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EFM Forthcoming Papers

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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

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

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

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

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

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

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

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

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

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

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

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

The Contagion versus Interdependence Controversy between Hedge Funds and Equity Markets

Tae Yoon Kim and Hee Soo Lee

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

Asset Pricing Puzzles in an OLG Economy with Generalized Preferences

Amadeu DaSilva and Mira Farka

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.

Earnout Deals: Method of Initial Payment and Acquirers’ Gains

Leonidas Barbopoulos*, Krishna Paudyal, and Sudi Sudarsanam

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.

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

Qing Ma and Susheng Wang

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

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

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

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

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

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

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

Markus Leippold and Roger Ruegg

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

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

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

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

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

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: 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

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

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

An International Analysis of CEO Social Capital and Corporate Risk-Taking

Stephen P. Ferris, David Javakhadze, and Tijana Rajkovic

This study examines the effects of CEO social capital on corporate risk-taking around the world. We document a significant positive relation between CEO social capital and aggregate corporate risk-taking. Further, we find that CEOs with large social capital prefer riskier investment and financial policies. We also determine that the effect of CEO social capital on corporate risk-taking is moderated by the extent of legal protections provided to shareholders, the financial development, and the culture of the country in which a firm is incorporated. Our results are robust to alternative proxies of risk-taking, alternative model specifications, and tests for endogeneity.

Keywords: Social capital, social networks, corporate risk-taking

JEL Classification: G30, Z13

Discounting Methods and Personal Taxes

Michael Dempsey

We advance models of valuation that incorporate personal taxes. The models are general in allowing for uneven cash flows, changes in debt levels, and changes in the costs of equity and debt. The models are mutually consistent and are consistent with the CAPM and Modigliani and Miller propositions allowing personal taxes.

Keywords: valuation, taxes, tax system, CAPM, WACC.p

JEL Classification: G12, G31, G38

CEO Talent: A Dime a Dozen, or Worth Its Weight in Gold?

Nicholas Donatielo, David F. Larcke, and Brian Tayan

Very little sophisticated research exists on the size, quality, and efficiency of the labor market for CEO talent. Our paper sheds light on this labor market by considering the perspectives of directors directly responsible for hiring and firing the CEOs of the largest publicly traded corporations in the U.S. We find that directors overwhelmingly believe that the CEO job is exceptionally challenging and only a handful of executives are qualified to run their company and others in their industry. This suggests that the labor market for outstanding CEO talent is significantly tighter and more competitive than governance experts might realize.

Keywords: CEO labor market, CEO recruitment, CEO succession planning, internal talent development, board of directors, CEO compensation, corporate governance

JEL Classification: G34

Does Size Matter in Predicting Hedge Funds’ Liquidation?

Adrien Becam, Andros Gregoriou, and Jairaj Gupta

In this study, we propose a set of covariates that exploit information content of hedge funds’ relative size, performance, growth, tail risk, and past liquidation rate, in predicting their liquidation. Empirical results show that our proposed covariates exhibit significant predictive power for up to two years even when we control for fund specific characteristics. Furthermore, we estimate separate liquidation prediction models for small, medium, and large funds. Our findings suggest that liquidation likelihood of hedge funds is inversely related to fund size, and statistical significance of factors affecting their liquidation vary across different size categories.

Keywords: hedge fund, liquidation, fund size, failure, default

JEL Classification: G11, G17, G33

The Payback of Mutual Fund Selectivity in European Markets

Feng Dong and John A. Doukas

Is European fund management selectivity skill (1-R2) profitable (alpha)? To examine this question, we use a sample of 2,947 actively-managed domestic equity mutual funds from 11 European countries. We find that high fund selectivity generates significant investor gains. The results are robust to investor sentiment and stock-market dispersion conditions. Moreover, we investigate the moderating effect of country characteristics on the profitability of fund selectivity and find that managers’ selectivity ability is more valuable in countries with high economic development, strong legal system, small but highly liquid equity markets, and young mutual fund industries.

