Inter-firm linkages and the wealth effects of financial distress along the supply chain

Extant research examines the extent to which bankruptcy has intra-industry valuation consequences. This study broadens the investigation by examining the wealth effects of distress and bankruptcy filing for suppliers and customers of filing firms. On average, important wealth effects occur prior to and at bankruptcy filings and extend beyond industry competitors along the supply chain. Specifically, distress related to bankruptcy filings is associated with negative and significant stock price effects for suppliers. Supplier wealth effects are more negative when intra-industry contagion is more severe. We also investigate the importance of industry structure, specialized product nature, and leverage on supply chain effects.     

The Determinants of Foreign Currency Hedging: Does Foreign Currency Debt Induce a Bias?

In this paper we use UK data to present strong empirical evidence that explains the mixed results in previous studies with respect to the effect of financial distress on the demand for corporate hedging. We build on recent studies that have identified a strong link between foreign currency (FC) debt use and leverage. Given this relationship, we show that using leverage variables as proxies for financial distress and the failure to distinguish between FC debt users and non‐users causes misleading inference. More specifically, when we partition our sample of FC hedgers into firms that use and do not use foreign debt, we show that leverage variables are significantly related to the FC hedging decision for firms that use FC debt either in isolation or in combination with FC derivatives but not for firms that only use FC derivatives. This suggests that FC debt users are influencing these results. However, we also find that other financial distress cost proxies with no obvious link to FC debt use are significant determinants in the corporate demand for FC hedging, including derivatives use.     

Determinants and consequences of financial distress: review of the empirical literature

We synthesise the empirical literature on the determinants and consequences of financial distress, critique the findings and offer suggestions for future research. We categorise these indicators into (i) firm-level fundamental determinants, (ii) macroeconomic determinants and (iii) firm-level corporate governance determinants. We categorise the consequences into (i) financial reporting and auditing consequences, (ii) firm-level operational consequences, (iii) capital market consequences and (iv) corporate governance consequences. We suggest that future research can make a more meaningful contribution, by developing more comprehensive models of predicting financial distress which will entail a departure from the current partial analysis to a more holistic complex analysis.     

The cost and timing of financial distress

Assessments of the trade-off theory have typically compared the present value of tax benefits to the present value of bankruptcy costs. We verify that this comparison overwhelmingly favors tax benefits, suggesting that firms are under-leveraged. However, when we allow firms to experience even modest (e.g., 1–2% annualized) financial distress costs prior to bankruptcy, the cumulative present value of such costs can easily offset the tax benefits.     

The effect of liquidity and solvency risk on the inclusion of bond covenants

Studies have analyzed the impact of firm and issue characteristics but not liquidity and solvency components of financial distress on the use of bond covenants. Using a comprehensive database of corporate bonds from 2001 to 2012, we find that firm liquidity, measured by standardized Lambda, has a negative statistical and economic impact on the inclusion of all categories and sub-categories of restrictive bond covenants. Developed from financial statement information by Emery and Lyons (1991), Lambda is designed as a coverage ratio that, under certain distribution assumptions, maps into the probability of a firm being unable to pay its short-term bills. The strongest solvency proxy is the 10-year credit default swap (CDS) spread which is significant across the categories and sub-categories for investment and payment covenants, weakly significant for the subordinated debt sub-category of the subsequent financing covenant, but strongly significant for the control poison put sub-category of event covenants. This evidence supports a model that uses SLambda as a proxy for liquidity risk and the 10-year CDS spread as a proxy for solvency risk. The liquidity/covenant relationship is dampened when firms have access to commercial paper funding or bank loans. However, during the recent financial crisis liquidity event this liquidity/covenant relationship was enhanced especially for firms which were dependent on commercial paper during this time when the commercial paper market was deteriorating.     

IMF programs, financial and real sector performance, and the Asian crisis

This paper has three objectives. First, using a richer and more comprehensive set of IMF-related news than previous studies, we examine the impact of IMF-related news on both financial and real stock sector returns in Indonesia during the Asian crisis. Second, we draw lessons about financial and real sectoral patterns of adjustment in crisis countries, including whether and how IMF programs facilitate this adjustment. Third, we explore the interplay between IMF actions in crisis countries and the actions and responses of local authorities. To do so, not only do we account for the impact of news regarding IMF policy actions but also the government’s reaction to them and willingness to implement such policies, and the public sentiment about the implemented IMF programs and government policies. We discuss the policy implications of the findings.     

