European Financial Management

Association

European Financial Management, VOL 4: 3, November 1998

On The Predictability of The Stock Market Volatility: Does History Matter?
Kpate Adjaoute, Martin Bruand and Rajna Gibson-Asner

Abstract.
This study compares the performance of the ISD, the GARCH(1,1), the historical volatility estimates and of two lagged trading volume measures for predicting the Swiss Stock Market Index's (SMI) volatility. The ISD has a superior daily informational content than the GARCH(1,1) estimate and retains unbiased but decreasing explanatory power over up to 20 days ahead horizons. Mean and spread daily volume measures play a significant correcting role when forecasting stock market volatility over daily and longer intervals respectively and clearly dominate the GARCH(1,1) forecasts. Their significance emphasizes heterogeneous horizon traders' influence on the SMI volatility time series properties.

Keywords: Volatility, Forecast, GARCH, Volume

JEL: C53; C32; G13

European Financial Management, VOL 4: 3, November 1998

Optimal Hedging and the Partial Loss Offset Provision
Eric Briys and Francois de Varenne

Abstract.
In this paper, we examine how taxation affects the optimal hedging behavior of an investor exposed to price risk under partial loss offset provision. In this regime, only part of the loss is refunded through the tax. As such, it implies a non linearity in the taxation schedule. More specifically, we look at an individual endowed with some fixed quantity of a commodity and facing a price risk. The optimal hedging policy is derived. The comparative statics of a tightening of the PLO provision and a changing risk aversion are analyzed. We show that the response of the optimal hedging policy to a change in the tax rate can be signed by a preference free or a preference related sufficient condition, involving the notions of cost-of-carry and partial risk aversion.

European Financial Management, VOL 4: 3, November 1998

Contestability and Pay Differential in The Executive Suites
James S. Ang, Shmuel Hauser and Beni Lauterbach

Abstract.
In comparison to the abundant evidence on CEOs' compensations, little is known about the compensation of other senior executives, and on how the pay differential between CEO and other senior executives affects firm performance. We examine several potential explanations of the pay differential in the executive suite, using a sample of 367 Israeli films listed on the Tel-Aviv Stock Exchange. The empirical results fail to support the tournament and pay equity models. Instead, our evidence suggests a model where senior executives are encouraged (by the structure implied in their pay contract) to cooperate with each other (the team playing model). In a subset of firms managed by their owners we observe greater pay differentials between the owner-CEO and other senior executives. Interestingly, only in this subset of owner-managed firms, higher pay differentials can be associated with better firm performance.

Keywords: Executive compensation; organizational structure; tournaments

JEL: G32; J31; L2

European Financial Management, VOL 4: 3, November 1998

Macroeconomic Determinants of European Stock Market Volatility
Vihang Errunza and Ked Hogan

Abstract.
In this paper we investigate whether macroeconomic variability can explain time variation in European stock market volatility. We find that unlike the documented case of the U.S., in many cases, the time variation in stock market volatility is found to be significantly affected by the past variability of either monetary or real macroeconomic factors. Our findings have important implications for capital and portfolio allocations.

Keywords: European Stock Markets, Volatility, Macroeconomic Determinants, Predictability

JEL: G15; F41

European Financial Management, VOL 4: 3, November 1998

Determinants of Swap Spreads in a Developing Financial Market: Evidence from Finland
Antti Suhonen

Abstract.
This paper presents empirical evidence on the determinants of swap spreads in Finland using four years of data. Spreads exhibit a significant negative relationship with the amount of fixed rate deposits with banks, which reflects the importance of banks in the Finnish capital markets. Spreads are positively linked to business cycle and market risk factors such as the slope of the yield curve and the volatility of interest rates. The influence of hedging costs has become increasingly important over time, especially in longer dated swaps. A relationship is also observed between swap spreads and the external value of the currency.

Keywords: Interest rates, Derivatives, Swaps, Capital Markets, Cointegration

JEL: G130

European Financial Management, VOL 4: 3, November 1998

PROFESSIONAL FORUM

The Two Key Principles Behind Effective TQM Programs
Karen Hopper Wruck and Michael C. Jensen

Abstract.
We analyze Total Quality Management (TQM) from an economic and organizational perspective. We find that TQM is a new organizing technology that is science-based, non-hierarchical and non-market-oriented. It improves productivity by encouraging the use of science in decision-making and discouraging counter-productive defensive behavior. It also encourages effective creation and use of specific knowledge throughout the organization. Effective implementation of TQM generally requires major changes in all three components of the organizational rules of the game, namely systems for allocating decision rights, performance measurement systems, and reward and punishment systems.

Keywords: Total Quality Management, Science, Specific Knowledge, Productivity
 
 

The Role of Beta and Size in the Cross-Section of European Stocks
Steven L. Heston, K. Geert Rouwenhorst and Roberto E. Wessels.
John M. Olin School of Business, Washinton University,
School of Management, Yale University,
ARCAS-Wessels Roll Ross

Abstract.
This paper examines the ability of beta and size to explain cross-sectional variation in average returns in twelve European countries. We find that average stock returns are positively related to beta and negatively related to firm size. The beta premium is in part due to the fact that high beta countries outperform low beta countries. Within countries high beta stocks outperform low beta stocks only in January, not in other months. We reject the hypothesis that differences in average returns on size- and beta-sorted portfolios can be explained by market risk and exposure to the excess return of small over stocks (SMB). Consistent with recent U.S. evidence, we find that after controlling for size, there is no association between average returns and exposure to SMB.

Keywords: Equity Markets, International Risk Factors, Integration

JEL: G15; G11; G12

European Financial Management, VOL 5: 1, March 1999

Accounting for the Accuracy of Beta Estimates in CAPM Tests on Assets with Time-Varying Risks
Tom Berglund and Johan Knif.
Economics Dept. Swedish School of Economics and Business Administration,
Finance Dept. Swedish School of Economics and Business Administration

Abstract.
This paper advocates two ways to make more efficient use of available information in reducing the bias of the risk premium estimate in two-pass tests of the CAPM. First, explicit modeling of the time-variability of betas can improve the accuracy of the beta forecasts. Second, the cross-sectional information available can be exploited more efficiently using individual stocks instead of portfolios provided that noisy beta predictions are given a smaller weight than more accurate ones. This paper proposes an adjustment of the cross-sectional regressions of excess returns against betas to give larger weights to more reliable beta forecasts. A significant positive relationship between returns and the beta forecast is obtained when the proposed approach is applied to data from the Helsinki Stock Exchange, while the traditional Fama-MacBeth (1973) approach as such finds no relationship at all.

