The determinants of bond call premia: A signalling approach

A signalling model is presented that provides an additional explanation for the determination of call premia on corporate bonds. It is shown that firms may signal their exclusive information about their probability of default by the choice of their call premia. Stockholders of safer firms (i.e., those that have a lower probability of bankruptcy) have a higher incentive for providing a low call premium. This occurs because the call option will be valuable only if the firm survives by the first call date. This event, however, is more likely for the safer firm. The safer firm will therefore be more willing to sacrifice some current revenues (or equivalently, to provide a higher coupon than it would otherwise have to pay in order to sell the bond at par) by determining a lower call premium. The model therefore predicts a negative correlation between safety and call premia, a correlation that has been empirically confirmed by Fischer, Heinkel, and Zechner (1989). This correlation provides support to the signalling theory vis-à-vis the alternative explanation of taxes determining the call premia. Another contribution of this model is that it ties the call premium decision with expectations of future interest rates. Such expectations are considered important by practitioners, but were rarely considered in previous research.     

Reading the smile: the message conveyed by methods which infer risk neutral densities

In this study we compare the quality and information content of risk neutral densities obtained by various methods. We consider a non-parametric method based on a mixture of log–normal densities, the semi-parametric ones based on an Hermite approximation or based on an Edgeworth expansion, the parametric approach of Malz which assumes a jump-diffusion for the underlying process, and Heston's approach assuming a stochastic volatility model. We apply those models on FF/DM exchange rate options for two dates. Models differ when important news hits the market (here anticipated elections). The non-parametric model provides a good fit to options prices but is unable to provide as much information about market participants expectations than the jump-diffusion model.     

Cash Distributions of Inflationary Gains

When a firm maintains its debt/equity ratio, changes in expectations of inflation lead to windfall gains through the 'Fisher Effect'. Contrary to other studies, it is demonstrated here that the gain can be distributed to equity owners without impairing the firm's capacity to retire its debt.     

Growth and Public Debt: What Are the Relevant Trade‐Offs?

The interplay between growth and public debt is addressed considering a Barro‐type (1990) endogenous growth model where public spendings are financed through taxes on income and public debt. The government has a target level of public debt relative to GDP, and the long‐run debt‐to‐GDP ratio is used as a policy parameter. We show that when debt is a large enough proportion of GDP, two distinct balanced‐growth paths (BGPs) may coexist, one being indeterminate. We exhibit two types of important trade‐offs associated with self‐fulfilling expectations. First, we show that the lowest BGP is always decreasing with respect to the debt‐to‐GDP ratio while the highest one is increasing. Second, we show that the highest BGP, which provides the highest welfare, is always locally indeterminate while the lowest is always locally determinate. Therefore, local and global indeterminacy may arise and self‐fulfilling expectations appear as a crucial ingredient to understand the impact of debt on growth, welfare, and macroeconomic fluctuations. Finally, a simple calibration exercise allows to provide an understanding of the recent experiences of many OECD countries.     

Adaptive Learning in an Expectational Difference Equation with Several Lags: Selecting among Learnable REE

It is demonstrated that adaptive learning in the least squares sense may be incapable of satisfactorily reducing the number of attainable equilibria in a rational expectations model when focusing on the forward‐solutions to the model. The model examined, as an illustration, is a basic asset pricing model for exchange rate determination that is augmented with technical trading in the currency market in the form of moving averages since it is the most commonly used technique according to questionnaire surveys. The forward‐solutions to such a model are preferable to the backward‐solutions that are normally utilized since announcement effects is an important feature in currency trade. Because of technical trading in foreign exchange, the current exchange rate depends on j _max lags of the exchange rate, meaning that the model has j _max+1 rational expectations equilibria, where several of them are adaptively learnable in the least squares sense. However, since past exchange rates should not affect the current exchange rate when technical trading is absent, it is possible to single out a unique equilibrium among the adaptively learnable equilibria that is economically meaningful. It is worth noting that the model examined can also be viewed as a model for stock price determination in which the forward‐solutions to the model are preferable to the backward‐solutions since the importance of announcement effects is a common characteristic for currency and stock markets.     

