Evaluating corporate credit risks in emerging markets

Corporate leverage among emerging market firms went up considerably after the 2007–09 Global Financial Crisis (GFC). We investigate how the increased emerging market corporate leverage in the post-GFC period (2010–15) impacted the underlying credit risk, compared to the pre-GFC (2002–2006) and GFC (2007–09) periods. Using firm-level credit risk, financial, and balance sheet data for 350 firms in 23 emerging markets, we find that leverage growth leads to a significant increase in corporate credit default swap (CDS) spreads only in the post-GFC period, and the incremental effect is mainly evident among risky firms (firms with high leverage and idiosyncratic volatility). In contrast, emerging market CDS spreads during the GFC period are mainly driven by global market risk factors. The post-GFC corporate debt vulnerability is mitigated for high growth prospect firms and firms domiciled in countries with high net capital inflows and superior governance. While corporate leverage growth impacts aggregate corporate credit risk, there is no evidence that it increases sovereign credit risk. Our paper contributes to the recent literature on potential sources of default risk in emerging markets.     

Political uncertainty and a firm's credit risk: Evidence from the international CDS market

Using a large sample of firms with single-name credit default swap (CDS) contracts in 30 countries, we document the evidence that political uncertainty, proxied by national election dummy, is positively related to firm-level credit risk. Specifically, this positive relation is more pronounced for the firms that have no political connection or poor international diversification, and in the countries with higher political uncertainty and lower investor protections. Further, by using a difference-in-differences approach, we find evidence to support idiosyncratic volatility and debt rollover channels through which political uncertainty affects the credit risk of individual firm.     

Investment,leverage and political risk: Evidence from project-level FDI

Does capital structure influence firms' FDI capital expenditure decisions into countries with varying degrees of political risk? We explore this question using a novel dataset that matches 10,000 unique outward foreign direct investment (OFDI) projects with 1135 distinct U.S. firms over the period 2003–2014. We find that capital expenditures allocated to FDI projects are significantly lower for highly leveraged firms, in particular for firms with low growth opportunities. Firms also commit lower capital amounts to investments located in countries characterized by higher political risk. Furthermore, leverage and political risk interact with one another in determining the financial commitment of the FDI, with leverage exerting a significantly stronger negative effect on capital expenditures in countries where political risk is elevated. Our findings are consistent with the monitoring role of debt in curbing exposure to political risk in multinational firms' foreign operations, and corroborate the disciplinary role of leverage on firms' investment decisions.     

The Wealth Effects of Capital Investment Decisions: An Empirical Comparison of Korean Chaebol and Non‐Chaebol Firms

Abstract:   This paper investigates the capital investment decisions of Korean firms and their impact on shareholder wealth. Overall, we find positive abnormal returns surrounding the announcements of 697 cases of investment projects during the period 1992–1999. This paper also finds that the investment decisions of business group ( chaebol ‐affiliated) firms do not increase shareholder wealth, while the capital investment decisions of non‐ chaebol firms generate significantly positive abnormal returns. The multivariate tests provide consistent evidence that the announcement effects for chaebol firms are lower than for non‐ chaebol firms, after growth opportunities, investment size and firm size are controlled for. The findings support the view that the organizational structure of Korean chaebols creates an incentive for managers to make non‐value maximizing capital investment decisions.     

The real impact of stock market mispricing — Evidence from Australia

Using a large panel of Australian firms, we investigate if mispricing in the stock market has an impact on firm-level investment. A significantly positive relation is documented between investment and the proxies for mispricing, suggesting that overpriced (underpriced) firms tend to overinvest (underinvest). Furthermore, we find that equity-dependent firms display a more pronounced sensitivity of investment to stock misvaluation than do nonequity-dependent firms. Taken together, our findings evidence that mispricing in Australian capital markets may have significant influence on the real economy, and the influence works though an equity-financing channel.     

‘Wait-and-See’ business cycles?

Are shocks to firms' profitability risk, propagated by physical capital adjustment costs, a major source of business cycle fluctuations? This paper studies this question using a heterogeneous-firm dynamic stochastic general equilibrium model, where firms face fixed capital adjustment costs. Surprise increases in idiosyncratic risk lead firms to adopt a ‘wait-and-see’ policy for investment. The model is calibrated using a German firm-level data set with broader coverage than comparable U.S. data sets. The main result is that time-varying firm-level risk through ‘wait-and-see’ dynamics is unlikely a major source of business cycle fluctuations.     

Firm-level political risk and corporate leverage decisions

This study examines the effects of firm-level political risk on firm leverage decisions and speed of adjustment. We uncover that firm-level political risk has a negative impact on a firm's total and long-term leverage. We also find that firms facing high political risk tend to prefer debts with short-term maturity. However, firm-level political risk is positively related to debt specialisation, suggesting that firms are more inclined to adopt fewer debt types when they face high political risk. Further analysis reveals that firms with high political risk are associated with a faster speed of adjustment to target than those with low political risk. Our results are robust to endogeneity concerns and the effects of financial crisis.     

