Incorporating Enterprise Risk Management Into the Curriculum: The Delta Air Lines Case Study

This article describes a group project that was designed and implemented in an MBA-level corporate risk management class. The primary objective of this project is to integrate the concepts of enterprise risk management into the graduate-level risk management and insurance curriculum. This project combines both traditional and innovative risk management techniques into one semester-long group case study. The Delta Air Lines case study was divided into three segments to focus on three distinct objectives. The first component, identification of Delta's horizon risks, is designed to spur creative thinking among the groups. The second component, analysis of workers' compensation claims, is a very traditional risk management exercise in risk evaluation designed to utilize traditional statistical analysis techniques (specifically, trending). The third component is estimating both total loss distributions and layers of loss due to airline crashes for potential capital market risk financing alternatives. This component involves more innovative financial risk management techniques (i.e., distribution fitting and simulation analysis). The objective is to familiarize students with the current techniques being used to evaluate risks that are currently (or potentially) being securitized in the capital markets.     

Performance hypothesis testing with the Sharpe ratio: The case of hedge funds

As recent research highlights that the Sharpe ratio has a decision theoretic foundation even in the case of asymmetric or fat-tailed excess returns and thus is adequate even for the evaluation of hedge funds, this note provides the first Sharpe ratio based performance analysis of the hedge fund market. Furthermore, it addresses the important practical question whether the choice of hypothesis test used to statistically compare Sharpe ratios can influence an investor’s hedge fund selection process. Our key findings are as follows: (i) Only a small fraction of hedge funds in our large dataset can significantly outperform passive investments in corresponding hedge fund indices. (ii) Especially in the presence of autocorrelated or skewed excess returns, the traditional test of Jobson and Korkie, 1981, Memmel, 2003 tends to overstate the number of significant outperformers and thus provides potentially misleading information for investors. Decision makers are advised to use the bootstrap test of Ledoit and Wolf (2008) allowing robust and more reliable inference.     

Social media and price discovery: The case of cross-listed firms

In this article, we examine whether social media information affects the price-discovery process for cross-listed companies. Using over 29 million overnight tweets mentioning cross-listed companies, we examine the role of social media for a link between the last periods of trading in the US markets and the first periods in the UK market. Our estimates suggest that the size and content of information flows on social networks support the price-discovery process. The interactions between lagged US stock features and overnight tweets significantly affect stock returns and volatility of cross-listed stocks when the UK market opens. These effects weaken and disappear 1 to 3 hr after the opening of the UK market. We also develop a profitable trading strategy based on overnight social media, and the profits remain economically significant after considering transaction costs.     

International financial integration and national price levels: The role of the exchange rate regime

This paper proposes a new perspective on systematic deviations from purchasing power parity. Panel evidence for OECD countries shows that international financial integration increases the national price level under managed exchange rate regimes and lowers the price level under floating exchange rates. An open economy sticky-price model reproduces these findings by relating them to the possibility of insurance against consumption losses in internationally integrated financial markets. The utilization of insurance is reflected by relative price adjustments which manifest themselves in changes of the national price level. The direction of relative price adjustments, however, depends on the extent to which insurance is used under different exchange rate regimes: under a peg, financial integration raises the national price level; under a float, however, financial integration lowers the national price level.     

Asymmetric price rigidity and the responsiveness of customers to price changes: The case of deposit interest rates

This article examines differences in the level and type of price rigidity as it applies to different types of deposits offered by commercial banks. Numerous characteristics of the data set employed make it ideally suited for such an investigation. Three basic findings are presented. First, the degree of price rigidity observed for a product varies systematically with the quantity response to a price change likely to be exhibited by customers,with greater rigidity associated with less customer responsiveness. Second, price rigidity is asymmetric in the sense that greater rigidity is observed for upward movements in deposit rates than for downward changes. Finally, this observed asymmetry appears to be greater for cases in which customers are likely to exhibit less of a quantity response to a change in deposit rates.     

International financial integration through the law of one price: The role of liquidity and capital controls

This paper takes advantage of the fact that some stocks trade both in domestic and international markets to characterize the degree of international financial integration. The paper argues that the cross-market premium (the ratio between the domestic and the international market price of cross-listed stocks) provides a valuable measure of international financial integration and the effectiveness of capital controls. Using autoregressive (AR) models to estimate convergence speeds and non-linear threshold autoregressive (TAR) models to identify non-arbitrage bands, the paper shows that price deviations across markets are rapidly arbitraged away and bands are narrow, particularly so for liquid stocks. The paper also shows that regulations on cross-border capital flows effectively segment domestic markets. As expected, the effects of both types of capital controls are asymmetric but in the opposite direction: controls on outflows induce positive premia, while controls on inflows generate negative premia. Both vary with the intensity of capital controls.     