The effect of gender and firm identification on auditor pre-negotiation judgments

This paper extends current auditor negotiation research by considering the effects of two dimensions of auditors' identity that are posited to be relevant to auditors' negotiation: gender and audit firm identification. Women earn over half of college degrees in accounting, and hold more than half of accounting and auditing positions in the US, yet the balance of the gender of partners at audit firms is currently not equal (AICPA, 2017). However, as more women advance into partnership positions in firms, it is increasingly important to have an understanding of how gender affects the behaviors, processes and outcomes of negotiation, and thus the quality of financial statements. The auditor-client negotiation context has features, such as ambiguity and representation of others that can “trigger” the salience of auditors' gender and firm identity. Once salient, these two dimensions of auditors' identity shape auditors' motivational orientation towards negotiations, which, in turn, affects the auditors' negotiation behavior and negotiation outcomes.The study finds that male and female auditors approach the negotiation over audit adjustments differently. Although many negotiation studies find that males negotiate more aggressively than do females, auditor-client negotiation offers a unique setting that has been found to reverse this common trend. We hypothesize and find that female auditors recommend higher audit adjustments than males. However, the level of firm identification moderates female's recommended audit adjustments such that at higher levels of firm identification, the larger audit adjustments recommended by females decrease. This finding is consistent with the growing research on gender differences in auditing and the research on gender and risk tolerance, which find females to be more risk averse, but contrary to much of the negotiation research which shows males as more aggressive and achieving higher negotiated outcomes. In supplemental analysis, we find that our results hold in the senior manager subsample but not in the partner subsample. This result is consistent with theory on gender differences which suggests that the differences will disappear with increased occupational socialization (Smith & Rogers, 2000). Practical implications are discussed.     

Does multinationality matter? Implications of operational hedging for the exchange risk exposure

An important issue in global corporate risk management is whether the multinationality of a firm matters in terms of its effect on exchange risk exposure. In this paper, we examine the exchange risk exposure of US firms during 1983–2006, comparing multinational and non-multinational firms and focusing on the role of operational hedging. Since MNCs and non-multinationals differ in size and other characteristics, we construct matched samples of MNCs and non-multinationals based on the propensity score method. We find that the multinationality in fact matters for a firm’s exchange exposure but not in the way usually presumed – the exchange risk exposures are actually smaller and less significant for MNCs than non-multinationals. The results are robust with respect to different samples and model specifications. There is evidence that operational hedging decreases a firm’s exchange risk exposure and increases its stock returns. The effective deployment of operational risk management strategies provides one reason why MNCs may have insignificant exchange risk exposure estimates.     

Managerial flexibility and the wealth effect of new product introductions

This paper examines whether investors recognize the value of managerial flexibilities, as proxied by real options, in their valuation of new product introductions. We define a firm’s real options portfolio as the difference between the firm’s market value and its assets in place. A firm’s strategic flexibilities are modeled as the ratio of its real option portfolio to its book value. Using a sample of new product introductions from 1998–2007, we find our real options measure is positively related to announcement period abnormal returns. This result holds after we control for other variables known to be correlated with the announcement effect in previous studies. Our result is robust to alternative measures of real options based on analysts’ earnings expectations and whether a firm has one or multiple segments. In summary, our results suggest that a firm’s perceived strategic and operating flexibilities are an important factor in the valuation of new products.     

Do fundamentals matter for the D-Mark/Euro–Dollar? A regime switching approach

In this paper, we demonstrate that there is evidence of an unstable and nonlinear relationship between fundamentals and exchange rates. Modeling this time-varying nature of the importance of fundamentals in a Markov switching framework substantially improves the fit of the real interest rate differential model and leads to parameter estimates, which in one regime are in line with theoretical expectations and allow us to draw reasonable conclusions on the influence of fundamentals on exchange rate dynamics. Factors that prove to be closely related to regime switches are short-term interest rate, inflation differentials and differences in economic growth. Therefore, fundamentals do not only matter for the exchange rate within each regime, but are also related to the switches between the regimes.     

