Investment,consumption, and hedging under incomplete markets

Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.     

Idiosyncratic Risk and REIT Returns

The volatility of a stock returns can be decomposed into market and firm-specific volatility, with the former commonly known as systematic risk and the later as idiosyncratic risk. This study examines the relevance of idiosyncratic risk in explaining the monthly cross-sectional returns of REIT stocks. Contrary to the CAPM theory, a significant positive relationship is found between idiosyncratic volatility and the cross-sectional returns. This suggests that firm-specific risk matters in REIT pricing. The regression results further show that once idiosyncratic risk is controlled for in the asset-pricing model, the size and book-to-market equity ratio factors ceased to be significant. The explanatory power of the momentum effect remains robust in the presence of idiosyncratic risk.

The local market perception of firm risks during cross-listing events

We examine the local investors’ perceptions on the relative idiosyncratic risks around cross-listing events. We find that increases in relative firm-specific risks around the listing date are temporary and small for Level I American depositary receipts (ADRs) while Level III ADRs have the most variations. For exchange-listed ADRs from emerging markets, there is a significant decrease in the relative firm-specific risk in the year prior to listing, which increases during the cross-listing, while there are only significant increases in relative firm-specific risks for developed market firms. We interpret these as evidences of negative relationship between firm opaqueness and relative firm-specific risks.     

Brand Equity and Firm Risk: An Empirical Investigation in an Emerging Market

The aim of this article is to investigate the relationship between brand equity and firm risk in Turkey using a sample of 254 firm-year observations for the period 2009–2014. Our findings suggest that brand equity is an important determinant of equity risk in addition to conventional firm-specific variables. In particular, after controlling for firm-specific variables, the results reveal that firms with high brand equity experience lower volatility in stock returns. We also find that enhancing brand equity is an important tool for firms in reducing unsystematic and downside systematic risk in their stock prices. Our findings are robust to different valuation models of domestic and global investors as well as different methods of estimations. The results are encouraging for both marketing managers and investors, particularly those in emerging markets where stock price volatility is relatively higher than in developed markets.     

市场摩擦对特质风险溢价的影响效应——基于A股主板市场的实证分析

与国外发达市场相比,我国A股主板市场的市场摩擦因素对市场微观结构和资产定价的影响更大。在防范和化解系统性风险的过程中,进一步分析市场摩擦如何作用于特质风险定价效应的问题具有重要的理论和现实意义。本文通过采用多维市场摩擦指标来代理信息不对称、交易成本、买卖限制、卖空限制、风险对冲和外部冲击,检验中国股市特质风险和预期收益率的关系,并判断出市场摩擦因素间的差异性影响机制。回归发现,市场摩擦和特质风险因子(特质波动率和特质偏度)都具有定价效应。各维度市场摩擦因素降低了股票流动性,进而增强了特质波动率的负向定价效应,部分解释了“特质波动率之谜”,但市场摩擦对特质偏度因子溢价的影响较为微弱。同时,基于特质波动率和特质偏度因子的投资策略能够产生超越CAPM、三因子和五因子模型的绝对收益,并印证了市场摩擦对特质风险因子绝对收益的影响作用。     

资本市场开放与股权资本成本——基于沪港通、深港通的实证研究

本文基于沪港通和深港通研究资本市场开放对中国内地股权资本成本的影响。研究发现,受政策风险和市场环境等因素所限,沪港通在初始阶段并未对沪市公司的股权资本成本产生显著影响,但随着政策进一步完善、市场逐渐稳定和交易不断活跃,其对股权资本成本的降低效果于实施两年后开始显现;深港通建立在沪港通的制度基础和运行经验上,其在开通后显著降低了标的公司的股权资本成本。本文还进一步分析了资本市场开放影响股权资本成本的竞争渠道和信息渠道,发现深港通对股权资本成本的降低作用主要集中在投资者竞争程度较高,或是公开信息质量较高、信息不对称程度较低的股票样本。     

资本市场开放与股权资本成本——基于沪港通、深港通的实证研究

本文基于沪港通和深港通研究资本市场开放对中国内地股权资本成本的影响。研究发现,受政策风险和市场环境等因素所限,沪港通在初始阶段并未对沪市公司的股权资本成本产生显著影响,但随着政策进一步完善、市场逐渐稳定和交易不断活跃,其对股权资本成本的降低效果于实施两年后开始显现;深港通建立在沪港通的制度基础和运行经验上,其在开通后显著降低了标的公司的股权资本成本。本文还进一步分析了资本市场开放影响股权资本成本的竞争渠道和信息渠道,发现深港通对股权资本成本的降低作用主要集中在投资者竞争程度较高,或是公开信息质量较高、信息不对称程度较低的股票样本。     