Market price accounting and depositor discipline: The case of Japanese regional banks

We examine the determinants of Japanese regional bank pricing-to-market decisions and their impact on the intensity of depositor discipline, in the form of the sensitivity of deposit growth to bank financial conditions. To obtain consistent estimates, we first model and estimate the bank pricing-to-market decision and then estimate the intensity of depositor discipline after conditioning for that decision. We find that banks were less likely to adopt market price accounting the larger were their unrealized securities losses. We also find statistically significant evidence of depositor discipline among banks that elected to price to market. Our results indicate that depositor discipline was more intense for the subset of banks that adopted market price accounting.     

A note on price limit performance: The case of illiquid stocks

In the Chinese stock markets, there are A-shares and B-shares. Both share-types have identical cash flow rights but different ownership structures (i.e., A-shares are owned by local Chinese citizens and B-shares are owned primarily by foreigners), causing B-shares to be less liquid relative to A-shares. However, even though B-shares have much wider bid—ask spreads than A-shares, both share-types are subject to the same 10% daily price limit regulation. As such, B-shares, simply due to their wider spreads, may be more inclined than A-shares to hit price limits. Our empirical results support this contention. The findings have policy implications. First, given wide spreads for illiquid stocks, exchanges may consider using midpoint prices (between bid and ask prices) to establish price limit ranges for illiquid stocks. In addition, and perhaps more importantly, exchanges may consider using wider price limits for less liquid classes of stocks.     

State contingent banking and asset price bubbles: The case of Islamic banking industry

This paper examines how state contingent banking can help neutralize challenges like debt overhang and lack of optimal risk takings, problems associated with conventional banking that can eventually manifest in the creation of asset price bubbles and a financial crisis. Our analysis also contributes to the literature on Islamic banking which considers state contingent contracts as ideal from a religious perspective. We develop a model of banking with state contingent contracts on the liability and asset sides. Our model shows that in state contingent banking, the returns for the depositors, bank and the borrowers are more aligned with the real economy, which reduces the incentive for excessive borrowing, lending and investing. Our model also shows that with the state contingent banking on the liability side, during periods of heightened macroeconomic risk, depositors' payoff would be more volatile reducing the liquidity influx from the real economy to the banking sector. This neutralizes the pressure on state contingent banks to excessively lend on the asset side. Our model further demonstrates that state contingent contracts on the asset side can help avoid too much (or too little) lending by reducing the managerial discretion in charging low (or high) interest rates. With returns linked to the prices of the underlying assets, state contingent contracts may prevent lack of optimal risk taking.     

Financial integration and the price of world covariance risk: Large- vs. small-cap stocks

We investigate whether recent country-level evidence of global pricing is particular to large-cap stocks. Specifically, we examine cross-country return correlations and conduct asset pricing tests on three size-based stock portfolios for nine developed countries over the period from 1980 to 2004. We find that large-cap stocks realize significant comovements across countries, whereas small-cap stocks realize smaller average correlations (relative to both large-cap stocks and small-cap stocks across countries). More important, asset pricing tests suggest that while large-cap stocks are priced globally, global pricing is rejected for most small-cap stocks. Finally, the evidence indicates that financial integration deepened in recent years primarily for large-cap stocks. Overall, the results suggest that the global pricing pertains chiefly to large-cap stocks.     

The Italian hedge funds industry: An empirical analysis of performance and persistence

This study analyses Italian hedge funds performance and persistence. The peculiarity of the Italian hedge fund industry is that 95% of the hedge funds are funds of hedge funds (FoHF), whereas only 5% of them employ other investment styles. Using monthly data on FoHF provided by MondoHedge, we examine the impact of both market variables and funds’ own characteristics on funds performance using panel data. We find that the European, the Japanese and the emerging markets equity markets, and the commodity market have a positive impact on Italian FoHF performances, while the US Bond Market negatively affects them. Moreover, we find performance fees and notice days to have a negative impact on funds performances. Finally, we test the presence of performance persistence. Employing two different nonparametric methods, we find that funds performances are persistent on a monthly and quarterly basis, while the regression-based parametric method provides evidence of persistence only on a monthly basis.     

The second wave of hedge fund activism: The importance of reputation,clout, and expertise

Using a large dataset of hand-collected information on activist interventions from 2008 to 2014, we examine why certain hedge funds succeed in the face of competition. We document that the top hedge funds succeed, not merely because of how they select targets, but because they acquire a reputation for what we label “clout and expertise.” These hedge funds do not intervene more frequently; to the contrary, activists with more interventions are associated with lower returns. Instead, top activists have a demonstrated ability to succeed in difficult interventions by targeting large firms, launching successful proxy fights, filing and winning lawsuits, pressuring target boards through the media, overcoming anti-takeover defenses, and replacing board members. These activists' successes appear to result more from board representation, improved performance, and monitoring management than from capital structure or dividend policy changes.     

Capital market integration over the past decade: The case of the US dollar

This study investigates changing capital market integration over the decade 1973–83 as measured by the relationship between Eurodollar and domestic US dollar yields. The findings reveal that capital market integration has increased appreciably since the end of 1981.     