Firm life cycle stages and earnings management

We provide evidence that the differences in economic growth and stability of firms during different stages of their life cycle encourage managers to manage the reported earnings differently to achieve their goals. Our findings support the expectation that managers adjust the reported earnings upward using positive discretionary accruals during the introductory and decline stages of firm life cycle. The upward adjustment of reported earnings during the introductory stage enables them to achieve the objective of sending positive signals on firm performance when the firm is in a formative stage, and also provides a better base for prediction of future earnings. The upward adjustment of reported earnings during the decline stage are expected to enhance firm’s life, which would enable managers to take remedial actions to improve firm performance, especially when the firm is in a distress situation. On the other hand, our findings show that managers may consider using negative discretionary accruals during the growth and maturity stages so that they can save some earnings for use during later years when firm performance compared to market expectations is weak. The managers are, however, not likely to adjust the reported earnings downward when the reported earnings fall short of market expectations. Additionally, we find that large institutional shareholdings perform effective monitoring and discourage managers to use discretionary accruals because their use may result in lower reliability of reported earnings.

     

Disclosure strategies for management earnings forecasts: The role of managerial compensation structures,overoptimism, and effort

Management earnings forecasts have received significant attention as an important source for setting firm expectations. Our paper argues that how these forecasts are presented to the public is important for managing these expectations. We present both analytical and empirical analyses demonstrating that managers’ disclosure framing choices will depend on the information type, managerial overoptimism, and managerial compensation structures. We also provide evidence showing that disclosure framing choices can dampen stock return volatility. Finally, we indicate that disclosure strategies alter the misreporting results found in Guttman et al. (2006).     

The effects of foreign disturbances under flexible exchange rates

Foreign fiscal expansion has a contractionary, and monetary expansion an expansionary, effect on the small economy in the real wage model. The reverse conclusions hold in the money wage model only if the income elasticity of the demand for money is one or greater. The same results hold also for the stationay state effects. This theory provides an explanation—in the policy mix of the United States—for the recent lacklustre performance of Europe. Under rational expectations, foreign monetary expansion leads to an overshooting appreciation, fiscal expansion leading to several possible exchange rate responses. The new results are produced by consistently specified money demand and import functions, the supply side, and the wealth effect.     

Secured and unsecured debt in creditor-friendly bankruptcy

This article develops a continuous-time asset pricing model for valuing corporate securities in the presence of both secured and unsecured debt. We consider a framework where creditors dominate the negotiation process. This is consistent with the increasing influence of creditors in bankruptcy. We show that the unsecured creditors are incentivized to liquidate the firm prematurely relative to the first-best threshold. However, if the firm’s liquidation value is very low, it should complement its secured debt with unsecured debt as a form of insurance to avoid early liquidations. Our results have important implications for the debt structure and the resolution of financial distress of modern firms with substantial intangible assets.     

Do subjective expectations explain asset pricing puzzles?

The structural uncertainty model with Bayesian learning, advanced by Weitzman (AER 2007), provides a framework for gauging the effect of structural uncertainty on asset prices and risk premiums. This paper provides an operational version of this approach that incorporates realistic priors about consumption growth volatility, while guaranteeing finite asset pricing quantities. In contrast to the extant literature, the resulting asset pricing model with subjective expectations yields well-defined expected utility, finite moment generating function of the predictive distribution of consumption growth, and tractable expressions for equity premium and risk-free return. Our quantitative analysis reveals that explaining the historical equity premium and risk-free return, in the context of subjective expectations, requires implausible levels of structural uncertainty. Furthermore, these implausible prior beliefs result in consumption disaster probabilities that virtually coincide with those implied by more realistic priors. At the same time, the two sets of prior beliefs have diametrically opposite asset pricing implications.     

Macroeconometric testing of the rational expectations and structural neutrality hypotheses for the United States

Empirical tests of the neutrality of money growth found in recent literature are tests of the joint hypothesis of rational expectations and structural neutrality. Although tests of this joint hypothesis are informative, it is also important to gain information on the accuracy of its constituents. This paper presents the application of a methodology capable of providing information on the empirical validity of the rational expectations, structural neutrality, and joint hypotheses. Tests of these hypotheses are performed on the basis of FIML estimation of an extended version of a model recently presented by Robert Barro, using U.S. data for 1946–1973.     

