the two parameters: the level of relative risk aversion and the inverse of the elasticity of substitution.


Keywords: Equity premium puzzle, Overlapping generations model, General- ized Preferences, Portfolio allocation.


JEL Classification: G0, G12, D10, E21.



Liquidity Risk and Volatility Risk in Credit Spread Models: a Unified Approach


Stylianos Perrakis and Rui Zhong


Abstract:
We present an integrated framework incorporating both exogenous liquidity risk in the secondary corporate bond market and volatility risk in the dynamics of asset value in debt rollover models. Using an innovative theoretical approach we derive general expressions for the debt and equity values in all cases.Taking advantage of the analytical expressions for the asset value with the constant elasticity of variance (CEV) process, we show numerically using realistic parameter values from empirical studies that volatility risk, together with deteriorating bond market liquidity, decrease both debt and equity values and increase significantly the credit spreads.


Keywords: liquidity risk, volatility risk, credit risk, structural model


JEL Classification: G12, G13, G32, G3



The Revealed Preference of Sophisticated Investors


Jesse Blocher and Marat Molyboga


Abstract:
Berk and van Binsbergen (2016) have shown that the Capital Asset Pricing Model (CAPM) best represents the revealed preferences of any investor who can invest in mutual funds (i.e., all investors). This claim seems overly broad, as it applies to all asset classes. However, we show that hedge fund investors’ revealed preferences are also best modeled by the CAPM. Because hedge fund investors are sophisticated and can access all assets classes, our finding supports this broad claim. Using the CAPM is rational, as we show that CAPM alpha correlates with managerial skill and predicts performance better than other multi-factor models.


Keywords: Investor Preferences, Benchmarks, Capital Asset Pricing Model, Return Predictability


JEL Classification: G12, G14, G23



The Investment CAPM


Lu Zhang


Abstract:
A new class of Capital Asset Pricing Models (CAPM) arises from the first principle of real investment for individual firms. Conceptually as “causal” as the consumption CAPM, yet empirically more tractable, the investment CAPM emerges as a leading asset pricing paradigm. Firms do a good job in aligning investment policies with costs of capital, and this alignment drives many empirical patterns that are anomalous in the consumption CAPM. Most important, integrating the anomalies literature in finance and accounting with neoclassical economics, the investment CAPM succeeds in mounting an efficient markets counterrevolution to behavioral finance in the past 15 years


Keywords: the investment CAPM, the consumption CAPM, the CAPM, asset pricing anomalies, efficient markets, behavioral finance, the aggregation critique, general equilibrium, the joint-hypothesis problem


JEL Classification: D53, E22, G12, G14, G31



Earnout Deals: Method of Initial Payment and Acquirers’ Gains


Leonidas Barbopoulos*, Krishna Paudyal, and Sudi Sudarsanam


Abstract:We analyze the implications of initial payment methods in earnout deals on acquirers’ gains. The results, which are robust to self-selection bias and alternative model specifications, reveal that earnout deals outperform non-earnout deals. The acquirers gain the most from earnout deals when both initial and deferred payments are in stocks. The positive wealth effect of the choice of initial payment method in earnout deals is more prominent in cross-border deals than in domestic deals. Overall, the earnout deals generate higher gains when both the initial and deferred payments help spread the risk between the shareholders of acquiring and target firms.


Keywords: Earnout contracts; Initial payment in earnout deals; Asymmetric information; Acquirers’ gains.


JEL Classification: G34.



Optimal Ownership Structure in Private Equity


Bo Liu, Yang Liu, and Jinqiang Yang


Abstract:We develop a tractable model to analyse the valuation of a general partner (GP) and the ownership allocation in a private equity (PE) fund. Our results indicate that holding ownership will increase GP's value. We further explore the influential factors that affect GP's optimal ownership decision. Our model predicts that GP's managerial skill has positive effects on GP's shareholding choice. Factors such as leverage, unspanned risks, GP's compensation have negative impacts on GP's ownership decision. The fund's maturity has a non-monotonic and concave influence. Moreover, the widely used performance measures implied by our model are consistent with empirical findings.