Keywords: CAPM Tests; Time-Varying Risks, Consistency, Beta Accuracy

JEL: G12; G15

European Financial Management, VOL 5: 1, March 1999

The Government as Venture Capitalist? The Role of Organizational Structure and Contract Design in Germany's Privatization Process
I.J. Alexander Dyck and Karen Hooper Wruck
Harvard Business School,
Harvard University

Abstract.
This paper examines the role that organization structure and contract design played in resolving economic and political problems that arose during Germany?s privatization process. We find that German officials structured organizations and contracts in a way that made credible the government?s commitment to rapid privatization. This credibility served to protect the process from political and social opposition. In addition, it enabled Germany to attract talented private sector managers to its privatization effort. This began with the establishment of an independent privatization agency, the Treuhand. It culminated with the creation of another set of independent organizations called Management KGs, to which the Treuhand outsourced part of its restructuring, management and privatization work.

Keywords: Privatization, Contracts, Organizations, Government Ownership, Ownership Structure, Governance

JEL: G32; G38; L22; P52

European Financial Management, VOL 5: 1, March 1999

Price Limits and Stock Market Volatility in the Athens Stock Exchange
Kate Phylaktis, Manolis Kavussanos and Gikas Manalis.
City University Business School, London, UK,
City University Business School, London, UK,
National Bank of Greece, Athens, Greece

Abstract.
In this paper, we have examined the effects of price limits on the stock volatility in ASE. We put forward two hypotheses, the information hypothesis, which implies that price limits only slow down the process of adjustment and have no effect on stock volatility; and the overreaction hypothesis, which assumes that investors tend to overreact to new information, so that price limits give them time to reassess the information and reduce stock volatility. Our results show strong support for the information hypothesis. This evidence is obtained by performing the tests on ten stocks, which include heavily traded stocks as well as less active stocks, and covering a variety of industries, and on a market wide price index. The results are also robust to the frequency of the measurement of the returns, and to the tightness of the limits.

Keywords: Price Limits and Volatility, Emerging Capital Markets, ARCH/GARCH Modelling, Athens Stock Exchange

JEL: G14

European Financial Management, VOL 5: 1, March 1999

Forecasting the Correlation Structure of German Stock Returns: A Test of Firm-Specific Factor Models
Manfred Steiner and Martin Wallmeier
Department of Finance and Banking ,University of Augsburg, Germany,
Department of Finance and Banking ,University of Augsburg, Germany

Abstract.
This paper evaluates the performance of various factor models with firm-specific variables in forecasting correlation matrices at the German stock market. We investigate forecasts of correlations for a comprehensive sample and a sample of blue chips and analyze the impact of stock market crashs on the forecasting accuracy. Our empirical results show that the multi-factor models do not generally produce better forecasts than 'naive' models. Specifically, the traditional Industry Mean Model significantly outperforms all other techniques in most of the time periods.

Keywords: Portfolio management, diversification, factor models, financial ratios, correlation structure.

JEL: G11; G53; G23

European Financial Management, VOL 5: 1, March 1999

PROFESSIONAL FORUM

Banking and Capital Market Activity in Dublin: Recent Developments and Future Prospects under the Euro
Robert W. Hutchinson
School of Commerce and International Business Studies, University of Ulster at Coloraine, Northern Ireland

Abstract.
The introduction of Europe's single currency will have an immediate effect on the financial sectors of participating economies. While research in this area has focused on the broad implications for Europe's banking structure, this has been at the neglect of the smaller European financial centres which, while peripheral, make important contributions to their domestic economies. As a representative study, this paper examines how the recent developments in Ireland's financial sector will be affected by the introduction of the euro. It focuses on the probable cantraction of Dublin's financial markets and assesses the threat of foreign acquisition facing its main domestic clearing banks.
 

Keywords: Banking, Capital Markets, Monetary Union

JEL: G20

European Financial Management, VOL 5: 2, July 1999

Financial Architecture
Stewart C. Myers.
MIT Sloan School of Management

Keynote Address at the EFMA European Conference, Lisbon Portugal, June 1998.

Keywords: Financial Structure, High-Tech Firms, Conglomerates, LBOs

JEL: G3; G31

European Financial Management, VOL 5:2, July 1999

Herding in Analyst Earning Forecasts: Evidence from the United Kingdom
Werner F.M. Bondt and William P. Forbes
University of Wisconsin-Madison,
University of Manchester, UK

Abstract.
We present an empirical analysis of herding behavior in analyst forecasts of earnings-per-share. Herding is defined as "excessive agreement" among analyst predictions, i.e., a surprising degree of consensus relative to the predictability of corporate earnings. The data are for U.K. companies between 1986 and 1997. We examine the effects of forecast horizon and analyst coverage on forecast accuracy and dispersion. The evidence supports overoptimism, overreaction, and herding in analyst forecasts.
Keywords: Herding Behavior, Analyst Earning Forecasts, Overoptimism, Overrreaction

JEL: G1; G14

European Financial Management, VOL 5:2, July 1999

Dual-Listing on International Exchanges: The Case of Emerging Markets' Stocks
Ana Paula Serra
Institute of Finance and Accounting, London Business School

Abstract.
This paper examines the effects on stock returns of dual-listing on an international exchange. My sample consists of 70 firms from 10 emerging markets that dual-listed on the NYSE, NASDAQ and SEAQ-I (London) over the period 1991-1995. I evaluate whether an international dual-listing has any significant effect on returns, for the particular case of emerging markets' firms, and I proceed to investigate whether there is evidence to support an International Asset Pricing based explanation. In addition I compare the impact of US and London SEAQ-I listings. My results confirm previous empirical findings on international listings: the firms in my sample experience significant positive abnormal returns before listing and a significant decline in returns following listing. Evidence seems to be supportive of the segmentation hypothesis: dual-listing effects are more pronounced for emerging markets listings and that pattern is similar across exchanges.
Keywords: International Asset Pricing; Segmentation; Dual-Listings; Emerging Markets; Event Studies