The influence of managerial incentives on the resolution of financial distress

This study investigates the influence of managerial incentives on the resolution of financial distress. Our model predicts that when creditors and equityholders prefer different resolution methods, the likelihood of choosing Chapter 11 over private renegotiation is related to the ownership structure of the distressed firm. Empirical test results using a sample of 81 voluntary Chapter 11 firms and 65 private workout firms support the model’s prediction. We show that managerial ownership is positively related to the incidence of Chapter 11 filing when there is conflict between equityholders and creditors over the choice between Chapter 11 and a private renegotiation. Consistent with prior literature, we also find that the choice of resolution methods depends on the extent of creditor holdout problems and the level of economic distress. We also performed the analysis of a subsequent 5 years of post-distress performance for all sample firms. The majorities of firms that file for Chapter 11 lose their independence and are either acquired or liquidated. However, more than half of firms in private workouts survived as independent firms.

Seeking safety: The relation between CEO inside debt holdings and the riskiness of firm investment and financial policies

CEO inside debt holdings (pension benefits and deferred compensation) are generally unsecured and unfunded liabilities of the firm. Because these characteristics of inside debt expose the CEO to default risk similar to that faced by outside creditors, theory predicts that CEOs with large inside debt holdings will display lower levels of risk-seeking behavior (Jensen and Meckling, 1976). Consistent with the theoretical predictions, we find a negative association between CEO inside debt holdings and the volatility of future firm stock returns, R&D expenditures, and financial leverage, and a positive association between CEO inside debt holdings and the extent of diversification and asset liquidity. Collectively, our results provide empirical evidence suggesting that CEOs with large inside debt holdings prefer investment and financial policies that are less risky.     

Distance to default,subordinated debt,and distress indicators in the banking industry*

The recent financial crisis has highlighted the inadequacy of present supervisory arrangements to identify reliable ex‐ante indicators of banking distress. For a sample of US bank holding companies, we analyse the extent to which distance to default based on market data can be explained using accounting‐based indicators of risk. We show that a larger number of bank fundamentals help predict default for institutions that issue subordinated debt. For banks that issue sub‐debt, we find that higher charter values and low bank capitalizations further increase the power of bank fundamentals to predict default risk.     

The response of the external finance premium in Asian corporate bond markets to financial characteristics,financial constraints and two financial crises

Empirical investigation of the external finance premium has been conducted on the margin between internal finance and bank borrowing or equities but little attention has been given to corporate bonds, especially for the emerging Asian market. In this paper, we hypothesize that balance sheet indicators of creditworthiness could affect the external finance premium for bonds as they do for premia in other markets. Using bond-specific and firm-specific data for China, Hong Kong, Indonesia, Korea, Philippines, Singapore and Thailand during 1995–2009 we find that firms with better financial health face lower external finance premia in all countries. When we introduce firm-level heterogeneity, we show that financial variables appear to be both statistically and quantitatively more important for financially constrained firms. Finally, when we examine the effects of the 1997–1998 Asian crisis and the 2007–2009 global financial crisis, we find that the sensitivity of the premium is greater for constrained firms during the Asian crisis compared to other times.     

The dampening effect of bank foreign liabilities on monetary policy: Revisiting monetary cooperation in East Asia

This paper addresses the cost of formal monetary cooperation from the perspective of monetary policy effectiveness. As banks tend to borrow from abroad in foreign currencies to fund domestic lending, monetary policy may have a reduced effect on the credit market and the economy. Results derived from bank level data in East Asia indicate that bank foreign liabilities significantly reduce the effectiveness of the credit channel of monetary policy, implying a relatively low cost of giving up monetary autonomy.     

Capital structure around the world: The roles of firm- and country-specific determinants

We analyze the importance of firm-specific and country-specific factors in the leverage choice of firms from 42 countries around the world. Our analysis yields two new results. First, we find that firm-specific determinants of leverage differ across countries, while prior studies implicitly assume equal impact of these determinants. Second, although we concur with the conventional direct impact of country-specific factors on the capital structure of firms, we show that there is an indirect impact because country-specific factors also influence the roles of firm-specific determinants of leverage.     

The impact of target firm financial distress in Australian takeovers

Of the motives that have been advanced to explain corporate acquisitions, the least explored is the acquisition of a target experiencing financial distress. This study addresses this void by examining whether target firm financial distress is related to takeover: attitude, premiums, payment method, competition and outcome. Despite inconsistent findings across our distress measures the tenor of the results suggest that distressed targets receive higher premiums and are less likely to be offered cash consideration. Additionally, takeover completion is lower and takeover competition higher for targets in financial distress. Financial distress does not influence whether a takeover is hostile or friendly.     