Keywords: private equity, illiquidity, incomplete market, ownership structure, managerial compensation


JEL Classification: G11, G23, G24



Consistent Valuation of Project Finance and LBO's using the Flows-to-equity Method


Ian Cooper and Nyborg Kjell


Abstract:The flows-to-equity method is used to value transactions where debt amortises according to a fixed schedule, requiring a formula that links the changing leverage with a time-varying equity discount rate. We show that extant formulas yield incorrect valuations because they are inconsistent with the basic assumptions of this method. The error from using the wrong formula can be large, especially at currently low interest rates. We derive a formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress. We resolve an important issue about what to use as the cost of debt.


Keywords:valuation, flows-to-equity, equity cash flow, cost of equity, project finance, LBO, cost of debt


JEL Classification: G12, G24, G31, G32, G33, G34



A Unified Theory of Forward- and Backward-looking M&As and Divestitures


Qing Ma and Susheng Wang


Abstract:In a unified theory of forward- and backward-looking M&As and divestitures, an M&A today may be a cause for a divestiture in the future; conversely a divestiture today may be a consequence of an M&A in the past. M&As and divestitures are not only two sides of the same coin, they are also causes and consequences of each other. In this paper, in a two-period model, two firms consider integrating or separating in each period. We analyze forward- and backward- looking M&As and divestitures, and compare them with static M&As and divestitures.


Keywords: unified framework, forward looking, backward looking, M&A, divestiture


JEL Classification: G34



Income Uncertainty and the Decision to Invest in Bulk Shipping


Ioannis Kyriakou, Panos K. Pouliasis, Nikos C. Papapostolou, and Nikos K. Nomikos


Abstract:
We develop a coherent framework for valuing real assets and determining the optimal time to invest. To this end, we model the stochastic nature of income, present a valuation paradigm for freight-linked assets and, using real option theory, we demonstrate its usefulness in investment appraisal and optimal timing of entry in the shipping industry. We find that long-run freight rate and volatility affect the decision timing and investment value that diminishes with increasing vessel age. As time-to-build declines, the value of the option to wait increases implying a high opportunity cost embedded in the investment decision due to construction lags.


Keywords: real options, investment, uncertainty, contingent claims, shipping


JEL Classification: C13, C63, G13, G31, L92



Corporate Debt Maturity and Stock Price Crash Risk


Viet Anh Dang, Edward Lee, Yangke Liu, Cheng Zeng

Abstract:
We find that firms with a larger proportion of short-term debt have lower future stock price crash risk, consistent with short-term debt lenders playing an effective monitoring role in constraining managers’ bad-news-hoarding behavior. The inverse relation between short-maturity debt and future crash risk is more pronounced for firms that are harder to monitor due to weaker corporate governance, higher information asymmetry, and greater risk-taking. These findings suggest that short-term debt substitutes for other monitoring mechanisms in curbing managerial opportunism and reducing future crash risk. Our study implies that short-maturity debt not only preserves creditors’ interests, but also protects shareholders’ wealth.


Keywords:debt maturity, stock price crash risk, corporate governance, information asymmetry


JEL Classification: G3, G12, G14



Selling Winners, Buying Losers: Mental Decision Rules of Individual Investors on Their Holdings


Cristiana Cerqueira Leal, Gilberto Loureiro, and Manuel Armada

Abstract:We extend the study of the disposition effect – the preference for selling (holding) current winning (losing) stocks- by adding a new element to this decision process: the investors’ preference to purchase additional units of the current losing stocks. Using a unique database, we find that individual investors prefer to sell their winning stocks and, simultaneously, hold and increase their exposure to the losing ones. The additional purchase is pervasive across investors, but stronger for less sophisticated investors. Our evidence suggests that reference prices, prior stock returns, stock visibility, and investor performance and sophistication are determinants of investors’ trading behavior.


Keywords: Disposition effect; additional purchase; portfolio choice; individual investors; mental accounting; trading decision.


JEL Classification: G02,G11,G14



Persistency of the Momentum Effect


Hong-Yi Chen, Pin-Huang Chou, and Chia-Hsun Hsieh

Abstract:The intermediate-term momentum persistency is not universal among all stocks. More than 40% of winners and losers immediately fall out of their respective groups in the month following formation, resulting in a monthly loss of more than 17% for a momentum strategy constructed on such stocks. By contrast, persistent winners and losers, defined as those staying in their groups for at least one more month, exhibit much stronger momentum persistency. Further analysis indicates that, consistent with the delayed reaction hypothesis for price momentum, the persistency is stronger for stocks with greater information asymmetry and more extensively heterogeneous investor beliefs.