JEL: G15

European Financial Management, VOL 5:2, July 1999

A One-Factor Volatility Smile Model with Closed-form Solutions for European Options
Anlong Li
ABN Amro Bank,

Abstract.
The common practice of using different volatilities for options of different strikes in the Black-Scholes (1973) model imposes inconsistent assumptions on underlying securities. The phenomenon is referred to as the volatility smile. This paper addresses this problem by replacing the Brownian motion or, alternatively, the Geometric Brownian motion in the Black-Scholes model with a two-piece quadratic or linear function of the Brownian motion. By selecting appropriate parameters of this function we obtain a wide range of shapes of implied volatility curves with respect to option strikes. The model has closed-form solutions for European options, which enables fast calibration of the model to market option prices. The model can also be efficiently implemented in discrete time for pricing complex options.

Keywords: Option Pricing, Implied Volatility, Skewness, Volatility Smiles, Equivalent Martingale Measure.

JEL: G1

European Financial Management, VOL 5:2, July 1999

A Multi-Factor Model for the Risk Management of Portfolios
Sandra Peterson and Richard C. Stapleton
 

Abstract.
We propose a methodology for modelling the value at risk of a complex portfolio, based on an extension of the Ho, Stapleton and Subrahmanyam technique. We model the variance-covariance structure of up to seven variables. These could represent four country indices and three exchange rates, for example. In addition, the effect of an arbitrary number of orthogonal factors can be analysed. The system is illustrated by estimating the value at risk for a portfolio of international stocks where the factors are stock market indices and exchange rates, a portfolio of international bonds where the factors are interest rates as well as exchange rates, and a portfolio of interest rate derivatives in different currencies. In this last case, we model a two-factor term structure of interest rates in each of the currencies, valuing the derivatives at a future date using these term structures and the Black model. The model is applied for different fineness of the binomial density and computational accuracy and efficiency are estimated.

Keywords: Risk Management, Portfolios, Value-at-Risk

JEL: G13; G15; G21

European Financial Management, VOL 5:2, July 1999

Exchange Rate Exposure, Foreign Involvement and Currency Hedging of Firms: Some Swedish Evidence
Stefan Nydahl
Department of Economics, Uppsala University and Quantal International Inc.

Abstract.
This paper investigates the effect of exchange rate fluctuation on a firm's value, the so-called exchange rate exposure, for a sample of Swedish firms. In contrast to previous results, using U.S. data, the values of Swedish firms, as reflected in the stock price, seem quite sensitive to movements in the exchange rate. Studying the cross sectional differences in exposure, the estimated exposure is positively and significantly related to the fractional of total sales made abroad and negatively related to the use of currency derivatives.
Keywords: Exchange Rate Exposure, Foreign Activities, Hedging.

JEL: F30; G10

European Financial Management, VOL 5:2 July 1999

EFMA 1998 ROUNDTABLE DISCUSSIONS

World Wide Changes in the Governance and Control of Corporations
Antonio Borges, John Coffee, E. Han Kim, Ekkehard Wegner and Peter Martin
 

European Financial Management, VOL 5:2 July 1999

EFMA 1998 ROUNDTABLE DISCUSSIONS

The Future of Exchanges in an Integrated Europe
Richard A. Brealey, Didier Davidoff, Jose C.P. Teixeira, Fields Wicker-Miurin and Eric Sirri
 

Introduction
Patrice Fontaine.
ESA Grenoble, France

 Abstract.
This special issue is devoted to a number of important and timely issues relating to the French financial environment. This issue consists of six papers dealing with market microstructure, liquidity, risk premia, price discovery issues, announcement effects and valuation of derivatives in the French capital market setting.

European Financial Management, VOL 5:3 November 1999

Risk Aversion and The Bid-Ask Spread
P. Roger and L Eeckhoudt.
University Louis Pasteur, France,
FUCAM, Belgium

Abstract.
This paper studies the properties of bid and ask prices posted by a monopolistic market-maker, without parametric assumptions about the utility function of the market maker or about the probability distribution of the return of the risky asset. We first prove that the two prices can be higher or lower than the expected value of the asset, and that the spread is decreasing in the initial wealth when the market maker exhibits decreasing absolute risk aversion. We conclude by some examples illustrating the fact that almost all shapes can be obtained for the bid-ask spread (as a function of the inventory) depending on the probability distribution of the payment of the risky asset.

Keywords: Bid-Ask Spread, Risk Aversion, Inventory Effect

JEL: D40; G12; G14

European Financial Management, VOL 5:3 November 1999

A Unifying Microstructure Framework for Modeling Intraday and Interday Asset Pricing Dynamics: The Case of Exchange Rates
Thierry Chauveau and Richard Topol
CEBI-TEAM, University Paris & CDC-marches/FMR, France,
CNRS & OFCE, Paris, France

Abstract.
A model of the dynamics of intradaily exchange rates is presented. The current Over-The-Counter (OTC) exchange rate is the quote of the quoting bank.Two polar cases are considered: (i) If each bank is able to observe the noises relative to the orders of its own clients, then the OTC exchange rate is shown to obey a random walk with a constant conditional variance. (ii) If each bank is not able to observe the noises relative to the orders of its own clients, the OTC exchange rate is no more a random walk and conditional heteroskedasticity appears.
 

Keywords:ARCH Models, Conditional Variance, Efficiency, Exchange Rate, Heteroscedasticity, Intraday, Market Microstructure, Rational Expectations, Stochastic Volatility Models.