A comparative study of the probability of default for global financial firms

This article presents a modification of Merton’s (1976) ruin option pricing model to estimate the implied probability of default from stock and option market prices. To test the model, we analyze all global financial firms with traded options in the US and focus on the subprime mortgage crisis period. We compare the performance of the implied probability of default from our model to the expected default frequencies based on the Moody’s KMV model and agency credit ratings by constructing cumulative accuracy profiles (CAP) and the receiver operating characteristic (ROC). We find that the probability of default estimates from our model are equal or superior to other credit risk measures studied based on CAP and ROC. In particular, during the subprime crisis our model surpassed credit ratings and matched or exceeded KMV in anticipating the magnitude of the crisis. We have also found some initial evidence that adding off-balance-sheet derivatives exposure improves the performance of the KMV model.     

The role of state and foreign owners in corporate risk-taking: Evidence from privatization

Using a unique database of 381 newly privatized firms from 57 countries, we investigate the impact of shareholders' identity on corporate risk-taking behavior. We find strong and robust evidence that state (foreign) ownership is negatively (positively) related to corporate risk-taking. Moreover, we find that high risk-taking by foreign owners depends on the strength of country-level governance institutions. Our results suggest that relinquishment of government control, openness to foreign investment, and improvement of country-level governance institutions are key determining factors of corporate risk-taking in newly privatized firms.     

A re-examination of exposure to exchange rate risk: The impact of earnings management and currency derivative usage

In an attempt to explain the weak evidence of priced exchange rate risk, we hypothesize that in addition to currency derivative usages, earnings management serves as another factor contributing to a reduction in exchange rate exposure. Our evidence reveals that earnings management activities, particularly those undertaken for the purpose of income smoothing, significantly reduce firm-specific exchange rate exposure, and that such role is particularly important if appropriate currency derivative instruments are limited. These results complement prior attempts to explain the puzzle of unpriced exchange rate risk. The investigation also highlights the importance of recognizing different managerial purposes behind discretionary accruals.     

The Risk Effects of Acquiring Distressed Firms

Existing research shows that bidder default risk increases following acquisitions due to a rise in post‐acquisition leverage and managerial risk‐taking actions offsetting the potential for asset diversification. This study examines whether the risk effects of acquiring distressed targets are fundamentally different and investigates possible explanations for any dissimilarities. Bidders often acquire relatively smaller distressed targets in domestic and related industries and have a higher initial target stake and more financial flexibility, thereby minimizing risk exposure. Controlling for several characteristics of bidder investment behaviour in both types of deals, however, we find that the increase in bidder default risk is substantially larger when acquiring distressed firms.     

A revisit to the dependence structure between the stock and foreign exchange markets: A dependence-switching copula approach

This paper develops a dependence-switching copula model to examine dependence and tail dependence for four different market statuses, namely, rising-stocks/appreciating-currency, falling-stocks/depreciating-currency, rising-stocks/depreciating-currency, and falling-stocks/appreciating-currency. The model is then applied to daily stock returns and exchange rate changes for six major industrial countries over the 1990–2010 period. The dependence and tail dependence among the above four market statuses are asymmetric for most countries in the negative correlation regime, but symmetric in the positive correlation regime. These results enrich the findings in the existing literature and suggest that analyzing cross-market linkages within a time-invariant copula framework may not be appropriate.     

The effect of financial constraints,investment policy,product market competition and corporate governance on the value of cash holdings

This study empirically investigates the value shareholders place on excess cash holdings and how shareholders’ valuation of cash holdings is associated with financial constraints, firm growth, cash‐flow uncertainty and product market competition for Australian firms from 1990 to 2007. Our results indicate that the marginal value of cash holdings to shareholders declines with larger cash holdings and higher leverage. However, firms that are more financially constrained, that have higher growth rates and that face greater uncertainty exhibit a higher marginal value of cash holdings. These findings are consistent with the explanation that excess cash holdings are not necessarily detrimental to firm value. Firms with costly external financing and that also save more cash for current operating and future investing needs find that the market values these cash hoarding policies favourably. Finally, there is limited evidence of an association between various corporate governance measures and the value of cash holdings for a shorter sample period.     

The effect of IMF lending on the probability of sovereign debt crises

This paper explores empirically how the adoption of IMF programs affects sovereign risk over the medium term. We find that IMF programs significantly increase the probability of subsequent sovereign defaults by approximately 1.5–2 percentage points. These results cannot be attributed to endogeneity bias as they are supported by specifications that explain sovereign defaults and program participation simultaneously. Furthermore, IMF programs turn out to be especially detrimental to fiscal solvency when the Fund distributes its resources to countries whose economic fundamentals are already weak. Our evidence is therefore consistent with the hypothesis that debtor moral hazard is most likely to occur in these circumstances. Other explanations that point to the effects of debt dilution and the possibility of IMF triggered debt runs, however, are also possible.