Keywords:delayed reaction hypothesis, duration, heterogeneous beliefs, information asymmetry, persistent momentum strategy


JEL Classification: G11, G14



Credit Risk in Italian Banks' Exposure to Non-Financial Firms


Matteo Accornero, Giuseppe Cascarino, Roberto Felici, Fabio Parlapiano, and Alberto Maria Sorre

Abstract:This paper outlines a framework based on microdata and a structural model to gauge credit risk in banks’ exposures to non-financial firms. Sectoral risk factors are accounted for using a multi-factor model as prompted in Duellman and Masschelein (2006). We use expected and unexpected losses as indicators of credit risk stemming from the corporate sector as a whole, and we put forward a measure of systemic risk relevance of economic sectors. We apply the model to the Italian economy, showing the sensitivity of credit risk indicators to different characteristics of default risk, cyclicality and concentration of economic sectors.


Keywords:Credit risk, Sectoral risk, Systemic risk, Structural Multi-Factor Model


JEL Classification: G21, G32



Exchange Traded Funds and Asset Return Correlations


Zhi Da and Sophie Shive

Abstract:We provide novel evidence supporting the notion that arbitrageurs can contribute to return comovement via ETF arbitrage. Using a large sample of U.S. equity ETF holdings, we document the link between measures of ETF activity and return comovement at both the fund and the stock levels, after controlling for a host of variables and fixed effects and by exploiting the “discontinuity” between stock indices. The effect is also stronger among small and illiquid stocks. An examination of ETF return autocorrelations and stock lagged beta provides evidence for price reversal, suggesting that some ETF-driven return comovement may be excessive.


Keywords:exchange-traded-fund, correlation, arbitrage


JEL Classification: G23, G12



The Mixed vs the Integrated Approach to Style Investing: Much Ado About Nothing


Markus Leippold and Roger Ruegg

Abstract:We study the difference between the returns to the integrated approach to style investing and those to the mixed approach. Unlike the mixed approach, the integrated approach aggregates factor characteristics at security level. Recent literature finds that the integrated approach dominates the mixed approach. Using statistical tools for robust performance testing, we demystify these findings as a statistical fluke. We do not find any evidence favoring the integrated approach. What we do find is that the integrated approach exhibits a higher sensitivity to the low-risk anomaly. However, this reduction in risk does not lead to an improvement in performance.


Keywords:Factor investing, integrated and mixed approach, value, momentum, low volatility.


JEL Classification: G11, G12, G14




Non-Myopic Portfolio Choice with Unpredictable Returns: The Jump-to-Default Case


Anna Battauz and Alessandro Sbuelz

Abstract:If a risky asset is subject to a jump-to-default event, the investment horizon affects the optimal portfolio rule, even if the asset returns are unpredictable. The optimal rule solves a non-linear differential equation that, by not depending on the investor's pre-default value function, allows for its direct computation. Importantly for financial planners offering portfolio advice for the long term, tiny amounts of constant jump-to-default risk induce marked time variation in the optimal portfolios of long-run conservative investors. Our results are robust to the introduction of multiple non-defaultable risky assets.


Keywords:Dynamic asset allocation, time-varying hedging portfolio, jump-to-default risk, return predictability, irreversible regime change


JEL Classification: G01, G11, G12, C61




Growth Options and Firm Valuation


Holger Kraft, Eduardo Schwartz and Farina Weiss

Abstract:This paper studies the relation between firm value and a firm's growth options. We find strong empirical evidence that Tobin's Q increases with firm-level volatility. The significance mainly comes from R&D firms which have more growth options than non-R&D firms. By decomposing firm-level volatility into its systematic and unsystematic part, we document that only idiosyncratic volatility has a significant effect on valuation. Second, we analyze the relation of stock returns to realized contemporaneous idiosyncratic volatility and R&D expenses. Sorting on idiosyncratic volatility yields a significant negative relation between portfolio alphas and contemporaneous idiosyncratic volatility for non-R&D portfolios.


