Trading frequency and asset pricing on the London Stock Exchange: Evidence from a new price impact ratio

This study proposes a new price impact ratio as an alternative to the widely used Amihud’s (2002) Return-to-Volume ratio. We demonstrate that the new price impact ratio, which is deemed Return-to-Turnover ratio, has a number of appealing features. Using daily data from all stocks listed on the London Stock Exchange over the period 1991–2008, we provide overwhelming evidence that this ratio, while being unequivocal to construct and interpret, is also free of a size bias. More importantly, it encapsulates the stocks’ cross-sectional variability in trading frequency, a relatively neglected but possibly important determinant of stock returns given the recently observed trends in financial markets. Overall, our findings argue against the conventional wisdom that there is a simple direct link between trading costs and stock returns by strongly suggesting that it is the compound effect of trading frequency and transaction costs that matters for asset pricing, not each aspect in isolation.     

Is unlevered firm volatility asymmetric?

Asymmetric volatility refers to the stylized fact that stock volatility is negatively correlated to stock returns. Traditionally, this phenomenon has been explained by the financial leverage effect. This explanation has recently been challenged in favor of a risk premium based explanation. We develop a new, unlevering approach to document how well financial leverage, rather than size, beta, book-to-market, or operating leverage, explains volatility asymmetry on a firm-by-firm basis. Our results reveal that, at the firm level, financial leverage explains much of the volatility asymmetry. This result is robust to different unlevering methodologies, samples, and measurement intervals. However, we find that financial leverage does not explain index-level volatility asymmetry. We show that this difference between index-level asymmetry and firm-level asymmetry is driven by the asymmetry of the unlevered covariance component of index volatility.     

Systemic risk measurement: Multivariate GARCH estimation of CoVaR

We modify Adrian and Brunnermeier’s (2011) CoVaR, the VaR of the financial system conditional on an institution being in financial distress. We change the definition of financial distress from an institution being exactly at its VaR to being at most at its VaR. This change allows us to consider more severe distress events, to backtest CoVaR, and to improve its consistency (monotonicity) with respect to the dependence parameter. We define the systemic risk contribution of an institution as the change from its CoVaR in its benchmark state (defined as a one-standard deviation event) to its CoVaR under financial distress. We estimate the systemic risk contributions of four financial industry groups consisting of a large number of institutions for the sample period June 2000 to February 2008 and the 12 months prior to the beginning of the crisis. We also investigate the link between institutions’ contributions to systemic risk and their characteristics.     

A cyclical model of exchange rate volatility

In this paper, we investigate the long run dynamics of the intraday range of the GBP/USD, JPY/USD and CHF/USD exchange rates. We use a non-parametric filter to extract the low frequency component of the intraday range, and model the cyclical deviation of the range from the long run trend as a stationary autoregressive process. We use the cyclical volatility model to generate out-of-sample forecasts of exchange rate volatility for horizons of up to 1 year under the assumption that the long run trend is fully persistent. As a benchmark, we compare the forecasts of the cyclical volatility model with those of the range-based EGARCH and FIEGARCH models of Brandt and Jones (2006). Not only does the cyclical volatility model provide a very substantial computational advantage over the EGARCH and FIEGARCH models, but it also offers an improvement in out-of-sample forecast performance.     

Managerial compensation and the debt placement decision

Extant research argues that borrowing from financial intermediaries subjects managers to external monitoring. However, given managers' flexibility in choosing the type of debt financing, why would managers submit themselves to external monitoring? Recent theory points to the role of managerial incentive compensation. Specifically, it is argued that managers will borrow from financial intermediaries if their compensation is tied to firm performance. Additionally, it is noted that a more optimal compensation scheme will induce managers to undertake intermediated loans only when the firm is sufficiently profitable. Such a compensation scheme is likely to exist in opaque firm settings where borrowing from financial intermediaries can serve to signal firm profitability. Our study provides corroborative evidence. We find that the choice of syndicated bank loans is positively associated with CEO equity incentives. Second, this syndicated debt-incentive compensation link is influenced by firm profitability, particularly among information problematic firms. Overall, our study points to the role of incentive compensation in the debt placement decision.     

A bright side of financial constraints in cash management

This paper tests whether financial constraints play a disciplinary role in cash dissipation in the presence of agency problems. We hypothesize that when firms have difficulty raising external funds, empire-building managers of cash-rich firms will be less likely to spend cash on negative NPV projects as compared to unconstrained managers. Empirically, we examine firm performance after cash dissipation and associate it with the degree of financial constraints. We find that cash spending by managers in financially constrained firms is associated with higher future profitability and stock returns compared to cash spending by managers in unconstrained firms. Further tests reveal that the positive effect of financial constraints on firm performance is not driven by differences in corporate governance. Financial constraints actually substitute for good governance in disciplining managers. We find that corporate governance improves the efficiency of cash dissipation in unconstrained firms, but not in constrained firms. Likewise, financial constraints' disciplinary effect is found to be concentrated in firms that are poorly governed.     

