Default Risk and Equity Returns: A Comparison of the Bank-Based German and the U.S. Financial System

In this paper, we address the question whether the impact of default risk on equity returns depends on the financial system firms operate in. Using an implementation of Merton's option-pricing model for the value of equity to estimate firms' default risk, we construct a factor that measures the excess return of firms with low default risk over firms with high default risk. We then compare results from asset pricing tests for the German and the U.S. stock markets. Since Germany is the prime example of a bank-based financial system, where debt is supposedly a major instrument of corporate governance, we expect that a systematic default risk effect on equity returns should be more pronounced for German rather than U.S. firms. Our evidence suggests that a higher firm default risk systematically leads to lower returns in both capital markets. This contradicts some previous results for the U.S. by Vassalou/Xing (2004), but we show that their default risk factor looses its explanatory power if one includes a default risk factor measured as a factor mimicking portfolio. It further turns out that the composition of corporate debt affects equity returns in Germany. Firms' default risk sensitivities are attenuated the more a firm depends on bank debt financing

Where do firms manage earnings?

Despite decades of research on how, why, and when companies manage earnings, there is a paucity of evidence about the geographic location of earnings management within multinational firms. In this study, we examine where companies manage earnings using a sample of 2,067 U.S. multinational firms from 1994 to 2009. We predict and find that firms with extensive foreign operations in weak rule of law countries have more foreign earnings management than companies with subsidiaries in locations where the rule of law is strong. We also find some evidence that profitable firms with extensive tax haven subsidiaries manage earnings more than other firms and that the earnings management is concentrated in foreign income. Apart from these results, we find that most earnings management takes place in domestic income, not foreign income.Arthur Andersen (Firm) (Arthur Andersen Faculty Fund

Predicting Extreme Returns and Portfolio Management Implications

We consider which readily observable characteristics of individual stocks (e.g., option implied volatility, accounting data, analyst data) may be used to forecast subsequent extreme price movements. We are the first to explicitly consider the predictive influence of option implied volatility in such a framework, which we unsurprisingly find to be an important indicator of future extreme price movements. However, after controlling for implied volatility levels, other factors, particularly firm age and size, still have additional predictive power of extreme future returns. Furthermore, excluding predicted extreme return stocks leads to a portfolio that has lower risk (standard deviation of returns) without sacrificing performance

Corporate boards and performance pricing in private debt contracts

This paper investigates the effects of corporate governance on the use of performance pricing in debt contracts on a sample of newly syndicated loans in the U.S. private debt market. While cross-sectional results provide no evidence for the predicted relation between corporate governance quality and the likelihood of using performance pricing in debt contracts, there is evidence for the predicted positive relation between corporate governance quality and the use of interest-increasing performance pricing provisions. Evidence also provides support for the predicted negative relation between corporate governance quality and the use of financial ratio as the measure of performance underlying the provisions. Overall, empirical evidence supports the hypothesis that debt-holders perceive aspects of corporate governance to be beneficial and factor them in their contracting decisions

The Role of Information and Financial Reporting in Corporate Governance and Debt Contracting

We review recent literature on the role of financial reporting transparency in reducing governance-related agency conflicts among managers, directors, and shareholders, as well as in reducing agency conflicts between shareholders and creditors, and offer researchers some suggested avenues for future research. Key themes include the endogenous nature of debt contracts and governance mechanisms with respect to information asymmetry between contracting parties, the heterogeneous nature of the informational demands of contracting parties, and the heterogeneous nature of the resulting governance and debt contracts. We also emphasize the role of a commitment to financial reporting transparency in facilitating informal multiperiod contracts among managers, directors, shareholders, and creditors