Keywords:Firm valuation, Real options, Volatility, R&D expenses, PCA


JEL Classification: G12




Sentiment, Order Imbalance and Co-movement. An Examination of Shocks to Retail and Institutional Trading Activity


Patricia Chelley-Steeley, Neophytos Lambertides, Christos S. Savva

Abstract:Using order flow imbalance as a measure of sentiment we show that positive and negative shocks to sentiment lead to lower co-movement between portfolio and market returns in the post-shock period. Furthermore, an asymmetry is present as positive shocks to sentiment have less impact on co-movement changes than negative shocks. Moreover, shocks to retail sentiment and the sentiment of two types of institutional investors leads to a reduction in co-movement. Positive shocks to institutional order flow imbalance lead to smaller reductions in co-movement than associated with retail shocks. These effects exist even after controlling for firm specific and market-wide news.


Keywords: Order flow shock and sentiment, co-movement, smooth transition model


JEL Classification: G12, G14




The Effectiveness of Asset, Liability, and Equity Hedging Against the Catastrophe Risk: The Cases of Winter Storms in North America and Europe


Yang-Che Wu, and Ming Jing Yang

Abstract:The winter storms in North America and Europe are responsible for the majority of the insured natural catastrophe losses. This study analyzes the effectiveness of insurers hedging against the winter storm risk in terms of asset (catastrophe derivatives), liability (catastrophe bonds), and equity (catastrophe equity puts) risk management perspectives. The analysis results of the various financial performances show that our suggested hedging strategies are effective based on the long-term positive profit and the improvement in the insolvency ratios. The conclusions of this study provide the insurers with the less volatile premiums and more diversified portfolios under the catastrophe risk management.


Keywords: Catastrophe Derivatives, Catastrophe Bonds, Catastrophe Equity Puts, Catastrophe Risk Management


JEL Classification: G32, G11, C15




Do Investment Banks Create Value for their Clients? Empirical Evidence from European Acquisitions


Johannes Kolb

Abstract:Europe provides an interesting setting to explore the role that investment banks play in acquisitions because it is composed of countries with different legal regimes—the shareholder-oriented common law regime in the UK/Ireland and the stakeholder oriented civil law regime in Continental Europe. Since investment banks are hired to act in the interests of shareholders, and due to differences in disclosure requirements, market transparency, accounting standards and ownership between the UK and Continental Europe, I argue that investment banks are relatively more important in UK-only acquisitions. My findings support this conjecture.


Keywords: mergers and acquisitions; investment banks; Europe; corporate governance; law and finance


JEL Classification: G34; G38; G14; G24




Investment Beliefs of University Endowments


Andrew Ang, Adnres Ayala and William N. Goetzmann

Abstract: American university and college endowments now hold close to one-third of their portfolios in private equity and hedge funds. We estimate that at the end of 2012, the typical endowment believes that its private equity investments will outperform a portfolio of conventional assets by 3.9% per year and that hedge funds will outperform by 0.7% per year, and these out-performance beliefs have increased over time. Private universities, universities with larger endowments and higher spending rates, and those that rely more on the endowment to meet operational budgets tend to believe that alternatives deliver higher alphas.


Keywords: Hedge funds, private equity, alternative assets, portfolio choice, asset allocation


JEL Classification: G11, G14, G23




Intangible Assets and the Book-to-Market Effect


Hyuna Park

Abstract:The book-to-market effect is well known, but prior research does not analyze the impact of goodwill and related transformations in accounting rules that may bring significant changes to the effect. This paper analyzes the impact of SFAS 142, Goodwill and Other Intangible Assets, issued in 2001. I find that the book-to-market effect is weaker in the post-SFAS 142 period especially in the firms that have goodwill, impairment loss or risk. The book-to-market effect is stronger for subsamples of firms that do not have goodwill. These findings are robust to size groups, different factor models, and test methods.


Keywords:fair-value accounting, valuation of R&D, goodwill impairment, value premium


JEL Classification: G12, M41, O3




Stock Market Integration, Cost of Equity Capital and Corporate Investment: Evidence from Brazil


David Hillier and Tiago Loncan

Abstract:We study the effect of stock market integration on the cost of capital and investment, using Brazil as a case study. We show that integration, as proxied by foreign ownership, has a positive impact on the financing side by reducing cost of capital. On the output side, we find that integration increases corporate investment, but only for well-governed firms. We contribute to the debate on the pros and cons of financial globalisation, particularly by providing evidence of important linkages between financial integration and real economic activity.


Keywords:Stock Market Integration; Cost of Capital; International Asset Pricing; Investment


JEL Classification: F65, F61, F36, G15, G12