Keywords: European fund selectivity skill, fund manager skill, fund performance

JEL Classification: G11, G14, G20, G23

There are Two Very Different Accruals Anomalies

Andrew Detzel, Philipp Schaberl and Jack Strauss

We document that several well-known asset-pricing implications of accruals differ for in- vestment and non-investment-related components. Exposure to an investment-accruals factor explains the cross-section of returns better than accruals themselves, and senti- ment negatively predicts this factors returns. The opposite results hold for non-investment accruals. Cash profitability only subsumes long-term non-investment accruals in the cross-section of returns and economy-wide investment accruals negatively predict stock- market returns while other accruals do not. These results challenge existing accruals- anomaly theories and resolve mixed evidence by showing the anomaly is two separate phe- nomena: a risk-based investment accruals premium and a mispricing of non-investment accruals.

Keywords: Accruals anomaly, profitability, real investment, cross-section of stock returns

JEL Classification: E44, G12

Is Bank Capital Sensitive to a Tax Allowance on Marginal Equity?

Jose Martin Flores and Christophe Moussu

This paper studies how bank capital changes following the implementation and removal of a tax incentive on equity. We examine the impact of the introduction of a tax allowance in Italy granted to banks (and other firms) that increase their equity from a base year. Using a difference-in-differences setting, we observe an 8.83% increase in bank capital ratios following the implementation of this reform. When this tax mechanism is phased out, we observe an opposite effect on the equity ratio, showing the absence of a hysteresis effect in bank capital. We document a heterogeneous effect for large and small banks.

Keywords:Tax, bank capital, debt-equity tax bias.

JEL Classification: G21, G28, G32.

Contingent Capital with Repeated Interconversion Between Debt- and Equity-like Instruments

Yanping Cai, Zhaojun Yang, and Zhiming Zhao

This paper introduces a new form of contingent capital, contingent convertible securities (CCSs), which might repeatedly convert between debt- and equity-like instruments depending on financial conditions. We derive explicit prices of corporate securities, assuming the cash flow is modeled as a geometric Brownian motion. We present an explicit value of the increased tax shields due to CCSs. We provide an explicit optimal capital structure when CCSs are issued and interestingly, the ratio of the optimal straight bond coupon to CCS coupon is constant and independent of the firm’s financial conditions. All the conclusions hold true also for contingent convertibles.

Keywords: contingent capital, repeated interconversion, capital structure

JEL Classification: G12, G32

Worthless Companies

J. B. Heaton

Companies with worthless assets can have substantial efficient markets equity values and debt that trades near par if there is a probability that an irrational bidder will acquire the company. Even if most capital market participants recognize that the company’s assets are worthless, efficient markets pricing of the worthless company’s equity and debt precludes arbitrage, and it may be impossible to persuade the potential irrational bidder to abandon its plans. The worthless company hypothesis may shed light on the valuation of some high-profile start-ups, the 1990s dot-com bubble, and the bad performance of some short sellers.

Keywords: mergers & acquisitions, bad bidders, bubble company, unicorns, short selling

JEL Classification: G02, G32, G34, K22

Investor Heterogeneity and Trading

Anzhela Knyazeva, Diana Knyazeva, and Leonard Kostovetsky

Institutional investors play a crucial role in the information environment of firms. We argue that heterogeneity in the information ability of institutional investors has a significant impact on trading around information releases. We propose novel measures of within-firm investor heterogeneity and find that investor heterogeneity increases abnormal trading volume around news, holding constant the average levels of investor sophistication. We also find larger spread reductions around announcements for firms with greater investor heterogeneity. The effect of investor heterogeneity on trading continues to hold after accounting for total institutional ownership, the presence of certain types of institutional investors, and analyst coverage.

Keywords: institutional investors, investor heterogeneity, information, trading volume, spreads

JEL Classification: G10, G12, G14

Are the Fama French Factors Treated as Risk? Evidence from CEO Compensation

Jeremy Bertomeu, Edwige Cheynel, and Michelle Liu-Watts



JEL Classification:

The Information Content of the Implied Volatility Term Structure on Future Returns

Yaw-Huei Wang and Kuang-Chieh Yen

We derive the theoretical relation between the term structure of implied variance and the expected excess returns of the underlying asset. Adopting three alternative approaches to compile the variables representing the information on the implied volatility index level and term structure, we show the important role of the term structure in determining future excess returns of the S&P 500 index. Both the in-sample and out-of-sample analyses suggest that the information content of the term structure variable is significant and a strong complement to that of the level variable, especially for shorter-term excess returns.

