Common Risk Factors and Global Financial Trends
Investment Paper 2: Common Risk Factors in Stock and Bond Returns
This paper identifies five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity.
There are two bond-market factors related to maturity and default risks. Most importantly, the five factors seem to explain average returns on stocks and bonds.
The authors used time-series regressions to address central asset-pricing issues: how different combinations of variables can capture the common variation over time in the returns on bonds and stocks, and the cross-section of average returns.
The results concluded the following:
- TERM and DEF were used to explain the cross-section of returns. It seems that the default factor is more powerful than TERM. TERM and DEF are less risky.
- The firm size factor seems to affect earnings.
- Book-to-market equity affects firms by having prescient abnormal returns.
- The three-factor model or five-factor model will give the same explanation of stock and bond returns.
- The Sharpe-Lintner model was the most used for portfolio performance valuation.
Investment Paper 3: Are Fama and French Factors Global or Country Specific?
This article examines whether country-specific or global versions of Fama and French’s three-factor model better explain time-series variation in international stock returns.
Findings
Regressions for portfolios and individual stocks indicate that domestic factor models explain much more time-series variation in returns and generally have lower pricing errors than the world factor model.
In addition, decomposing the world factors into domestic and foreign components demonstrates that adding foreign factors to domestic models leads to less accurate in-sample and out-of-sample pricing. Practical applications of the three-factor model, such as cost of capital calculations and performance evaluations, are best performed on a country-specific basis. Therefore, the article does not support extending the Fama and French factor model to a global context.
Corporate Finance Paper 5: Do Financial Crises Alter the Dynamics of Corporate Capital Structure? Evidence from GCC Countries
We study the impact of the 2008 financial crisis on the capital structure of GCC firms. We employ a dataset covering a 10-year period from eight sectors to investigate patterns in corporate leverage before and after the crisis and identify changes in debt financing.
Our results indicate that leverage ratios were negatively and significantly impacted by the 2008 crisis due to a lack of debt supply by lenders. We also find that the demand for debt by firms is the main driver of leverage before the crisis, whereas the demand for debt by firms and the supply of debt by lenders are both important determinants of leverage after the crisis. Moreover, we find that firms adjust their leverage ratios toward the target leverage much slower after the crisis. Our results also indicate that the impact of the crisis on capital structure differs across industries and countries.
These results are paramount for stakeholders to understand and mitigate the impact of crises on capital structure. Two traditional approaches have emerged attempting to explain capital structure decisions.
- The trade-off theory: This theory weighs the benefits of debt achieved through tax savings and the reduction of managerial agency costs against bankruptcy costs and the agency costs between shareholders and bondholders. A dynamic extension of this theory allows firms to deviate from their target leverage, where firms adjust their leverage by balancing the benefits from being at their optimal capital structure and the adjustment costs toward the target leverage.
- The pecking order theory: This theory does not assume the existence of an optimal capital structure and postulates that capital structure decisions are driven by the costs of adverse selection between the firm and outside investors. When financing their operations, managers attempt to reduce asymmetry costs in capital markets. According to the pecking order theory, the firm first uses internal resources, then issues debt if internal resources are insufficient, and finally issues external equity, believed to be the most expensive.
Corporate Finance Paper 4: The Costs of Going Public
This paper presents evidence regarding the two quantifiable components of the costs of going public: direct expenses and underpricing, which are primarily investment banking fees, and both are economically significant. Together, these costs average 21.22% of the realized market value of the securities issued for firm commitment offers and 31.87% for best efforts offers. For a given offer size, the direct expenses are of the same order of magnitude for both contract types, but the underpricing is greater for best efforts offers.
An explanation of why some firms choose to use best efforts offers despite their apparent higher total costs is given. I resolve this apparent paradox as follows: if there is enough uncertainty about the value of the firm, an issuing firm is better off using a best effort contract because the required underpricing if it used a firm commitment contract would be too severe.
Using a dataset of initial public offers from 1977-1982, I find empirical results consistent with the theory: firms that are more volatile in the aftermarket are more likely to have used a best efforts contract to go public. The process of going public starts when a registration statement, containing descriptive material about the issuing firm and the proposed offer, is filed with the United States Securities and Exchange Commission.
Corporate Finance Paper 6: The Impact of Initiating Dividend Payments on Shareholders’ Wealth
This study investigates the impact of dividends on stockholders’ wealth by analyzing 168 firms that either pay the first dividend in their corporate history or initiate dividends after a 10-year hiatus.
The empirical results exhibit larger positive excess returns than any previous study on dividends. This result does not depend on any other events (such as earnings announcements), and the excess return is positively related to the size of the initial payment. Subsequent dividend increases for the same sample of firms are also investigated. Compared with the initiation of dividends, the results suggest that subsequent increases may produce a larger positive impact on shareholders’ wealth. The results also indicate that other studies may have underestimated the effect of dividend increases. The findings for both initial and subsequent dividends are consistent with the view that dividends convey unique, valuable information to investors. The effects we find are larger than those presented in other studies and do not appear to be caused by contemporaneous announcements such as earnings reports.
These results are consistent with the view that dividends convey unique, valuable information to investors, as Lintner (1956) and others have documented; managers’ behavior also appears to be consistent with this view.
The impact of a firm’s dividend policy on its value is an unresolved issue. In their seminal work, Miller and Modigliani demonstrate that, absent imperfections, dividend policy should not affect shareholders’ wealth.
Financial Market Paper 3: The Real Exchange Rate Determination: An Empirical Investigation
This study examines real exchange rate determination in Asian economies (Japan, Korea, and Hong Kong). The methods show that the real exchange rate and terms of trade can be jointly determined. Productivity differential, terms of trade, the real oil price, and reserve differential are found to be important in real exchange rate determination in the long run. However, the significant impacts of those variables on real exchange rate determination differ across economies.
The real exchange rate plays an important role in international trade and investment determination. The results of generalized forecast error variance decompositions show that:
- Terms of trade, the real oil price, and reserve differential are the important contributors to real exchange rate determination in Japan.
- Terms of trade and reserve differential are the important contributors to real exchange rate determination in Korea.
- Reserve differential and the real oil price are the important contributors to real exchange rate determination in Hong Kong.
Thus, there is no universal set of important contributors to real exchange rate determination. On the whole, terms of trade, reserve differential, productivity differential, and the real oil price are found to be important in real exchange rate determination, but the significant impacts of those variables on real exchange rate determination differ across economies.