Corporate Leverage and Currency Crises

This paper provides an explanation of currency crises based on an argument that bailing out financially distressed exporting firms through a currency depreciation is ex-post optimal. Exporting firms have profitable investment opportunities, but they will not invest because high leverage causes debt overhang problems. The government can make investments feasible by not defending a fixed exchange rate and letting the currency depreciate. Currency depreciation always increases the profitability of new investments when revenues are in a foreign currency and costs are at least partially in domestic. Interestingly, foreign borrowing by exporting firms doesn't change the qualitative results: if firms' debt is denominated in foreign currency, a larger depreciation is needed to restore incentives to invest. An important feature in our model is that in general exporting firms choose to finance investments with debt instead of equity. Currency depreciation is socially optimal if risky projects have a higher expected return than safe projects and if firms are forced to rely on debt financing because of underdeveloped equity markets. Although currency depreciation is always ex-post optimal, it can be harmful ex-ante. Exporting firms know that the government will let the currency depreciate, if their risky investments have failed. This leads to excessive investment in risky projects even if more valuable safe projects are available.Currency depreciation; debt overhang; emerging markets; efficient investment policy; excessive risk taking

Corporate Financial Policies and Performance Prior to Currency Crises

Using company level data from 17 countries that have suffered a currency crisis during the past decade, this paper documents that firms have increasing leverage and declining profitability prior to a crisis. After sorting companies into two groups based on their exchange rate beta, we show that companies that benefit from currency depreciations have higher leverage, lower earnings to revenue ratios and lower interest coverage ratios compared to firms that are harmed by currency depreciations. These results are consistent with the recent literature that puts the financial policies and performance of corporations as the central issue in currency crisis.http://deepblue.lib.umich.edu/bitstream/2027.42/39770/3/wp386.pd

Corporate Financial Policies and Performance Around Currency Crises

Using data from 17 countries that have suffered a currency crisis, this paper studies firm-level leverage and performance measures before and after a crisis has occurred. We show that in the years preceding a currency crisis, companies that are expected to benefit from currency depreciations increase their leverage more than companies that are expected to be harmed by currency depreciations. The evidence regarding the profitability and financial fragility ratios is consistent with the leverage results, since companies that are expected to benefit from depreciations fare worse than other companies before a crisis. We also provide evidence that the Asian crisis is different from the previous European and Latin American ones: in Asia firms become more fragile after the crisis and their profitability declines and leverage increases further, whereas in Europe and Latin America there are clear signs of recovery after a crisis has occurred, especially for firms that are ex-ante expected to benefit from depreciations.currency crises; currency depreciation; corporate leverage; capital structure; profitability; financial fragility; exchange rates

Corporate Financial Policies and Performance Prior to Currency Crises

Using company level data from 17 countries that have suffered a currency crisis during the past decade, this paper documents that firms have increasing leverage and declining profitability prior to a crisis. After sorting companies into two groups based on their exchange rate beta, we show that companies that benefit from currency depreciations have higher leverage, lower earnings to revenue ratios and lower interest coverage ratios compared to firms that are harmed by currency depreciations. These results are consistent with the recent literature that puts the financial policies and performance of corporations as the central issue in currency crisis.currency crisis, corporate leverage, capital structure, profitability, exchange rates