JEL:F3; C6; G0

European Financial Management, VOL 5:3 November 1999

Is There Value-Added Information in Liquidity and Risk Premiums?
Jacques Hamon and Bertrand Jacquillat
Universite Paris Dauphine, France,
Associes en Finances & Universite Paris Dauphine, France

Abstract.
Size has become a significant factor in explaining returns. According to the size effect, smaller capitalization stocks on average outperform larger capitalization stocks over long periods of time. This paper first documents the traditional size effect on the French market for the 1986-1998 period. It introduces a new proxy for size, free float, which is argued to be the appropriate measure of size and liquidity for most non-US markets. Evidence is presented of a negative link between historical returns and free float. The link is significant even outside of the month of January, a notable divergence from results obtained on the NYSE. The rest of the paper is an attempt to take advantage of this ?ex-post? phenomenon on an ?ex-ante? basis, with an empirical study of the link between expected return, risk, and liquidity in a sample consisting of the main 150 stocks quoted on the Paris Bourse between January 1986 and January 1998. Liquidity premiums are estimated for portfolios from both a univariate and a multivariate perspective. The paper shows how risk and liquidity premiums can be used separately or in tandem for market timing and asset allocation. In all cases, the use of both premiums together leads to superior performance. Results confirm our measurements of liquidity and liquidity premiums and supply evidence that liquidity premiums together with risk premiums are useful in active asset management.

Keywords:Asset Allocation, Liquidity Premium, Market Timing, Risk Premium, Small Size Effect.

JEL: G11; G12; G14

European Financial Management, VOL 5:3 November 1999

Short Sales Constraints, Liquidity and Price Discovery: An Empirical Analysis of the Paris Bourse
Bruno Biais, Christophe Bisiere, and Jean-Paul Decamps

Abstract.
In the Paris Bourse some stocks are traded on a spot basis, while others are traded on a monthly settlement basis. The latter are likely to be less subject to leverage and short sales constraints. We empirically analyze the consequences of this difference for the order flow and the return process. Consistent with the theoretical analysis of Diamond and Verrechia (1987), we find that market sell orders are less frequent on the spot market than on the monthly settlement market (although not very significantly) and that the spot market reflects good news (significantly) faster than bad news.

Keywords:Paris Bourse, Short-Sales Constraints, Price Discovery, Monthly Settlement, Liquidity.

JEL: G14

European Financial Management, VOL 5:3 November 1999

The Induced Effects of Earnings Announcements on Asymmetric Information
Jean-Francois Gajewski

Abstract.
This paper empirically analyses trades and quotes around the times of 37 earnings announcements in the Paris Bourse. We find that trading volume is larger on announcement days, spreads are wider after announcements, and the permanent positive (resp. Negative) price impact of purchases (sales) is greater around announcements. While the findings pertaining to the spread and the permanent impact of trades are consistent with the view that earnings announcements correspond to an increase in information asymmetries, the result that trading volume is larger suggests that other effects are at work.

Keywords:Asymmetric Information, Capital Markets, Earnings

JEL: D82; G14; M41

European Financial Management, VOL 5:3 November 1999

The Valuation of Interest Rate Digital Options and Range Notes Revisited
Patrick Navatte and Francois Quittard-Pinon
Universite de Rennes 1, France,
Universite de Lyon 1 , France

Abstract.
The aim of this paper is to value interest rate structured products in a simpler and more intuitive way than Turnbull(1995). Considering some assumptions with respect to the evolution of the term structure of interest rates, the price of a European interest rate digital call option is given. Recall it is a contract designed to pay one dollar at maturity if a reference interest rate is above a prespecified level (the strike), and zero in all the others cases. Combining two options of this type enables us to value a European range digital option. Then using a one factor linear Gaussian model and the new well-known change of numeraire approach, a closed-form formula is found to value range notes which pay at the end of each defined period, a sum equal to prespecified interest rate times the number of days the reference interest rate lies inside a corridor.

Keywords: Digital Option, Range Note, Forward Neutral Probability, Interest Rate Dynamics.

JEL: C63; G12; G13
 

European Financial Management, VOL 6:1 March 2000

A Currency Index Global Capital Asset Pricing Model
Thomas J. O'Brien and Walter Dolde.
University of Connecticut, Storrs,
University of Connecticut, Storrs

Abstract.
A Two-factor Global Capital Asset Pricing Model, where the factors are the global market portfolio and a currency index, is described and illustrated. The model is consistent with the empirical evidence of a priced currency index factor by Ferson and Harvey [1993, 1994]. The model and illustration help demonstrate a problem with the common practice of adjusting an asset's expected rate of return across currencies via nominal riskless interest rate differentials.

Keywords: International, Asset, Pricing

JEL:G15

European Financial Management, VOL 6:1 March 2000

A Theoretical Analysis of Alternative Approaches to Financial Regulation
Francesco M. Paris
Department of Quantitative Methods, Universtity of Brescia, Italy

Abstract.
This paper studies alternative regulatory approaches within the framework of intermediaries' capital requirements, one of the cornerstones of modern financial regulation. The basic assumptions are that the intermediary's capital is valued as a down-and-out call option written on its own assets and that the optimal capital requirement is the one minimizing the total expected social costs. The analysis discusses the total expected costs' function within three alternative regulatory context and allows for a comparison of alternative approaches formalized by a set of five fundamental propositions explaining the impact of regulatory choice on critical aspects such as the intermdiary's capital size and riskiness, his/her assets' choice, the competition among either different intermediaries or functions and, last but least, the intermediary's operational structure.
 

Keywords: Regulation, Bank Capital, Assets' Volatility, Leverage

JEL: G28

European Financial Management, VOL 6:1 March 2000

The Information Content of Implied Volatility, Skewness and Kurtosis : The Empirical Evidence from Long Term CAC 40 Options
Patrick Navatte and Christophe Villa
University of Rennes, France,
University of Rennes, France

Abstract.
The implied standard deviation is widely believed to be the best available forecast of the volatility of the returns over the remaining contract life (Jorion 1995). In this paper, we generalize this result to the higher moments of the distribution (Skewness and Kurtosis) based on a Gram-Charlier series expansion of the normal distribution (Corrado and Su 1996) using long term CAC 40 option prices contract, named PXL. First, we find that implied first moments contain a substantial amount of information for realized future moments of CAC 40 returns although this amount is decreasing with respect to the moment's order. Second, we find that different shapes of the volatility smile are consistent with different distributions of the underlying returns. Based on these results, we also observe that including other implied moments significantly improve the out-of-sample pricing performance of the Black-Scholes (1973) model.

