Order flow volatility and equity costs of capital

Ministry of Education, Singapore under its Academic Research Funding Tier 1; Sim Kee Boon Institute for Financial Economics at Singapore Management Universit

Negative Hedging: Performance Sensitive Debt and CEOs’ Equity Incentives (CRI 2009-014)

We examine the relation between CEOs’ equity incentives and their use of performance-sensitive debt contracts. These contracts require higher or lower interest payments when the borrower\u27s performance deteriorates or improves, thereby increasing expected costs of financial distress while making a firm riskier to the benefit of option holders. We find that managers whose compensation is more sensitive to stock volatility choose steeper and more convex performance pricing schedules, while those with high delta incentives choose flatter, less convex pricing schedules. Performance pricing contracts therefore seem to provide a channel for managers to increase firms’ financial risk to gain private benefits

Do Golden Parachutes increase CEO’s DESIRE to be taken over? empirical evidence from australia and united states

This study investigates whether the large payouts that are available to Chief Executive Officers (CEOs) from a change in corporate control (takeover) do motivate some CEOs to seek acquisition of their firms by making them more attractive to a takeover bid. Using Australian and the US data, employing OLS regression, we report that there is a significant relationship between a CEOs change in control payments and their firm’s net cash levels (one of the key factors of takeover attractiveness). Our empirical results also indicate that CEOs desire their firms to be acquired by decreasing shareholders’ equity, thus supporting the view that change in control payments exist primarily for incumbent managers. Our findings provide support to the proposition that managers enjoy having large cash balances to be available to them as it allows them with greater opportunities to derive personal benefit from it. Therefore, our findings suggest that managers prefer to have large cash balances available to them to ensure their future wellbeing by setting up favourable terms in the control agreements

Liquidity, Volatility, and Equity Trading Costs Across Countries and Over Time

Actual investment performance reflects the underlying strategy of the portfolio manager and the execution costs incurred in realizing those objectives. Execution costs, especially in illiquid markets, can dramatically reduce the notional return to an investment strategy. This paper examines the interactions between cost, liquidity, and volatility, and analyzes their determinants using panel-data for 42 countries from September 1996 to December 1998. We document wide variation in trading costs across countries; emerging markets in particular have significantly higher trading costs even after correcting for factors affecting costs such as market capitalization and volatility. We analyze the inter-relationships between turnover, equity trading costs, and volatility, and investigate the impact of these variables on equity returns. In particular, we show that increased volatility, acting through costs, reduces a portfolio's expected return. However, higher volatility reduces turnover also, mitigating the actual impact of higher costs on returns. Further, turnover is inversely related to trading costs, providing a possible explanation for the increase in turnover in recent years. The results demonstrate that the composition of global efficient portfolios can change dramatically when cost and turnover are taken into account.http://deepblue.lib.umich.edu/bitstream/2027.42/39706/3/wp322.pd

Organized equity markets in Germany

The German financial system is the archetype of a bank-dominated system. This implies that organized equity markets are, in some sense, underdeveloped. The purpose of this paper is, first, to describe the German equity markets and, second, to analyze whether it is underdeveloped in any meaningful sense. In the descriptive part we provide a detailed account of the microstructure of the German equity markets, putting special emphasis on recent developments. When comparing the German market with its peers, we find that it is indeed underdeveloped with respect to market capitalization. In terms of liquidity, on the other hand, the German equity market is not generally underdeveloped. It does, however, lack a liquid market for block trading. Klassifikation: G 51 . Revised version forthcoming in "The German Financial System", edited by Jan P. Krahnen and Reinhard H. Schmidt, Oxford University Press

External financing of US corporations: Are loans and securities complements or substitutes?

