Executive compensation and the cost of debt

This study examines how different components of executive compensation affect the cost of debt. We find that debt-like and equity-like pay components have differing effects: an increase in defined benefit pensions is associated with lower bond yield spread, while higher share holdings lead to higher spreads. In addition, we find that stock options have a mixed impact on the cost of debt whereas cash bonus has no significant impact. Overall, our results indicate that corporate bondholders are fully aware of both risk-taking and risk-avoiding incentives created by various executive pay components.     

The effects of changes in index composition on stock prices and volume: Evidence from the Istanbul stock exchange

Previous evidence has shown that stocks included in (excluded from) an index exhibit significant positive (negative) abnormal returns on the announcement day, and that trading volume is affected by the event. This study examines the price and volume effects on stocks associated with the changes in the value-weighted index composition of two indices, of the ISE, where the index funds and index derivatives do not exist. Consistent with previous evidence, stocks included in (excluded from) the index tend to generate positive (negative) abnormal returns in ISE. Volume and volume volatility are also significantly affected. Our results seem to support the hypotheses of price-pressure, imperfect substitute and attention due to the lack of index-funds and derivatives market in Turkey.     

Do a firm's equity returns reflect the risk of its pension plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.     

Dynamic order submission strategies with competition between a dealer market and a crossing network

We analyze a dynamic microstructure model in which a dealer market (DM) and a crossing network (CN) interact for three informational settings. A key result is that coexistence of trading systems generates systematic patterns in order flow, which depend on the degree of transparency. Further, we study overall welfare, measured by the gains from trade of all agents, and compare it with the maximum overall welfare. The discrepancy between both measures is attributable to two inefficiencies. Due to these inefficiencies, introducing a CN next to a DM, as well as increasing the transparency level, not necessarily produces greater overall welfare.     

Corporate financing decisions, managerial market timing, and real investment

Both market timing and investment-based theories of corporate financing predict under-performance after firms raise capital, but only market timing predicts that the composition of financing (equity compared with debt) should also forecast returns. In cross-sectional tests, we find that the amount of net financing is more important than its composition in explaining future stock returns. In the time series, investment-based factor models explain abnormal stock performance following a variety of corporate financing events that previous studies link to market timing. At the aggregate level, the amount of new financing is also more important for future market returns than its composition. Overall, our joint tests reveal that measures of real investment are correlated with future returns and measures of managerial market timing are not.     

Institutional demand pressure and the cost of corporate loans

Between 2001 and 2007, annual institutional funding in highly leveraged loans went up from $32 billion to $426 billion, accounting for nearly 70% of the jump in total syndicated loan issuance over the same period. Did the inflow of institutional funding in the syndicated loan market lead to mispricing of credit? To understand this relation, we look at the institutional demand pressure defined as the number of days a loan remains in syndication. Using market-level and cross-sectional variation in time-on-the-market, we find that a shorter syndication period is associated with a lower final interest rate. The relation is robust to the use of institutional fund flow as an instrument. Furthermore, we find significant price differences between institutional investors’ tranches and banks’ tranches of the same loans, even though they share the same underlying fundamentals. Increasing demand pressure causes the interest rate on institutional tranches to fall below the interest rate on bank tranches. Overall, a one-standard-deviation reduction in average time-on-the-market decreases the interest rate for institutional loans by over 30 basis points per annum. While this effect is significantly larger for loan tranches bought by collateralized debt obligations (CDOs), it is not fully explained by their role.     

UNDERWRITER REPUTATION AND AFTERMARKET PERFORMANCE OF CLOSED‐END FUNDS

I find a positive relation between underwriter reputation and the initial and long‐run aftermarket performance of closed‐end funds. This relation persists even after controlling for fund characteristics, types, and investment strategies. The positive relation between underwriter reputation and initial returns supports the notion that prestigious investment bankers tend to promote a price run‐up in the immediate aftermarket to enhance their reputation with the issuers and the investors. The better long‐run performance for funds underwritten by prestigious underwriters suggests that prestigious underwriters protect their reputation by underwriting only high‐quality issues that will perform well in the long run.     