Keywords:Implied Density Function, Smile, Volatility, Skewness, Kurtosis.

JEL: C14; C52; G12; G13; G14

European Financial Management, VOL 6:1 March 2000

The Direct Costs of UK Rights Issues and Open Offers
Seth Armitage
Department of Business Studies, University of Edinburgh

Abstract.
The paper describes selling and underwriting procedures in rights issues and open offers, and analyses the costs of issue reported in prospectuses, including the substantial costs which are not for underwriting. The impression is often given that costs are fixed at 2% of gross proceeds, but they vary and average 5.78% (median 4.28%). Controlling for economies of scale and fees not related to the issue, costs increase with the proportion of the issue underwritten and with the depth of discount, and decrease with the proportion of the company owned by large shareholders.

Keywords:Rights Issues, Open Offers, Direct Costs

JEL: G24

European Financial Management, VOL 6:1 March 2000

PROFESSIONAL FORUM

International Working Capital Practices
Cecilia Ricci and Nino di Vito
Seton Hall University,
Price Waterhouse, London,UK

Abstract.
This paper reports the results of a survey on the international working capital management practices of the top 200 companies in the United Kingdom. The purpose of the survey was to obtain information on some international aspects of working capital management in major British firms.
Keywords: Working Capital, Treasury, United Kingdom, International

JEL Code: G14
 

European Financial Management, VOL 6:1 March 2000

PROFESSIONAL FORUM

Does the One Man Show pay? Theory and Evidence on the Dual CEOs Revisited
Jay Dahya and Nickolaos G. Travlos
Cardiff Business School, UWCC, UK
University of Piraeus, Greece and Cardiff Business School, UWCC, UK

Abstract.
Contrary to the view expressed in several countries and the corresponding pressure exerted by shareholder activists and regulators to separate the titles of CEO and Board of Chairman, this study proposes that there is an optimal board composition for each firm which varies across firms and over time. A review of the extant empirical evidence reveals that most prior studies bypass this notion which raises serious implications for related empirical studies. In addition, this study documents striking differences in leadership structures between the US and UK and calls for further research in an international context.
Keywords: Board Structure, Dual CEO, Government Policy and Regulation
JEL Code:G3
 

European Financial Management, VOL 6:2 June 2000

An Explanation of the Forward Premium "Puzzle"
Richard Roll and Shu Yan
The Anderson School, UCLA
The Anderson School, UCLA

 Abstract.
Existing literature reports an empirical puzzle about the foreign exchange forward premium, the spread between the forward rate and the concurrently-observed spot exchange rate. The premium is often negatively correlated with subsequent changes in the spot rate. This defies economic intuition and possibly violates market efficiency. Various explanations have been offered, ranging from non-stationary risk premia through econometric mis-specifications. Some researchers have accepted the puzzle as a fact of inefficient foreign exchange markets, a phenomenon that provides profitable trading opportunities. We suggest there is really no puzzle at all. The simplest conceivable model adequately fits the data; forward exchange rates are unbiased predictors of subsequent spot rates. The puzzle has arisen because (a) the forward rate, the spot rate, and the forward premium all follow non-stationary (or nearly so) time series processes, and (b) the forward rate is a noisy predictor. We document these features with an extended sample and show how they can give the delusion of a puzzle.

Keywords:Foreign Exchange, Anomalies, Non-stationary Time Series

JEL: F31, G15

European Financial Management, VOL 6:2 June 2000

Options and Earnings Announcements: An Empirical study of Volatility, Trading Volume, Open Interest and Liquidity
Monique W.M. Donders, Roy Kouwenberg and Ton C.F. Vorst
Mees Pierson Derivatives Research, Netherlands
Tinbergen Institute, Netherlands
Department of Finance and Erasmus Center for Financial Research, Erasmus University, Netherlands

Abstract.
In this paper we study the impact of earnings announcements on trading volume, open interest and spreads in the stock option market. We find that option volume is higher around announcement days, even if we correct for stock volume and the expected future volatility of stock returns. Results in the pre-event period are different for good and bad news samples, indicating that option traders have access to (possibly short lived) private information. During the days before the announcements open interest tends to increase. After the earnings new dissemination traders seem to lose interest in the contracts and cancel part of their option positions thereby reducing open interest to normal levels. Analysis of quoted spreads provide no evidence of dealers' anticipation of higher information asymmetry in the pre- or post announcement period. However, results for effective spreads indicate that the transaction costs are higher on the announcement day itself and on the day immediately following the earnings dissemination. Both quoted and effective spreads are shown to respond to changes in trading volume and expected return variability.

Keywords:Earnings Announcements, Volatility, Volume, Spreads, Open Interest

JEL: G13, G14

European Financial Management, VOL 6:2 June 2000

Long-run Stock Performance of German Initial Public Offerings and Seasoned Equity Issues
Richard Stehle, Olaf Ehrhardt and Rene Przyborowsky
Humboldt-Universitat zu Berlin
 

Abstract.
Existing estimates of the long-run abnormal performance after initial public offerings in Germany differ between +1.54 % and -19.85 % for holding periods of 36 months. We discuss the methodological problems of these studies and the peculiarities of the German market. Using a large sample, alternative benchmarks (the equally and the value-weighted market portfolio, size portfolios and matching stocks), and a simulation study we conclude that size portfolios and matching stocks are better benchmarks than market portfolios, mainly because IPO stocks typically have a small or medium market capitalization and a size effect in stock returns exists. The new listing bias, discussed intensively by Barber/Lyon (1997) seems to be of minor importance in the German market. Using buy-and-hold abnormal returns, we estimate that German stocks involved in an IPO or in a SEO, on the average, underperform a portfolio consisting of stocks with a similar market capitalization by 6 % in three years. This is considerably less than the underperformance after IPOs and SEOs in the US market reported by Loughran/Ritter (1995) and the underperformance after IPOs in Germany reported by Ljungqvist (1997). For stocks involved in a SEO the underperformance is statistically significant, for IPO stocks it is not. This is the first estimate of the abnormal performance after SEOs for the German market. We also show that the apparent underperformance of the 1988-1990 IPO cohort discovered by Ljungqvist (1997) disappears when the abnormal performance estimate is based on size portfolios, instead of market portfolios. Since we have a relatively small number of observations per event, the use of matching firms as benchmarks in the calculation of long-run abnormal returns is associated with a much higher variance of the average long-run abnormal performance estimate than the use of size portfolios in both, the actual event studies and the simulations.