GOLBALIZATION, CORPORATE FINANCE, AND THE COST OF CAPITAL

International financial markets are progressively becoming one huge, integrated, global capital market—a development that is contributing to higher stock prices in developed as well as developing economies. For companies that are large and visible enough to attract global investors, having a global shareholder base means having a lower cost of capital and hence a greater equity value for two main reasons: First, because the risks of equity are shared among more investors with different portfolio exposures and hence a different “appetite” for bearing certain risks, equity market risk premiums should fall for all companies in countries with access to global markets. Although the largest reductions in cost of capital resulting from globalization will be experienced by companies in liberalizing economies that are gaining access to the global markets for the first time, risk premiums can also be expected to fall for firms in long-integrated markets as well. Second, when firms in countries with less-developed capital markets raise capital in the public markets of countries (like the U.S.) with highly developed markets, they get more than lower-cost capital; they also import at least aspects of the corporate governance systems that prevail in those markets. For companies accustomed to less-developed markets, raising capital overseas is likely to mean that more sophisticated investors, armed with more advanced technologies, will participate in monitoring their performance and management. And, in a virtuous cycle, more effective monitoring increases investor confidence in the future performance of those companies and so improves the terms on which they raise capital. Besides reducing market risk premiums and improving corporate governance, globalization also affects the systematic risk, or “beta,” of individual companies. In global markets, the beta of a firm's equity depends on how the stock contributes to the volatility not of the home market portfolio, but of the world market portfolio. For companies with access to global capital markets whose profitability is tied more closely to the local than to the global economy, use of the traditional Capital Asset Pricing Model (CAPM) will overstate the cost of capital because risks that are not diversifiable within a national economy can be diversified by holding a global portfolio. Thus, to reflect the new reality of a globally determined cost of capital, all companies with access to global markets should consider using a global CAPM that views a company as part of the global portfolio of stocks. In making this argument, the article reviews the growing body of academic studies that provide evidence of the predictive power of the global CAPM as well as the reduction in world risk premiums.     

Asset Pricing of Insurance Loss Liabilities: Some Examples

I construct examples of valuing insurance loss liabilities with asset pricing models, comparing the Rubinstein‐Leland model with the better‐known CAPM. The two models give different values only if the loss payment is asymmetric and correlated with the market portfolio, conditions which can result from the nature of the underlying loss or from the impact of insolvency on the insurer's payment.
In examples where insolvency is not possible and there is no liquidity cost of raising new equity on short notice, the value of a loss liability is equal to the value of the underlying loss, i.e., of the promised coverage, and depends neither on (1) the size of the loss pool; nor on (2) the unsystematic risk of the insurer's liabilities; nor on (3) the composition of an insurer's investment portfolio; nor on (4) the amount of insurer equity.
These factors do affect the value of a loss liability in examples where insolvency and liquidity costs are considered. Other things equal, if a factor increases the likelihood of insolvency, the fair value of a loss liability is lower because the insured is partially self‐insuring; but the liquidity cost of maintaining solvency by raising new equity on short notice is higher, implying a higher fair value of the loss liability.     

A Comparison of Cost of Equity Estimates of Local and Global CAPMs

Cost of equity estimates are compared for three pricing models: the traditional local CAPM, the single (market) factor global CAPM, and the two‐factor global CAPM, with both market and currency index factors. For 2989 US stocks, the average difference in the cost of equity estimates is about 48 basis points between the local CAPM and the single‐factor global CAPM, and is about 61 basis points between the two global models. For 70 developed‐market ADRs, the corresponding average differences are 76 and 47 basis points, respectively. For 48 emerging‐market ADRs, the corresponding average differences are 57 and 70 basis points.     

What Cost of Capital Should You Use? The Market Has an Answer

The most widely used means of estimating a company's cost of equity capital is the Capital Asset Pricing Model (CAPM). But as a growing number of academics and practitioners have suggested, use of the CAPM produces estimates that often fail to reflect the risks of the companies as perceived by current and potential investors. The authors' work, together with other research, also suggests that the cost of equity produced by the CAPM is often too high. To the extent this is so, companies are discounting investment projects at rates of return that may be leading them to pass up value‐adding opportunities. The authors advocate the use of a simple and practical alternative to the CAPM that does not use either an assumed market risk premium or a beta. It uses instead an equity premium that is implied by the current market price of a company's stock and, as such, is implicitly derived from investors' assessments of the firm's risk that are reflected in that price. More specifically, the alternative approach solves for the internal rate of return that equates the present value of expected future cash flows to the current market price. In support of this approach, studies have shown that such market‐implied measures are better predictors than CAPM‐based estimates of future stock returns, both at the individual‐firm and aggregate market levels.     

Global investigation on the country-level idiosyncratic volatility and its determinants

Adapting the Fama–French three-factor model to a global context, this paper investigates idiosyncratic volatility as a measure of country-specific risk, and explores its determinants by using the equity and risk data of 47 developed and emerging countries during the period 1995–2016. We find the stock market turnover to have a positive and significant impact on the country-level idiosyncratic volatility, while information disclosure and investor uncertainty avoidance degree are negatively associated with country-level idiosyncratic risk. Moreover, improvements in economic, financial, and political risks, as measured by GDP growth, FX stability, foreign debt health, and non-corruption degree decrease the country-level idiosyncratic volatility significantly. Among all sets of market structure, investor preference, and economic, financial, and political risk variables considered, we find financial risk factors, FX stability and foreign debt health, to have the highest explanatory power over the cross-sectional differences in country-level idiosyncratic risk.     