Inward FDI and Financial Constraints in Central and East European Countries

This study examines whether domestically owned firms in Central and Eastern European countries (CEECs) confronted higher financial constraints in their investments than did foreign-owned enterprises, and whether the domestic enterprises' financial constraints were caused by incoming foreign direct investment (FDI). In theory, foreign investment may be needed to bring in capital only initially; the subsequent investment can be financed locally. On the other hand, foreign-owned companies may be more attractive borrowers, crowding out domestic firms from imperfect host-country capital markets. Both hypotheses, however, are rejected, as the results are not consistent across different dependent variables and verification methods. There is some evidence that FDI reduced foreign subsidiaries' constraints without increasing the constraints suffered by the domestic enterprises. Tests are performed with regressions based on two alternative firm-level models, a direct one using perception-based assessment of the constraints, and an indirect one with financial indicators.     

Managerial ability,investment efficiency and stock price crash risk

We examine empirically the effect of managerial ability on firm-level investment efficiency and how this affects future stock price crash risk. Using a managerial ability measure developed by Demerjian et al. (2012), the paper documents consistent evidence that the more able managers over-invest compared to their not-so-able counterparts, even after controlling for the effects of financial reporting quality and other firm specific determinants of investment efficiency. This evidence is robust to alternative proxies for investment efficiency. The empirical evidence also suggests that crash risk increases for firms with more able managers, primarily through the investment inefficiency channel. Overall, the study contributes to a better understanding of the influence of managerial ability on investment decisions in the context of diverging opinions regarding manager-specific effects on organizational outcomes.     

Capital structure with risky foreign investment

Firms facing significant business risks have incentives to mitigate the costs of these risks by adjusting their capital structures. This paper investigates this link by analyzing the exposures of multinational firms to political risk. The evidence indicates that returns on investment in politically risky countries are more volatile than returns elsewhere. Multinational firms reduce their leverage in response to these political risks: a one standard deviation increase in foreign political risk is associated with 3.5% reduced leverage. The effect of foreign political risks on leverage is most pronounced for firms in industries whose returns are most susceptible to political influence.     

In search of climate distress risk

Using the Merton distance to default model we investigate whether a firm's climate risk affects its default (distress) risk. S&P 500 non-financial firms during 2010–2019 are analysed and we employ both corporate carbon footprints and climate risk disclosures in annual filings to measure climate risk. Our results show that climate risk has a negative impact on firms' distance to default. This impact is limited to the disclosure of transition risk in annual filings. In contrast, disclosures of physical or non-specific risk do not affect firm-level default risk, while the impact of corporate carbon footprints is inconsistent but insignificant in most models. We also find that the negative effect of climate transition risk on firms' distance to default is stronger for firms headquartered in states with carbon pricing (California and states covered by the Regional Greenhouse Gas Initiative) and temporarily strengthens because of the Paris Agreement in 2015. However, this ‘Paris’ effect is short-lived and fades away in subsequent years.     

Do corporate tax cuts increase investments?

This paper studies the effect of corporate taxes on investment. Since firms with a foreign parent have more cross-country profit shifting opportunities than domestically owned firms do, their effective tax rate and, consequently, their tax-induced costs to investment are lower. We therefore expect capital investment responses to a corporate tax cut to be heterogeneous across firms. Using firm-level data on German corporations, we exploit the 2008 tax reform, which substantially cut corporate taxes as an exogenous policy shock and expect domestically owned firms' investments to be more responsive to the reform. We show exactly this in a difference-in-differences setting. We find that the reduction in corporate tax payments led to a one-to-one increase in the real investments of domestic firms. The effect is stronger for domestic firms relying more on internal funds. Correspondingly, labor investment increased more for domestic firms, ensuring a constant mix of input factors. In addition, we show that domestic firms' sales grew faster after the tax cut than the sales of foreign-owned firms. Our results imply that corporate tax changes can increase corporate investment but that domestic firms benefit more than foreign-owned firms from a tax cut through higher investment responses resulting in greater sales growth.     

Asymmetric valuation of sustained growth by bond- and equity-holders

Viewing equity as a call option on the firm’s assets with a strike price equal to contractual debt obligations yields an asymmetric prediction on how debt and equity markets view sustained growth. Debt holders are expected to benefit from sustained growth when the default risk is high, while equity holders value such growth when risk is low. Using Altman’s z-score and debt ratings as alternative proxies for the default risk, we document a negative association between bond yield spreads and sustained growth in earnings for firms with high risk only. In sharp contrast, using earnings multiples from returns-earnings regressions as a proxy for equity market rewards, we find that earnings multiples are larger when earnings growth is sustained for the low risk sample only. Decomposing earnings growth into revenue and nonrevenue growth, we find that the debt market rewards for firms with revenue growth are confined to the high risk sample only, while nonrevenue growth firms are not rewarded for either sample. Equity investors value revenue-led earnings growth for low and high risk samples while nonrevenue growth is rewarded for the low risk sample only. Our study adds to our understanding of how changes in firm value from sustained earnings and revenue growth are divided between key providers of capital and how default risk plays an instrumental role in this valuation process.     