Keywords:Initial Public Offerings, Seasoned Equity Issues, Long-run Stock Performance, Market Efficiency, German Stock Market

JEL: G14, G12, G15

European Financial Management, VOL 6:2 June 2000

An Empirical Analysis of Corporate Debt Maturity Structure
Aydin Ozkan
University of Durham, UK

 Abstract.
This paper provides an empirical examination of the determinants of corporate debt maturity structure. A partial adjustment model is estimated by GMM estimation procedure using data for an unbalanced panel of UK firms over the period 1983-1996. The evidence is consistent with the hypothesis that firms with more growth opportunities in their investment sets tend to have more shorter-term debt. There is also strong evidence for a positive impact of size on debt maturity structure. The results also provide strong support for the maturity-matching hypothesis that firms match the maturity structure of their debt to that of their assets. The findings are inconsistent with the signalling hypothesis that firms use their debt maturity structure to signal information to the market. We find no evidence that taxes affect debt maturity structure. Our results suggest that firms have long-term target ratios and they adjust to the target ratio relatively fast, which might suggest that the costs of being away from their target debt maturity ratios are significant.

Keywords:Debt Maturity Structure, Panel Data, Generalised Method of Moments

JEL: G2, G3

European Financial Management, VOL 6:2 June 2000

Cross-sectional Analysis of Swedish Stock Returns with Time-varying Beta
Hossein Asgharian and Bjorn Hansson
Department of Economics, Lund University
Department of Economics, Lund University

Abstract.
This paper analyses the ability of beta and other factors, like firm size and book-to-market, to explain cross-sectional variation in average stock returns on the Swedish stock market for the period 1980-1997. We use a bivariate GARCH(1,1) process to estimate time-varying betas for asset returns. The estimated variances of these betas, derived from a Taylor series approximation, are used for correcting errors in variables problem. Our model accounts for problems such as cross-sectional and intertemporal heteroscedasticity. An Extreme Bounds Analysis is utilized for testing the sensitivity of the estimated coefficients to changes in the set of included explanatory variables. Since the tests are carried out on realized returns, which presumably are quite noisy approximations of expected returns; we also analyze if the variables play different roles depending on if it is a Bull or Bear market. Our results show that the coefficient for beta is never significantly different from zero, while variables book to market, size and leverage have significant coefficients. Different sensitivity analyses suggest that the results, to some extent, may be due to cross-correlations between the variables, the characteristics of the extreme periods included in the sample, the average sign of the excess market return during the sample period, and the choice of the estimation and test methods. The findings also show that the estimated conditional beta is a more accurate measure of the true market beta than the beta estimated by OLS.

Keywords: Cross Sectional Multifactor Model, Swedish Stock Returns, Time-varying Beta, Errors in Variables, Extreme Bound Analysis

JEL: G12, C21

European Financial Management, VOL 6:2 June 2000

Trading Volatility Spreads: A Test of Index Option Market Efficiency
Ser-Huang Poon and Peter F. Pope
Department of Accounting and Finance, The Management School, Lancaster University, UK
Department of Accounting and Finance, The Management School, Lancaster University, UK

Abstract.
Volatility spread (defined here as the ratio or the difference of two volatility estimates) is a useful piece of information for designing option trading strategies, especially if the return on one asset tracks the returns on the other. We study, in this paper, the volatility of the returns on two related indices, viz. the S&P 100 and S&P 500. Using a canonical correlation method proposed by Ray and Tsay (1997), we demonstrate that the two index return series share common volatility component that exhibits high level of persistence and long range dependent. Model estimates are used to monitor the spread implied in options prices (i.e. the isd spread with isd acronym for implied standard deviation), and form the basis of option trading strategies at "real time". The options used in testing our trading strategies are the Chicago Board Options Exchange tick-by-tick prices of the OEX options written on S&P 100 and the SPX options written on S&P 500. Simulated trades driven by isd spread generated significant trading profits in a vega-neutral trading strategy for call options. Such a trading strategy can easily be implemented on options written on any other pair of closely related assets.

Keywords:Market Efficiency, Index Option, Common Volatility, Canonical Correlation, vega-delta-neutral Portfolio

JEL: C10, C32, C53, E37, G14

Risk Management Lessons from Long-Term Capital Management
Phillippe Jorion
University of California-Irvine

Abstract.
Long-Term Capital Management (LTCM), the world’s largest hedge fund, collapsed in September 1998. Its failure could have “triggered the seizing up of markets”, “potentially impairing the economies of many nations.” For such a near-catastrophic event, the finance profession has precious little information to draw from. The purpose of this paper is to draw risk management lessons from the LTCM debacle by piecing together publicly available information. The paper discusses the growth and strategy of the fund. By 1998, LTCM had about $5 billion in investor equity, $125 billion in balance sheet assets, and over $1.2 trillion in total derivatives. Thus it had a huge leverage ratio of 25-to-1. As a hedge fund, LTCM did not have to reveal information about its strategies. In its marketing materials, however, the fund advertised itself as trying to be no riskier than a position in U.S. equities. This objective implied that the fund was trying to maximize profits subject to a volatility constraint, which can be rephrased in terms of the fund's Value at Risk (VAR). The paper shows how, in theory, VAR could be used to decide the amount of capital necessary to support a particular risk profile. LTCM was taking large bets on highly correlated securities, which generated positions akin to selling options. It was reported to be short credit and liquidity spreads as well as short equity options. Selling options generates steady profits but also, once in a while, catastrophic losses. LTCM also provides a good example of risk management taken to the extreme. The strategy searched for assets with high correlations. Using the same covariance matrix to measure risk and to optimize positions, however, inevitably leads to underestimation of risk. This is all the more likely when insurance is sold on events that happen infrequently—such as sovereign defaults. This strategy also led the fund to be singularly undiversified. In spite of myriads of apparently different positions, the fund was basically exposed to a common risk factor. In addition, LTCM’s large positions made it very difficult to modify the portfolio’s risk profile. The fund was exposed to asset liquidity risk. Finally, as it was unable to raise sufficient cash to pay off its obligations, it was also exposed to funding liquidity risk. Overall, the LTCM's story should provide a powerful object lesson in risk management. With such large, undiversified, positions, market risk creates liquidity risk.