Family control and idiosyncratic volatility: Evidence from listed firms in Hong Kong

Family control of listed firms in Hong Kong is substantively different and materially higher than in the US which could offer different insights into the effects of family ownership on corporate transparency. Using a sample of listed Hong Kong firms and idiosyncratic volatility as a proxy for firm-specific stock price informativeness, we find that family firms exhibit higher idiosyncratic volatility of stock prices than similar non-family firms. Further, the relation between family ownership and idiosyncratic volatility is weaker for firms with higher leverage but stronger in periods before equity issues. Additionally, we find that family firms disclose more information, particularly related to operations, than nonfamily firms in annual reports. These results are consistent with the argument that family firms disclose more information than their nonfamily peers to reassure skeptical outside investors that they are not expropriating their investment.     

Idiosyncratic volatility: An indicator of noise trading?

We investigate the market efficiency implications of firm-specific return variation measured by absolute idiosyncratic volatility. We find that the absolute idiosyncratic volatility (the variance of the residual from an asset-pricing model) displays a positive and robust relationship to mispricing, which reflects an increasing role of noise traders. Previous literature has produced similar – or opposing – results. We deepen our understanding of the previous conflicting results by showing that (1) market volatility by itself is associated with mispricing, (2) absolute idiosyncratic volatility is associated with mispricing even when controlling for market volatility, (3) the strength of the association between absolute idiosyncratic volatility and mispricing depends on the level of market volatility, and (4) absolute and relative measures of idiosyncratic volatility have opposing associations with mispricing. Our findings contribute to the existing literature by reconciling the mixed results for the relationship between idiosyncratic volatility and mispricing displayed in the previous literature.     

Determinants of idiosyncratic volatility: Evidence from the Indian stock market

This paper investigates whether firm-specific characteristics explain idiosyncratic volatility in the stocks of non-financial firms traded in the Indian stock market. It employs the linear time series five-factor model, augmented with a liquidity factor and the conditional EGARCH model, to extract yearly idiosyncratic volatility. We estimate a panel data regression to quantify the relationship between firm-specific characteristics and the volatility of individual securities. The results show that idiosyncratic volatility is significant in emerging markets such as India, and that cross-sectional return variations of firms are associated with firm-specific characteristics such as firm size, book-to-market ratio, momentum, liquidity, cash flow-to-price ratio, and returns on assets. We find that the idiosyncratic risk documented in this study is associated with smaller size of company, higher liquidity, low momentum, high book-to-market ratio, and low cash flow-to-price ratio. The findings suggest need to develop alternative tools to make investment decisions in emerging markets.     

A note on estimating the divisional cost of capital for diversified companies: an empirical evaluation of heuristic-based approaches

This note provides an empirical analysis of the potential for heuristic-based approaches to derive a divisional cost of equity from a firm's total cost of capital. Since an empirical relationship between fundamental information and systematic risk has previously been shown in other studies, idiosyncratic information on risk and performance ought to serve as a good proxy to calculate divisional adjustments. Two practically used, heuristic-based approaches are tested and a significant relationship is found between one of the measures and CAPM beta. This method may offer a plausible and comparatively uncomplicated method for adjusting a firm's total cost of capital for divisional use.     

Cross section of option returns and idiosyncratic stock volatility

This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.     

Idiosyncratic momentum and the cross‐section of stock returns: Further evidence

In this article, we evaluate the profitability and economic source of the predictive power of the idiosyncratic momentum effect, by using five popular asset pricing models to construct the idiosyncratic momentum. We show that all five idiosyncratic momentum strategies produce similar return predictability and consistently outperform the conventional momentum strategy in the cross‐sectional pricing of equity portfolios and individual stocks. This positive effect of idiosyncratic momentum on returns is consistent with the investment capital asset pricing model (CAPM). Further analysis reveals that the firm‐level idiosyncratic momentum effect cannot extend to the aggregate stock market.     

The impact of the market portfolio on the valuation,incentives and optimality of executive stock options

This paper examines the effect on valuation and incentives of allowing executives receiving options to trade on the market portfolio. We propose a continuous time utility maximization model to value stock and option compensation from the executive's perspective. The executive may invest non-option wealth in the market and riskless asset but not in the company stock itself, leaving them subject to firm-specific risk for incentive?purposes. Since the executive is risk averse, this unhedgeable firm risk leads them to place less value on the options than their cost to the company.

By distinguishing between these two types of risks, we are able to examine the effect of stock volatility, firm-specific risk and market risk on the value to the executive. In particular, options do not give incentive to increase total risk, but rather to increase the proportion of market relative to firm-specific risk, so executives prefer high beta companies. The paper also examines the relationship between risk and incentives, and finds firm-specific risk decreases incentives whilst market risk may decrease incentives depending on other parameters. The model supports the use of stock rather than options if the company can adjust cash pay when granting stock-based compensation.