Perks and the informativeness of stock prices in the Chinese market

While the literature shows that perks can affect firm values positively or negatively, we argue that firms with higher perks are more likely to be associated with a lower quality of financial reporting, which, in turn, can affect the informativeness of stock prices. Based on hand-collected data on perks from Chinese listed firms, we find that firms with lower perks are associated with higher informativeness of stock prices (or lower R-square). Moreover, the positive association between perks and R-square is shown to be weaker for firms with higher financial reporting quality through audit and earnings quality measures.     

Hometown advantage: The effects of monitoring institution location on financial reporting discretion

We examine the impact of institutional ownership on financial reporting discretion, focusing on whether the impact varies with institutions' cost of acquiring monitoring information. Using geographic distance between the firm and the institutional investor as a proxy for the cost of acquiring monitoring information, we find that corporate managers are less likely to use financial reporting discretion in the presence of local monitoring institutions than distant monitoring institutions. We also find that the impact of monitoring institutions on financial reporting discretion varies with the costs and benefits of financial reporting discretion.     

Are small family firms financially sophisticated?

We study the drivers of financial sophistication in small family firms. Sophistication is defined as the use of non-basic financial products such as options, swaps, debt restructuring, and mergers and acquisitions (M&A) advisory services. Our analysis is based on a unique dataset with detailed information on 187 Italian family firms. We find that the main drivers of financial sophistication are: (1) the generation that currently owns the firm; (2) the presence of a non-family CFO; and (3) the existence of a non-family shareholder. We analyze the impact of these factors on the following four classes of non-basic financial products: corporate finance, cash management, corporate lending and risk management. Our results can be used to determine the characteristics of financially sophisticated family firms and whether their corporate governance and ownership structure increase the use of non-basic financial products.     

International variations in expected equity premia: Role of financial architecture and governance

Estimates of ex-ante equity premia are important in planning investments in pension funds, life insurance pools, and for other long-term financial obligations or goals. However, while global cross-border investment positions and flows have been rising, there is little research on non-US ex-ante equity premia or on their determinants in a global setting. This paper uses data on a recent 8-year period from 33 countries and models simultaneously our estimate of the ex-ante equity premium as a dependent variable and our measure of financial architecture as an instrumental variable. We document that ex-ante equity premia are larger in countries that have a more bank-oriented financial architecture, are wealthier, and have better governance. These results are robust to alternative model specifications and estimation techniques. Given the importance of equity premia and financial architecture, these results should be of much interest to scholars, managers, regulators, and policy makers.     

Do modified audit opinions have economic consequences? Empirical evidence based on financial constraints

We present a framework and empirical evidence to explain why, on average, 11% of listed firms in China received modified audit opinions (MAOs) between 1992 and 2009. We argue that there are two reasons for this phenomenon: strong earnings management incentives lower firms’ financial reporting quality and soft budget constraints weaken the information and governance roles of audit opinions. We find that firms’ financial constraints eased after receiving MAOs, which suggests that MAOs have limited economic consequences. Further analysis shows that this phenomenon predominantly exists in government-controlled firms and firms that receive MAOs for the first time. We also find that MAOs have not influenced financial constraints after 2006. Finally, we find that MAOs did not affect borrowing cash flows from banks until 2005, suggesting that MAOs did not start affecting bank financing until that year. We also find that firms receive more related-party financing after receiving MAOs. Our results indicate that a limited effect on bank financing and increased related-party financing reduce the effect of MAOs on financial constraints.     

The diversification effects of volatility-related assets

We examine whether investors can improve their investment opportunity sets through the addition of volatility-related assets into various groupings of benchmark portfolios. By first analyzing the weekly returns of three VIX-related assets over the period 1996-2008 and then applying mean-variance spanning tests, we find that adding VIX-related assets does lead to a statistically significant enlargement of the investment opportunity set for investors. Our empirical findings are robust and have two implications. First, there is scope for the further development of financial products relating to volatility indexes. Second, hedge fund managers can utilize VIX futures contracts or VIX-squared portfolios to enhance their equity portfolio performance, as measured by the Sharpe ratio.     

Cross hedging under multiplicative basis risk

Cross hedging price risk in an incomplete financial market creates basis risk. We propose a new way of modeling basis risk where price risk and basis risk are combined in a multiplicative way. Under this specification, positive prudence is a necessary and sufficient condition for underhedging in an unbiased market. Using the example of cross hedging jet fuel price risk with crude oil futures, we show that the new specification is superior in describing the price series and that optimal cross hedges differ significantly from those derived under the traditional additive cross hedging model.     

Exchange rate volatility across financial crises

This paper studies the impact of global financial turmoil on the exchange rate policies in emerging countries. Spillovers from advanced financial markets to currencies in emerging countries are likely to be exacerbated during crisis periods. To test this hypothesis, we assess the exchange rate policies by currencies’ volatility and investigate their relationship to a global financial stress indicator, measured by the volatility on global markets. We introduce the possibility of nonlinearities by running smooth transition regressions over a sample of 21 emerging countries from January 1994 to September 2009. The results confirm that exchange rate volatility does increase more than proportionally with the global financial stress, for most countries in the sample. We also evidence regional contagion effects spreading from one emerging currency to other currencies in the neighboring area.     