Keywords:Risk Management, Long-Term Capital Management, Value-at-Risk

JEL: G11, G13, G14, G23

European Financial Management, VOL 6:3 September 2000

A Survey into the Use of Derivatives by Large Non-Financial Firms Operating in Belgium
Marc J.K. Ceuster, Edward Durinck, Eddy Laveren, and Jozef Lodewyckx
University of Antwerp (UFSIA), Antwerpen, Belgium

Abstract.
Empirical evidence on the use of derivatives for risk management on the European continent is virtually non-existent. To fill this gap, our survey documents the usage of derivatives by non-financial large firms operating in Belgium. This paper provides descriptive evidence with respect to several questions that are raised in the literature. Why do firms hedge? Which financial risks are being managed? How widespread is the use of derivatives? Which derivatives are used for which purposes? How is a risk management policy implemented? How are performance measurement and reporting structured?

Keywords:Derivatives, Risk Management, Hedging

JEL: G20, G28, M40

European Financial Management, VOL 6:3 September 2000

Re-Assesing the Long-Term Underperformance of UK Initial Public Offerings
Susanne Espenlaub, Alan Gregory, and Ian Tonks
Manchester School of Accounting and Finance, University of Manchester,
Department of Management, University of Exeter
Department of Economics, University of Bristol

Abstract.
Previous work has identified that IPOs underperform a market index, and the purpose of this paper is to examine the robustness of this finding. We re-examine the evidence on the long-term returns of IPOs in the UK using a new data set of firms over the period 1985-92, in which we compare abnormal performance based on a number of alternative methods including a calendar-time approach. We find that, using an event-time approach, there are substantial negative abnormal returns to an IPO after the first three years irrespective of the benchmark used. However, over the five years after an IPO, abnormal returns exhibit less dramatic underperformance, and the conclusion on negative abnormal returns depends on the benchmark applied. Further if these returns are measured in calendar time, we find that the (statistical) significance of underperformance is even less marked.

Keywords:Initial Public Offerings; Equity issues; Long-run returns; Market efficiency

JEL: G14

European Financial Management, VOL 6:3 September 2000

Similarly Traded Securities: Greek Common vs. Preferred Stock
Nikolaos T. Milonas
Department of Economics, University of Athens, Greece

Abstract.
This paper examines the price spread between voting (common) and non-voting (preferred) stocks during the period 1990-1995 for a sample of 55 Greek companies. Because in Greece preferred stocks are not essentially different from common stocks, a number of hypotheses were tested to explain the observed differences. The data reveal an average spread of 27.5% for the entire period which, however, varies across years considerably. In cross-sectional regressions it was found that the volatility of common stock returns, the liquidity of common shares relative to preferred shares, the ownership concentration, and the minimum dividend yield guaranteed to preferred stockholders explain a significant portion of the spread.

Keywords: Voting Right, Price Spread, Ownership Concentration, Volatility, Liquidity.

JEL: G14

European Financial Management, VOL 6:3 September 2000

Risk Structure of Interest Rates: An Empirical Analysis for Deutsch Mark Denominated Bonds
Klaus Dullman, Marliese Uhrig-Homburg, and Marc Windfuhr
University of Mannheim, Mannheim, Germany

Abstract.
This paper empirically studies the risk structure of interest rates for Deutschemark-denominated bonds. For this purpose, we estimate term structures of interest rates using the parsimonious fitting function of Nelson and Siegel (1987) for virtually riskfree Government bonds and five different rating categories classified by Moody's ratings (Aaa, Aa, A, Baa, Ba). The sample period covers the time interval from July 1990 to December 1996. We investigate the pricing errors resulting from our estimation procedure and analyze credit spreads over the term structure of Government bonds.

Keywords:Credit Spreads, Term Structure Estimation, Bond Ratings

JEL: G14, G15

European Financial Management, VOL 6:3 September 2000

PROFESSIONAL FORUM

Venture Capitalists, Investment APpraisal and Accounting Information: A Comparative Study of the US, UK, France, Belgium and Holland
Sophie Manigart, Koen De Waele, Mike Wright, Ken Robbie, Phillippe Desbrieres, Harry Sapienza, and Amy Beekman
University of Ghent, Faculteit Economie en Bedrijfskunde, De Vlerick School voor Management, Ghent, Belgium
University of Ghent, Faculteit Economie en Bedrijfskunde, De Vlerick School voor Management, Ghent, Belgium
Centre for Management Buy-out Research, University of Nottingham Business School, University of Nottingham, Nottingham, England
Centre for Management Buy-out Research, University of Nottingham Business School, University of Nottingham, Nottingham, England
Institut d'Administration des Entreprises, Universite de Bourgogne, Dijon, France
The Darla Moore School of Business, University of South Carolina, Columbia, USA
The Darla Moore School of Business, University of South Carolina, Columbia, USA

Abstract.
The differences between the information used for the pre-investment valuation and the valuation methods used by venture capital investors in five countries (US, UK, France, Belgium and Holland) are empirically studied. The analysis is based on postal questionnaire surveys of representative samples of senior venture capitalists in each country. Differences are found, which may be attributed to the dominant corporate governance mechanism or the level of development of the venture capital market. Between-country differences persist even after taking into account between-country differences in the relative importance of investment stages and venture capital types. Apparently similar systems and venture capital markets place varying emphases on different valuation methods, with theoretically 'correct' methods not always being preferred in practice. The findings of the study highlight the need for venture capital firms entering non-domestic markets to invest considerable effort in understanding the operation of these markets if they are to exploit fully their perceived competitive advantages and minimize the likelihood of repeating the problems experienced by venture capital entrants into foreign markets in the late 1980s.