Investment and financing constraints in China: Does working capital management make a difference?

We use a panel of over 116,000 Chinese firms of different ownership types over the period 2000–2007 to analyze the linkages between investment in fixed and working capital and financing constraints. We find that those firms characterized by high working capital display high sensitivities of investment in working capital to cash flow (WKS) and low sensitivities of investment in fixed capital to cash flow (FKS). We then construct and analyze firm-level FKS and WKS measures and find that, despite severe external financing constraints, those firms with low FKS and high WKS exhibit the highest fixed investment rates. This suggests that an active management of working capital may help firms to alleviate the effects of financing constraints on fixed investment.     

Risk Capital: Theory and Applications

After a brief review of the current theory and practice of risk capital by financial firms, the authors define the concept of risk capital and identify the costs and benefits of using more or less of it. Next, they present their procedure for allocating risk capital to assets and lines of business on the basis of marginal default values, and in a way designed to prevent risk shifting and internal arbitrage. Then, they show how allocations of risk capital are likely to be affected by, and in turn influence, a financial firm's decisions about both the scale and composition of its portfolio of businesses. Finally, the authors present a number of applications and consider their implications for maximizing the value of financial firms. In so doing, the authors also show how their method produces very different allocations of risk capital than those based on two measures that have long been widely used by financial firms: value at risk (VaR) and risk‐adjusted return on capital (RAROC). Moreover, the adjusted present value (APV) rule for evaluating investment opportunities is shown to be workable for nonfinancial as well as financial firms.     

A hybrid bankruptcy prediction model with dynamic loadings on accounting-ratio-based and market-based information: A binary quantile regression approach

While using the binary quantile regression (BQR) model, we establish a hybrid bankruptcy prediction model with dynamic loadings for both the accounting-ratio-based and market-based information. Using the proposed model, we conduct an empirical study on a dataset comprising of default events during the period from 1996 to 2006. In this study, those firms experienced bankruptcy/liquidation events as defined by the Compustat database are classified as “defaulted” firms, whereas all other firms listed in the Fortune 500 with over a B-rating during the same time period are identified as “survived” firms. The empirical findings of this study are consistent with the following notions. The distance-to-default (DD) variable derived from the market-based model is statistically significant in explaining the observed default events, particularly of those firms with relatively poor credit quality (i.e., high credit risk). Conversely, the z-score obtained with the accounting-ratio-based approach is statistically significant in predicting bankruptcies of firms of relatively good credit quality (i.e., low credit risk). In-sample and out-of-sample bankruptcy prediction tests demonstrated the superior performance of utilizing dynamic loadings rather than constant loadings derived by the conventional logit model.     

The Impact of Investment Opportunities and Free Cash Flow on Financial Liberalization:A Cross-Firm Analysis of Emerging Economies

This study undertakes firm-level analysis of investment opportunities and free cash flow in an attempt to explain the source of the wealth effect of financial liberalization for 14 emerging countries. We find that the market's responses to stock market liberalization announcements are more favorable for high-growth firms than for low-growth firms, a result that is consistent with the investment opportunities hypothesis. We also demonstrate that firms with high cash flow experience lower announcement-period returns associated with stock market liberalization than do firms with low cash flow. Our findings suggest that the free cash flow hypothesis dominates the corporate governance hypothesis in terms of the net effect of stock market liberalization on a firm's stock returns. We further document similar evidence with regard to banking liberalization. Finally, we demonstrate that stock market liberalization leads to the more efficient allocation of capital.     

Differences of opinion and selection bias in the credit rating industry

Many regulations use private sector credit ratings to determine investment prohibitions and capital requirements for institutional portfolio investments. These regulations implicitly assume that different agencies have equivalent rating scales, despite the fact that some agencies assign systematically higher ratings than others. We assess the appropriateness of these regulatory practices by testing whether observed rating differences reflect different rating scales or simply result from sample selection bias. Our analysis reveals only limited evidence of selection bias. We also ask what types of firms of firms are most likely to seek ratings from the agencies with higher rating scales. Our analysis uncovers no evidence that firms seek ratings from these agencies to clear specific regulatory hurdles or to reduce ex ante uncertainty about default risk.     

Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure

I build a dynamic capital structure model that demonstrates how business cycle variation in expected growth rates, economic uncertainty, and risk premia influences firms' financing policies. Countercyclical fluctuations in risk prices, default probabilities, and default losses arise endogenously through firms' responses to macroeconomic conditions. These comovements generate large credit risk premia for investment grade firms, which helps address the credit spread puzzle and the under‐leverage puzzle in a unified framework. The model generates interesting dynamics for financing and defaults, including market timing in debt issuance and credit contagion. It also provides a novel procedure to estimate state‐dependent default losses.