On the sources of private information in FX markets

We investigate the source of information advantage in inter-dealer FX trading using data on trades and counter-party identities. In liquid dollar exchange rates, information is concentrated among dealers that trade most frequently and specialize their activity in a particular rate. In cross-rates, traders that engage in triangular arbitrage are best informed. Better-informed traders are also located on larger trading floors. In cross-rates, the ability to forecast flows explains all of the advantage of the triangular arbitrageurs. In liquid dollar rates, specialist traders can forecast both order-flow and the component of exchange rate changes that is uncorrelated with flow.     

STOCK MARKET REACTION TO ANTICIPATED VERSUS SURPRISE RATING CHANGES

I examine whether bond rating changes can be anticipated by investors and test whether the stock price reaction to the eventual change varies as a result. All else equal, the market reaction to changes that could have been easily predicted should be significantly smaller than the reaction to changes that are largely a surprise. Although rating upgrades prove difficult to predict, approximately 20% of downgrades can be correctly predicted using a relatively small number of publicly available variables. There is no significant difference between the stock price reaction to anticipated versus unanticipated rating changes.     

Day-of-the-week effect in the Taiwan foreign exchange market

This study uses stochastic dominance with and without risk-free assets to examine whether trading days can affect patterns of the day-of-the-week effect in the Taiwan foreign exchange market. Our results generally indicate that higher returns appear on the first three days of the week across different trading-day regimes in the Taiwan foreign exchange market, confirming day-of-the-week effect. Allocating part of investors’ assets in risk-free assets is useful in distinguishing returns among weekdays for all currencies.     

Opacity of young businesses: Evidence from rating disagreements

A conventional wisdom in the contemporary corporate finance literature argues that small and medium-sized enterprises (SMEs) are informationally opaque. We use data from two credit information companies and in particular their disagreements over the creditworthiness of SMEs to study the empirical relevance of this often invoked assumption. Our panel data analysis shows that once unobserved firm-effects are controlled for, the disagreements (i.e., rating splits) are inversely related to the age of firms. We are not able to document such a robust relationship between the disagreements and the size of firms. This finding holds a lesson for empirical corporate finance researchers who need firm-level proxies for informational imperfections and asymmetries: of the two often-used proxies, firm size is not as closely related to informational opacity as firm age is.     

The index premium and its hidden cost for index funds

This paper empirically investigates the index premium and its implications from 1990 to 2005. For additions to the S&P 500 and Russell 2000, we find that the price impact from announcement to effective day has averaged + 8.8% and + 4.7%, respectively, and −15.1% and −4.6% for deletions. The premia have been growing over time, peaking in 2000, and declining since then. The implied price elasticity of demand increases with firm size and decreases with idiosyncratic risk, supporting theoretical predictions. We also introduce a new concept that we label the index turnover cost, which represents a hidden cost borne by index funds (and the indexes themselves) due to the index premium. We illustrate this cost and estimate its lower bound as 21-28 bp annually for the S&P 500 and 38-77 bp annually for the Russell 2000.     

Board composition and operational risk events of financial institutions

We investigate the relation between board composition and operational risk events of financial institutions in the period from 1996 to 2010. Drawing from corporate governance literature, we consider the impact of board characteristics on the likelihood of operational risk events. Overall, our findings suggest that board size is negatively and non-linearly associated with the possibility of operational risk events. For the event types of “Clients, Products, and Business Practices,” and “Internal Fraud and External Fraud,” firms with a higher proportion of independent directors are less likely to suffer from fraud or failure to comply with professional obligations to clients. Our results on age and tenure heterogeneity also indicate that having a more diverse board can have an adverse impact on the board monitoring function. These results can shed new light on board demographics and operational risk management in financial institutions.     