Keywords:Venture Capital; Investment Appraisal; Accounting Information; Corporate Governance

JEL: G24; G34

European Financial Management, VOL 6:4 December 2000

The Deterring Role of the Medium of Payment in Takeover Contests: Theory and Evidence from the UK
Philippe Cornu and Dusan Isakov
HEC, University of Geneva, Switzerland
HEC, University of Geneva, Switzerland.

Abstract.
The deterring role of the medium of payment in a takeover contest is analyzed from the point of view of the bidder. Cash, debt and equity are considered as alternative mediums of payment, and the bidder equilibrium strategies are specified following the Perfect Bayesian Equilibrium requirements for a signaling game. The model predicts notably that cash offers signal a high-valuing bidder, strongly determined to acquire the target firm. Moreover, cash offers deter competition better than debt or equity offers. The theoretical results are validated with data from the U.K. over 1995-96.

Keywords: Takeover; Competition; Medium of Payment

JEL: G34; C72

European Financial Management, VOL 6:4 December 2000

Ex-Ante Hedging Effectiveness of UK Stock Index Futures Contracts: Evidence for the FTSE 100 and FTSE MID 250
Darren Butterworth and Phil Holmes
Department of Economics and Finance, University of Durham
Department of Economics and Finance, University of Durham

Abstract.
Ex ante hedging effectiveness of the FTSE 100 and FTSE Mid 250 index futures contracts is examined for a range of portfolios, consisting of stock market indexes and professionally managed portfolios (investment trust companies). Previous studies which focused on ex post hedging performance using spot portfolios that mirror market indexes are shown to overstate the risk reduction potential of index futures. Although ex ante hedge ratios are found to be characterised by intertemporal instability, ex ante hedging performance of direct hedges and cross hedges approaches that of the ex post benchmark when hedge ratios are estimated using a sufficient window size.

Keywords:Ex ante Hedging, Hedge Ratio Instability, ITC

JEL: G10

European Financial Management, VOL 6:4 December 2000

Interest Rate Risk of European Financial Corporations
Peter Oertmann, Christel Rendu, and Heinz Zimmermann
University of St. Gallen, and Investment Consulting Group Inc., Switzerland
London Business School,
University of St. Gallen, Switzerland

Abstract.
We investigate the interest rate exposure of large European financial corporations' equity returns. For the period from January 1982 to March 1995 we estimate multifactor index models to examine the sensitivity of equity returns to market index returns and domestic as well as global interest rate movements. In addition, we specify an APT-model to test whether an exposure to interest rate movements is rewarded in the cross-section of expected returns. In the four European markets both domestic and global interest rate shifts constitute driving forces of stock returns beyond the influence of the domestic market indices. However, the exposure to interest rate movements does not seem to be rewarded in the same fashion among the markets.

Keywords:Interest Rate Risk, Asset Pricing, Portfolio Management

JEL: C51, G12, G15

European Financial Management, VOL 6:4 December 2000

The Optimal Construction of Internationally Diversified Equity Portfolios Hedged Against Exchange Rate Uncertainty
Glen A. Larsen Jr and Bruce G. Resnick
Kelley School of Business, Indiana University, Indianapolis, USA
Babcock Graduate School of Management, Wake Forest University, Winston-Salem, USA

Abstract.
Much of the empirical work on hedging exchange rate exposure in portfolios of financial assets has used a unitary hedge ratio, or a currency overlay. Alternatively, the currencies themselves can be treated as assets and the position in them optimized. This study empirically tests whether the ex the post results of recent studies, which conclude that currencies should themselves be optimized, stand up under parameter uncertainty. It may very well be that ex ante, when parameter inputs must be estimated from historical data, the attempt to determine the optimal currency weights results in inferior performance in comparison to using a simple unitary hedging strategy, or even unhedged international investment. The results suggest that a local currency return unitary hedging strategy works best in the presence of parameter uncertainty.

Keywords:International Portfolio Diversification, Exchange Rate Uncertainty, Hedging, Parameter Uncertainty

JEL: G11, F31

European Financial Management, VOL 6:4 December 2000

Stock Dividend Distributions in Greece: Market Value Effects
George J. Papaioannou, Nickolaos G. Travlos and Nickolaos V. Tsangarakis
Hofstra University
Alba and Cardiff Business School
University of Piraeus

Abstract.
This study analyzes the price reaction to stock dividend distributions by firms listed on the Athens Stock Exchange on both the announcement and the ex-dividend day. It also analyzes earnings per share, dividends per share and trading volume in the pre- and post-announcement periods. The findings show statistically insignificant abnormal returns on both the announcement and the ex-dividend day. The analysis does not reveal any significant change in earnings per share and dividends per share, but it does reveal a significant decline in the market-adjusted trading volume in the post dividend period. The findings, based on a different institutional environment, expand the empirical evidence on the value effects of stock dividends.

Keywords:Stock Dividend; Earnings Per Share; Dividend Per Share; Trading Volume; Market Value Effect

JEL: G14, G15, G35

European Financial Management, VOL 6:4 December 2000

PROFESSIONAL FORUM

Takeovers: English and American
Geoffrey P. Miller
New York University

 Abstract.
Viewed against the backdrop of European company law generally, the U.K. and U.S. systems of corporate governance are remarkably similar. However, there are several salient differences between the system, including the fact that the U.K. has a more robust and less regulated takeover market than the U.S., while the United States is more permissive towards derivative litigation. This paper explains the differences as a function of politics. In the United States, where corporate law is dominated by state governments, the political forces aligned against hostile takeovers are quite potent, generating legislation and judicial decisions that have suppressed takeover activity. In the United Kingdom, with a more unitary system, the political forces play out differently, and the system accordingly generates rules more accommodating to unfriendly takeovers.

Keywords: Takeovers, Corporate Governance, Politics, Comparative Law.

JEL: G34, G39