Keywords: VIX term structure, Predictability, S&P 500 index returns.

JEL Classification: G13, G14

When do Investment Banks use IPO Price Support?

Sturla Fjesme

Practitioners, regulators, and the financial media argue that underwriters tie Initial Public Offering (IPO) allocations to investor post-listing buying of the issuer shares in a process labelled price support. Arguably, this excess demand boosts post-listing returns which underwriters trade quid-pro-quo with investor stock-trading-commission payments. In this paper, I investigate unique data from the Oslo Stock Exchange (OSE) including investor stock-trading-commissions, IPO allocations, and post-listing trading. I document that investors who provide high returns to underwriters before IPOs benefit from price support through increased returns in IPOs. I conclude that price support is used when investors share boosted returns with underwriters.

Keywords:IPOs, Price Support, Stock-trading commission

JEL Classification: G24

A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-to-Price

Stephen H. Penman, Francesco Reggiani, Scott A. Richardson and İrem Tuna

We provide a framework for identifying accounting numbers that indicate risk and expected return. Under specified accounting conditions for measuring earnings and book value, book-to-price (B/P) indicates expected returns, providing justification for B/P in asset pricing models. However, the framework also points to earnings-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. Using this framework we resolve a puzzle: in contrast to previous empirical research, we find that leverage is positively associated with future returns, as predicted by theory.

Keywords:Book-to-price; earnings-to-price: growth and risk; accounting principles

JEL Classification: G11,G12,M41

Confucianism, Cultural Interactions and Corporate Investment Efficiency

Lei Chen, Zhi Jin,Yongqiang Ma, and Hui Xu

Our study presents robust findings that Confucianism significantly improves investment efficiency of Chinese listed firms and that the improvement is achieved through decreasing overinvestment without inducing underinvestment. Financial reporting quality is found to be an important mechanism for the disciplinary effect of Confucianism to work. More importantly, we provide strong and consistent evidence that openness to the West neutralizes the role of the Confucianism in overinvestment. Against the backdrop of globalization, this paper offers valuable references to emerging markets that experience intensive interactions with developed economies.

Keywords:Confucianism, Openness to the West, Investment efficiency, Financial reporting quality

JEL Classification: G31, G32, G34, M41, Z10

The Face of Risk: CEO’s Facial Masculinity and Firm Risk

Shinichi Kamiya, Y. Han (Andy) Kim, and Soohyun Park



JEL Classification:

Are the Fama French Factors treated as Risk? Evidence from CEO compensation

Jeremy Bertomeu, Edwige Cheynel, and Michelle Liu-Watts

Asset pricing theory postulates that a risk factor correlates with individuals’ marginal utility of consumption. Hence, under plausible preferences, individuals should become more risk tolerant given favorable factor returns. We show that this wealth effect predicts a positive association between performance pay and factor returns. Our results support the hypothesized relationship for the market, book-to-market and momentum factors. Factors constructed from bond prices are positively associated to incentives, incrementally to the Fama French factors, but we obtain mixed evidence for higher-order market factors, liquidity factors or factors constructed from national income accounts, including pricing kernels.


JEL Classification:

Focal Points and Firm Risk

Ye Cai and Hersh Shefri

The “better than average” effect suggests that relative industry standing should serve as an important focal point for corporate managers. March and Shapira (1992) develop a framework to analyze the impact of focal points on firms’ risk profiles. This paper uses the March-Shapira model to investigate the relationship between firms’ relative industry standings and their risk profiles. We find that firms’ equity returns display strong March-Shapira effects. When we examine the different firm decisions that impact risk, we find the strong presence of March-Shapira effects in firms’ decisions about operating cash flows, diversifying acquisition activity, working capital, and capital structure.

Keywords: Acquisition risk; Aspiration-based risk taking, Overconfidence

JEL Classification: G02, G34