The impact of capital market imperfections on investment–cash flow sensitivity

We examine the investment–cash flow sensitivity of US manufacturing firms in relation to five factors associated with capital market imperfections – fund flows, institutional ownership, analyst following, bond ratings, and an index of antitakeover amendments. We find a steady decline in the estimated sensitivity over time. Furthermore, we find that investment–cash flow sensitivity decreases with increasing fund flows, institutional ownership, analyst following, antitakeover amendments and with the existence of a bond rating. The overall evidence suggests that investment–cash flow sensitivity decreases with factors that reduce capital market imperfections.     

ARE COMMON STOCKS A HEDGE AGAINST INFLATION?

We test whether U.K. common stocks hedge against inflation using a framework of the tax‐augmented Fisher hypothesis. Aggregate and disaggregate (seven industry groups) monthly data covering 48 years are used. All pairs of stock and retail price indexes are cointegrated. Tests in most cases reveal significant shifts in the cointegrating vectors, and accounting for these shifts improves the precision of the estimates. The point estimates of goods price elasticity are significantly above unity in all but two cases. These findings, though in sharp contrast to most existing findings that report price elasticity of below unity, appear theoretically more plausible because nominal stock returns must exceed the inflation rate to insulate tax‐paying investors.     

Lessons from the evolution of foreign exchange trading strategies

The adaptive markets hypothesis posits that trading strategies evolve as traders adapt their behavior to changing circumstances. This paper studies the evolution of trading strategies for a hypothetical trader who chooses portfolios from foreign exchange (forex) technical rules in major and emerging markets, the carry trade, and US equities. The results show that a backtesting procedure to choose optimal portfolios improves upon the performance of nonadaptive rules. We also find that forex trading alone dramatically outperforms the S&P 500, with much larger Sharpe ratios over the whole sample, but there is little gain to coordinating forex and equity strategies, which explains why practitioners consider these tools separately. Forex trading returns dip significantly in the 1990s but recover by the end of the decade and have been markedly superior to an equity position since 1998. Overall, trading rule returns still exist in forex markets—with substantial stability in the types of rules—though they have migrated to emerging markets to a considerable degree.     

Exchange rate expectations and the pricing of Chinese cross-listed stocks

I show that the price discounts of Chinese cross-listed stocks (American Depositary Receipts (ADRs) and H-shares) to their underlying A-shares indicate the expected yuan/US dollar exchange rate. The forecasting models reveal that ADR and H-share discounts predict exchange rate changes more accurately than the random walk and forward exchange rates, particularly at long forecast horizons. Using panel estimations, I find that ADR and H-share investors form their exchange rate expectations according to standard exchange rate theories such as the Harrod-Balassa-Samuelson effect, the risk of competitive devaluations, relative purchasing power parity, uncovered interest rate parity, and the risk of currency crisis.     

Volume- and size-related lead-lag effects in stock returns and volatility: An empirical investigation of the Warsaw Stock Exchange

We analyze the autocorrelation structure of returns and volatility of stocks listed in the single auction system on the Warsaw Stock Exchange during the period January 1996 - October 2000. First, we find that size- and volume-related cross-autocorrelation in portfolio returns exists even after accounting for the portfolio's own-autocorrelation. Second, we find that size and volume leadership are independent from each other. Third, our results indicate slower adjustment of the small (low volume) portfolios to market-wide information that differs for up and down markets. We also find evidence for volatility spillovers between portfolio returns.     

The profitability of regression-based trading rules for the Shanghai stock market

This paper uses daily Shanghai A share data to evaluate the profitability of trading rules based on the predictability found in the return series. We find that the value of the trading-rule-based portfolio at the end of our sample is between 2 and 11 times that of an equity-buy-and-hold portfolio. We assess the robustness of the results in various ways: by carrying out various statistical tests, by varying the period over which the evaluation is carried out, by using a recursive estimation procedure for the forecasting equation, by incorporating transactions costs, and by considering weekly and monthly data.