Resolving the deposit dilemma: A new DEA bank efficiency model

One of the weaknesses of current bank efficiency models is a disagreement as to the role of deposits in the bank production process. Some models view deposits as an input, while others view them as an output. Such disparity of approaches results in inconsistent efficiency estimates. In this study we propose an alternative Data Envelopment Analysis (DEA) bank efficiency model that treats deposits as an intermediate product, thus emphasizing the dual role of deposits in the bank production process. Consequently, the effect of the amount of deposits on bank efficiency depends on the efficiency at both stages of the bank production process. The main advantage of our model is that it does not require a researcher to make a judgment call as to whether having more (production approach) or less (intermediation approach) deposits is “better” for bank efficiency. Our unified framework has the potential to produce more consistent efficiency estimates.     

Dividend signaling under economic adversity: Evidence from the London Stock Exchange

The signaling or information content hypothesis is amongst the most prominent theories attempting to explain dividend policy decisions. However, no research has, to date, examined the information content of dividends in conjunction with generalized economic adversity. With the majority of the western economies facing the tough reality of the economic recession since late 2007–early 2008, we focus on the possibility of asymmetrical dividend signaling effects between periods of stability and economic adversity. Using data from the London Stock Exchange (LSE), where earnings and dividend news are released simultaneously, we test the dividend signaling hypothesis and the interaction of earnings and dividends under both steady and adverse economic conditions. We document positive and significant average abnormal stock price returns around the dividend/earnings announcements. We also find a significant interaction between economic conditions and the information content of dividends. After testing the dividend signaling hypothesis under both stable and recessionary economic conditions we find that dividends have less information content than earnings in periods of growth and stability, but more in periods of economic adversity.     

Ability of accounting and audit quality variables to predict bank failure during the financial crisis

We examine the ability of selected accounting and audit quality variables measured in a period prior to the financial crisis (i.e., the four quarters of 2006), to predict banks that subsequently failed during the financial crisis. We employ two sets of samples from the US: a troubled banks sample that includes banks that failed in or after 2007 as well as banks classified as being troubled based on profitability, loan quality, and balance sheet position in 2007, and a full sample that includes all banks with available required data. Using the troubled banks sample, we identify six reliable predictors of bank failure: auditor type, auditor industry specialization, Tier 1 capital ratio, proportion of securitized loans, growth in loans, and loan mix. For the larger full sample of banks, we identify the following ten predictors of bank failure: auditor type, Tier 1 capital ratio, proportion of securitized loans, nonperforming loans, loan loss provisions, growth in commercial loans, growth in real estate loans, growth in overall loans, loan mix, and whether the bank is a public bank.     

Term structure modelling with observable state variables

This paper proposes and implements a parsimonious three-factor model of the term structure whose dynamics is driven uniquely by observable state variables. This approach allows comparing alternative views on the way state variables – macroeconomic variables, in particular – influence the yield curve dynamics, avoids curse of dimensionality problems, and provides more reliable inference by using both the cross-sectional and the time series dimension of the data. I simulate the small-sample properties of the procedure and conduct in- and out-of-sample studies using a comprehensive set of US data. I show that even a parsimonious model where the level, slope and curvature factors of the term structure are driven by, respectively, inflation, monetary policy and economic activity consistently outperforms the (latent-variable) benchmark model in an out-of-sample study.     

The impact of terrorism on financial markets: An empirical study

The main focus of this paper is to study empirically the impact of terrorism on the behavior of stock, bond and commodity markets. We consider terrorist events that took place in 25 countries over an 11-year time period and implement our analysis using different methods: an event-study approach, a non-parametric methodology, and a filtered GARCH-EVT approach. In addition, we compare the effect of terrorist attacks on financial markets with the impact of other extreme events such as financial crashes and natural catastrophes. The results of our analysis show that a non-parametric approach is the most appropriate method among the three for analyzing the impact of terrorism on financial markets. We demonstrate the robustness of this method when interest rates, equity market integration, spillover and contemporaneous effects are controlled. We show how the results of this approach can be used for investors’ portfolio diversification strategies against terrorism risk.     

Marriage and other risky assets: A portfolio approach

We study the joint impact of gender and marital status on financial investments by testing the hypothesis that marriage represents – in a portfolio framework – a sort of safe asset and that this attribute may change over time. We show that married individuals have a higher propensity to invest in risky assets than single ones, that this marital status gap is stronger for women and that, for women only, it evolves and declines at the end of the sample period. Next we explore a number of possible explanations of the observed gender differences by controlling for background factors that capture the evolution of family and society. We find that both the higher female marital status gap and its time variability vanish for those women who are employed. Our empirical investigation is based on a dataset drawn from the 1993–2006 Bank of Italy Survey of Household Income and Wealth.