Hedging and Coordinated Risk Management: Evidence from Thrift Conversions

The authors propose an approach to analyzing risk management activities when multiple risks are bundled within a firm's assets or liabilities. They classify potentially bundled risks into two types: compensated risk and hedgeable risk. Firms earn rents for bearing compensated risk such as credit risk, and earn zero economic rents for bearing hedgeable risk such as interest rate risk. Because the costs associated with reducing hedgeable risk are lower than those associated with compensated risk, firms rationally eliminate hedgeable risks using either on- or off-balance sheet strategies. Thus, hedging becomes desirable even for risk-neutral or risk-seeking firms as a means of allocating risk. They denote this approach of optimal risk allocation among multiple risks with a firm as Coordinated Risk Management. The authors test the coordinated risk management approach by examining the interaction between interest rate risk (hedgeable risk) and credit risk (compensated risk) management at thrift institutions following conversion form a mutual-to-stock form of ownership. Although the concept of coordinated risk management applies to any firm, they use this sample because of data availability for the sample of converting thrifts and the control groups of non-converting institutions. The time-series findings are consistent with the coordinated management of interest rate risk and credit risk. In particular, immediately at conversion they observe decreased interest rate risk across institutions combined with a more gradual trend toward increasing credit risk. The negative relation between interest rate risk and credit risk is also significant in pooled tests. In addition, institutions use both on-balance sheet strategies and derivative instruments to reduce interest rate risk. This finding of decreasing interest rate risk occurs despite incentives to increase total risk following conversion. In light of the current discussions on the use of derivatives, this finding also indicates that thrifts use derivatives instruments for hedging rather than for speculative purposes. The cross-sectional results support models of optimal hedging. The authors provide evidence that interest rate risk hedging within an institution is positively associated with ex ante growth opportunities. They also provide evidence that managerial security holdings are a significant determinant of hedging activity. Finally, they report a negative association between managerial option holdings and interest rate risk hedging. Managers holding relatively high numbers of options maintain a risky position on-balance sheet with respect to unexpected changes in interest rates.

Disclosure and the Cost of Capital: Evidence from Firms’ Responses to the Enron Shock

This paper examines the link between disclosure and the cost of capital. We exploit an exogenous cost of capital shock created by the Enron scandal in Fall 2001 and analyze firms’ disclosure responses to this shock. These tests are opposite to the typical research design that analyzes cost of capital responses to disclosure changes. In reversing the tests and using an exogenous shock, we mitigate concerns about omitted variables in traditional cross-sectional disclosure studies. We estimate shocks to firms’ betas around the Enron events and the ensuing transparency crisis. Our analysis shows that these beta shocks are associated with increased disclosure. Firms expand the number of pages of their annual 10-K filings, notably the sections containing the financial statements and footnotes. The increase in disclosure is particularly pronounced for firms that have positive cost of capital shocks and larger financing needs. We also find that firms respond with additional interim disclosures (e.g., 8-K filings) and that these disclosures are complementary to the 10-K disclosures. Finally, we show that firms’ disclosure responses reduce firms’ costs of capital and hence the impact of the transparency crisis.

Hedging and Coordinated Risk Management: Evidence From Thrift Conversions

We provide an explanation for hedging as a means of allocating rather than reducing risk. We argue that firms facing a total risk constraint optimally allocate risk by reducing (increasing) exposure to risks providing zero (positive) economic rents. Our evidence suggests that mutual thrifts which convert to stock institutions reduce interestrate risk through improved balance sheet maturity matching and increased derivatives use at the time of conversion. This interest-rate risk reduction is followed by slower growth in credit risk. Post-conversion, risk management activities are significantly related to growth capacity and management compensation structure attained at conversion

The Impact of Cash Flow Volatility on Discretionary Investment and the Costs of Debt and Equity Financing

We show that higher cash flow volatility is associated with lower average levels of investment in capital expenditures, R&D, and advertising. This association suggests that firms do not use external capital markets to fully cover cash flow shortfalls but rather permanently forgo investment. Cash flow volatility also is associated with higher costs of accessing external capital. Moreover, these higher costs, as measured by some proxies, imply a greater sensitivity of investment to cash flow volatility. Thus, cash flow volatility not only increases the likelihood that a firm will need to access capital markets, it also increases the costs of doing so

Institutional Investments in Pure Play Stocks and Implications for Hedging Decisions

We show that institutions invest in stocks within an industry that maintain exposure to their underlying industry risk factor. These pure play stocks have greater numbers ofinstitutional investors and institutions systematically overweight them in their portfolios while underweighting low industry-exposure stocks of firms in the same nominal industry.Pure play stocks also have greater liquidity measured by stock turnover and price impact. An implication of these results is that catering to these preferences could be an important variable in firms\u27 risk management decisions, potentially offsetting incentives to reduce volatility via hedging. We further characterize institutions\u27 investments for pureplay stocks across institution type, industries, and over time

Executive Overconfidence and the Slippery Slope to Financial Misreporting

A detailed analysis of 49 firms subject to AAERs suggests that approximately one-quarter of the misstatements meet the legal standards of intent. In the remaining three quarters, the initial misstatement reflects an optimistic bias that is not necessarily intentional. Because of the bias, however, in subsequent periods these firms are more likely to be in a position in which they are compelled to intentionally misstate earnings. Overconfident executives are more likely to exhibit an optimistic bias and thus are more likely to start down a slippery slope of growing intentional misstatements. Evidence from a high-tech sample and a larger and more general sample support the overconfidence explanation for this path to misstatements and AAERs

Earnings Management Using the Valuation Allowance for Deferred Tax Assets Under SFAS No. 109

Statement of Financial Accounting Standards No. 109 (SFAS No. 109) allows firms to use their discretion to set arbitrarily high valuation allowances against deferred tax assets. Firms can then later use these hidden reserves to manage earnings. Our evidence indicates that most banks do not record a valuation allowance to manage earnings, but rather to follow the guidelines of SFAS No. 109. However, if the bank is sufficiently well capitalized to absorb the current-period impact on capital, then the amount of the valuation allowance increases with a bank\u27s capital. In later years, bank managers adjust the valuation allowance to smooth earnings. The magnitude of the discretionary adjustment increases with the deviation of unadjusted earnings from the forecast or historical earnings

Understanding Earnings Quality: A Review of the Proxies, Their Determinants and Their Consequences

Researchers have used various measures as indications of “earnings quality” including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because “quality” is contingent on the decision context. We also point out that the “quality” of earnings is a function of the firm’s fundamental performance. The contribution of a firm’s fundamental performance to its earnings quality is suggested as one area for future work