Stock market regulations and international financial integration: the case of Spain

International financial integration effects on the Spanish stock market are studied, both for the conditional mean and conditional variance. New institutional regulations in Spain are taken into account and their efficiency consequences are addressed. Results suggest an increasing international integration but nontrivial opportunities for financial diversification may still be relevant.     

The effects on investment incentives of an allowance for corporate equity tax system: the Belgian case as an example

The Modigliani–Miller theorem serves as the standard finance paradigm on corporate capital structure and managerial decision making. Implicitly, it is assumed that the market possesses full information about the firm. However, if firm managers have insider information, they may attempt to ‘signal’ changes in the firm’s financial structure and, in competitive equilibrium, shareholders will draw deductions from such signals. Empirical work shows that the value of underlying firms rises with leverage because investors expect such firms to implement positive NPV projects. We empirically examine this view using a sample of debt issue announcements by publicly traded firms listed on the London Stock Exchange. We argue that the timing of debt issues is fundamental in determining the relationship between leverage and risk-adjusted returns. We show that an announcing firm’s intrinsic value may not rise depending on when management publicly ‘signals’ changes in their firm’s capital structure. Specifically, we show that risk-adjusted returns rise positively for firms that make debt announcements during normal economic conditions while they tend to decline for firms making debt announcements during recessionary periods. During recessionary periods, market risk and loss aversion rise and investors focus less on the potential growth of debt announcing firms and focus more on potential losses instead. We conclude that the timing of new debt is of paramount importance and managers’ inability to prudently time such announcements can lead to exacerbated levels of systematic risk coupled with a significant erosion in shareholder wealth.     

A three-tiered nested analytical approach to financial integration: The case of emerging and frontier equity markets

This study investigates the patterns of integration of emerging and frontier equity markets with the US stock market during the period 2002–2014 characterised by financial turmoil and instability. To add rigour to the study, to overcome the limitations of simple correlation analysis of integration, and to produce more robust results, we propose a nested analytical approach based on a three-tiered research design. The first level uses the smooth transition conditional correlations among the US, emerging, and frontier markets. The second tier uses the results of the smooth transition approach to creating different international portfolios, which, based on alternative investment strategies, account for the time-varying correlations among markets and exploit the scope of international diversification with less integrated markets. Finally, the last tier of analysis uses returns and risks of these different international portfolios and applies structural models to explore characteristics and integration patterns in turbulent times. The three nested approaches indicate that the global financial crisis has produced a permanent increase in the degree of integration among the US and frontier markets. Conversely, the crisis's effect seems to have been only temporary in the case of integration among the US and emerging equity markets. Despite the changes brought by the crisis, the degree of integration among emerging markets and the US market is considerably more significant than the degree of integration among frontier and US markets. The novelty of this methodological approach enables us to provide some original contributions and empirical results that are robust and relevant to investors in international markets.     

Monitoring an owner: The case of Turner broadcasting

Turner Broadcasting illustrates how organizational mechanisms can be adapted to prevent a majority owner from imposing costs on minority shareholders through inept management or opportunistic behavior. These mechanisms involve issuing preferred stock with unusual features, concentrating its ownership among a small group of investors, allowing the new preferred shareholders to elect several directors, and requiring supramajority approval of major management decisions by a reconstituted board of directors. The alienability of the preferred stock is restricted to help insure that its ownership stays concentrated and in the hands of those with the specific knowledge and incentives to be effective monitors.     

Price uncertainty and vertical integration: an examination of petrochemical firms

The petrochemical industry employs assets subject to temporal and site specificity. The OPEC oil price shocks of the 1970s made it difficult to write contracts covering business dealings in the industry. I use this production and economic setting as a natural experiment to test transaction cost theory. In support of the theory, I find that input price uncertainty in the 1970s positively affected the extent of vertical integration by firms into input stages. Moreover, the positive reaction of vertical integration to price uncertainty mainly occurs in transactions subject to asset specificity. I also examine price controls and market power as alternative explanations for vertical integration in the industry, but fail to find support for these hypotheses.     

Target price forecasts: The roles of the 52-week high price and recent investor sentiment

This paper reveals that in addition to fundamental factors, the 52-week high price and recent investor sentiment play an important role in analysts’ target price formation. Analysts’ forecasts of short-term earnings and long-term earnings growth are shown to be important explanatory variables for target prices; equally, the 52-week high price and recent investor sentiment are also shown to explain target price levels and especially target price biases. Our analysis additionally reveals that analysts place greater weight on these two non-fundamental factors in settings with greater task complexity and to some extent in those with greater resource constraints. Conversely, on balance, the results suggest that this increased reliance does not translate into an increased impact per unit of each non-fundamental factor on forecast bias. Finally, our results show that target prices are useful in predicting future stock returns beyond earnings forecasts and commonly used risk proxies. However, in an internally consistent fashion, the informativeness of target prices for future returns is significantly reduced when greater weight is placed on either the 52-week high or recent investor sentiment in the target price formation process.