“Multiple avenues of intermediation” (Greenspan 2000) suggest substitutability of corporate loan and bond finance which smooths external financing flows. Holmstrom and Tirole (1997) stress complementarity; for most firms bank finance and consequent monitoring is essential for bond finance. Econometric work based on their model is consistent with complementarity both on average over time and during financial crises, and for levels and volatilities. It implies that “multiple avenues” may not be effective as a buffer in a bank credit crunch, and hence supply-side blockages of bank credit may impact on real activity. There are important implications for regulation, not least Basel II

Impact of irreversibility and uncertainty on the timing of infrastructure projects

This paper argues that because of the irreversibility and uncertainty associated with Build - Operate - Transfer (BOT) infrastructure projects, their financial evaluation should also routinely include the determination of the value of the option to defer the construction start-up. This ensures that project viability is comprehensively assessed before any revenue or loan guarantees are considered by project sponsors to support the project. This paper shows that the framework can be used even in the context of the intuitive binomial lattice model. This requires estimating volatility directly from the evolution of the net operating income while accounting for the correlation between the revenue and costs functions. This approach ensures that the uncertainties usually associated with toll revenues, in particular, are thoroughly investigated and their impact on project viability is thoroughly assessed. This paper illustrates the usefulness of the framework with data from an actual (BOT) toll road project. The results show that by postponing the project for a couple of years the project turns out to be viable, whereas it was not without the deferral. The evaluation approach proposed therefore provides a better framework for determining when and the extent of government financial support, if any, that may be needed to support a BOT project on the basis of project economics. The analysis may also be applicable to private sector investment projects, which are characterized by irreversibility and a high rate of uncertainty

Why Hedge? - A Critical Review of Theory and Empirical Evidence -

Finance theory does not provide a comprehensive framework for explaining risk management within the imperfect financial environment in which firms operate. Corporate managers, however, rank risk management as one of their most important objectives. Therefore, it is not surprising that papers on the question why firms hedge are mushrooming. This paper critically reviews this literature and analyses the implications for risk management practice. It is distinguished between two competing approaches to corporate hedging: equity value maximising strategies and strategies determined by managerial risk aversion. The first category suggests that managers act in the best interest of shareholders. They hedge to reduce real costs like taxes, costs of financial distress and costs of external finance or to replace home-made hedging by shareholders. The second category considers that managers maximise their personal utility rather than the market value of equity. Their hedging strategy, therefore, is determined by their compensation plan and reputational concerns. There is ambiguous empirical evidence on the dominant hedging motive. It depends on the environment in which firms operate (e.g. tax schedule) and on firm characteristics (e.g. capital intensity). In general, one can observe that (i) hedging taxable income is of minor importance, (ii) firms with a high probability of financial distress hedge more, (iii) companies with greater growth opportunities hedge more, (iv) managers with common stockholdings hedge more than managers with option holdings and (v) high ability managers hedge more than low ability managers. The total benefits of hedging are not the sum across the various motives. Therefore, a manager has to concentrate on a primary motive to implement an effective risk management programme: If his primary motive is to minimise corporate taxes, he will hedge taxable income. If his primary concern is to reduce the costs of financial distress and if he can faithfully communicate the firm?s true probability of default, his hedging strategy will focus on the market value of debt and equity. If hedging is prompted to reduce the demand for costly external finance, he will hedge cash flows. If the manager is concerned with his reputation, he will focus on accounting earnings. Once he has focused on a certain exposure, the manager has to decide whether he wants to minimise the volatility of this exposure or simply avoid large losses. -- Der Artikel gibt einen Literaturüberblick zur Fragestellung, warum Unternehmen Risikomanagement betreiben und analysiert die Umsetzung in der Unternehmenspraxis. Ausgehend von den Irrelevanzthesen von Modigliani/Miller wird gezeigt, daß die starke Betonung des Risikomanagements in Unternehmen auf zweierlei Arten erklärbar ist: Zum einen erhöht Hedging den Shareholder Value, da es Steuern, Bankrottkosten, die Kosten von externem Kapital und den Absicherungsbedarf von schlecht diversifizierten Aktionären verringern kann. Zum anderen kann Hedging den Nutzen von Managern erhöhen, soweit es einen Einfluß auf deren Vermögen oder Ruf hat. Was die Umsetzung der Hedging-Ziele in die Unternehmenspraxis anbetrifft, haben die Modelle unterschiedliche Konsequenzen bezüglich der Art und des Ausmaßes des abzusichernden Risikos.Risk Management,Hedging,Agency Theory,Shareholder Value