Informed Trading, Short Sales Constraints and Futures' Pricing

The purpose of this paper is to provide an explanation for relative pricing of futures contracts with respect to underlying stocks using a model incorporating short sales constraints and informational lags between the two markets. In this model stocks and futures are perfect substitutes, except for the fact that short sales are only allowed in futures markets. The futures price is more informative than the stock price, because the existence of short sales constraints in the stock market prohibits trading in some states of the world. If an informed trader with no initial endowment in stocks receives negative information about the common future value of stocks and futures, he is only able to sell futures. Uninformed traders also face a similar short sales constraint in the stock market. As a result of the short sales constraint, the stock price is less informative than the futures price even if the informed trader has received positive information. Stocks can be under- and overpriced in comparison with futures, provided that market makers in stocks and futures only observe the order flow in the other market with a lag. Our theory implies that: 1) the basis is positively associated with the contemporaneous futures returns; 2) the basis is negatively associated with the contemporaneous stock return; 3) futures returns lead stock returns; 4) stock returns also lead futures returns, but to a lesser extent; and 5) the trading volume in the stock market is positively associated with the contemporaneous stock return. The model is tested using daily data from the Finnish index futures markets. Finland provides a good environment for testing our theory, since short sales were not allowed during the period for which we have data (27 May 1988 - 31 May 1994). We find strong empirical support for the implications of our theory.futures' market; short sales constraints; asymmetric information

Phoenix rising: Legal reforms and changes in valuations in Finland during the economic crisis

Finland experienced an extremely severe economic depression in the early 1990s. In the midst of this crisis, significant new legislation was passed that increased supervisory powers of financial market regulators and reformed bankruptcy procedures, significantly decreasing the protection of creditors. We show that the introduction of these new laws resulted in positive abnormal stock returns. The new laws also lead to increases in firms’ Tobin’s q, especially for more levered firms. In contrast to previous studies, our results also suggest that public supervision of financial markets fosters rather than hampers financial market development.corporate governance; bankruptcy; financial supervision; shareholder protection; creditors’ rights; corpo-rate valuations; political economy

The euro and corporate financing

In this paper we study how the introduction of the euro has affected corporate financing in Europe. We use firm-level data from eleven euro area countries as well as from a control group of five other European countries spanning the years 1991–2006. We show that firms from euro area countries that previously had weak currencies have increased both their equity and their debt financing compared to the control group. We also show that results are stronger for firms that hail from less financially developed euro area countries, and that large firms from industries that are dependent on external financing have increased their debt financing more. These results support the hypothesis that improved access to capital markets in the euro area has enabled increased external financing, especially debt financingeuro; external financing; supply of capital; financial development; financial dependence; financial integration

Investor Protection and the Demand for Equity

Anecdotal evidence suggests that investor protection affects the demand for equity, but existing theories emphasize only the effect of investor protection on the supply of equity. We build a model showing that the demand for equity is important in explaining financial development. If the level of investor protection is low, wealthy investors have an incentive to become controlling shareholders and pay a high price for their stocks, because they can earn additional benefits by expropriating outside shareholders. As a consequence of lower expected returns both domestic and foreign portfolio investors have a disincentive to hold stocks. The model implies that differences in stock market participation rates across countries and the pervasiveness of home equity bias depend on the degree of investor protection. Additionally, we uncover a good country bias in investment decisions as portfolio investors from countries with low level of investor protection hold relatively more foreign equity. We provide novel international evidence on stock market participation rates, and on holdings of domestic and foreign stocks consistent with the predictions of the model.Home Equity Bias; Portfolio Choice; Limited Participation; Investor Protection; Private Benefits of Control

The Euro and Corporate Valuations

In this paper we study the changes in corporate valuations induced by the adoption of the euro as the common currency in Europe. We use corporate-evel data from ten countries that adopted the euro, the three EU countries that did not start using the euro, as well as Norway and Switzerland. We show that the introduction of the euro has increased Tobin's Q-ratios by 16.7% in the euro-countries that previously had weak currencies. The increase in Q-ratios decreases to 8.7% once we take into account the changes in the interest rates. The increases in Tobin's Q are larger for firms that were exposed to intra-European currency risks, i.e. firms that were ex-ante expected to benefit more from the common currency. Finally, the increases are also more significant for financially unconstrained firms. The evidence supports the view that the introduction of the euro has lowered firms' cost of capital in the euro-countries.Economic and Monetary Union (EMU); the euro; valuation; cost of capital; currency risk; currency union