Factors Affecting the Probability of Bankruptcy: A Managerial Decision Based Approach

The majority of classification models developed have used a pool of financial ratios combined with statistical variable selection techniques to maximize the accuracy of the classifier constructed. Rather than follow this approach, this article seeks to provide an explicit economic basis for the selection of variables for inclusion in bankruptcy models. This search to develop an economic theory of bankruptcy augments the existing bankruptcy prediction literature. Variables which occur in bankruptcy probability expressions derived from the solution of a stochastic optimizing model of firm behaviour are 'proxied' by variables constructed from financial statement data. The random nature of the lifetime of a single firm provides the rationale for the use of duration or hazard-based statistical methods in the validation of the derived bankruptcy probability expressions. Results of the validation exercise confirm that the majority of variables included in the empirical hazard formulation behave in a way that is consistent with the model of the firm. The results highlight the need for developments in the measurement of earnings dispersion.     

Dynamic risk, accounting-based valuation and firm fundamentals

This study extends the accounting-based valuation framework of Ohlson (Contemp Acc Res 11(2):661–687, 1995) and Feltham and Ohlson (Acc Rev 74(2):165–183, 1999) to incorporate dynamic expectations about the level of systematic risk in the economy. Our model explains recent empirical findings documenting a strong negative association between changes in economy-wide risk and future stock returns. Importantly, the model also generates costs of capital that are solely a linear function of accounting variables and other firm fundamentals, including the book-to-market ratio, the earnings-to-price ratio, the forward earnings-to-price ratio, size and the dividend yield. This result provides a theoretical rationale for the inclusion of these popular variables in cost of capital (expected return) computations by the accounting and finance literatures and obviates the need to estimate costs of capital from unobservable (future) covariances. The model also generates an accounting return decomposition in the spirit of Vuolteenaho (J Finance 57(1):233–264, 2002). Empirically, we find that costs of capital generated by our model are significantly associated with future returns both in and out of sample in contrast to standard benchmark models. We further obtain significantly lower valuation errors in out-of-sample tests than traditional models that ignore dynamic risk expectations.     

When Does a Merger Create Value? Using Option Prices to Elicit Market Beliefs

I introduce and test a method to identify market expectations about value creation in mergers. Post‐announcement market prices reflect beliefs about both merged and standalone firm values, and the likelihood of either outcome. Stock prices alone do not contain sufficient information to identify these latent beliefs. By adding exchange‐traded stock option data, I deliver a clear decomposition of observed value change into two parts: 1) value creation and 2) new information about standalone value. Previous research has struggled to disentangle the two. This decomposition provides a strong and practical measure of the market's expectations about value creation in a merger.     

An analysis of currency crisis in South Korea

This paper provides empirical evidence on the causes and timing of the 1997 currency crisis in South Korea. A persistent weakness in the economic fundamentals through out much of the pre-crisis period created necessary conditions for the crisis. However, the timing of the currency crisis was determined by a unique combination of an unprecedented increase in default risk faced by the banking system and a decrease in foreign exchange reserves (FXRES) that restricted the ability of the government to bail out. A VAR model identifies two important variables that were crucial in triggering the currency crisis. One is the ratio of dishonored bills (DS) that measures default risk and serves as a proxy for the market value of banks. The other is FXRES that measures the strength of the government's bailout policies. Estimates from a vector autoregressive (VAR) model confirm a strong impact of the lagged changes in the ratio of DS and FXRES on the current changes in the won's value. Immediately before the November crisis, the ratio of DS reached an all-time high while reserves dropped to 1-month imports. These developments significantly contributed to the negative expectations resulting in a massive capital outflow followed by a drastic devaluation of the currency.     

Proportionate Growth and the Theoretical Foundations of Financial Ratios

The article proposes a theoretical framework for understanding financial ratios, showing that the multiplicative character of the financial variables from which financial ratios are constructed is a necessary condition of valid ratio usage, not just an assumption supported by evidence. Also, by assuming that firm size is a measurable statistical effect, the article offers an informed reappraisal of the limitations of financial ratios, particularly the well–known limitation of proportionality. The article is divided into two parts, one where ratio components are viewed as deterministic vari– ables and the other where they are random. Such an approach allows the characteristics of ratios to be more easily understood before generalizing the relationship between ratio components to encompass randomness. In the second part, when variability introduced by firm size is treated as a random effect, it is shown that if the accounting variables Y and X used to calculate a financial ratio Y/X are exponential Brownian motion, and if continuous growth rates are equal and proportionate to firm size, this may lead to ratios which are asymmetric but which do not necessarily drift.