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ISSN 2229-6891
International Research Journal of
Applied Finance
Volume. III Issue. 4 April 2012
Contents
Stock Returns and Macroeconomics Factors: An Examination Of The Indonesian Domestic Economy 426 - 434 Alan Harper & Zhenhu Jin An Examination of the Markets Anticipation of Directors and Officers Liability Insurance 435 - 451 Stephen Perreault Determinants of bank failures? Evidence from US failed banks 452 - 462 Abdus Samad & Lowell M. Glenn Optimal Time Varying Asset Allocation with Actuarial Life Expectancies in Retirement 463 - 479 Gordon Irlam Debt Financing and Output Market Behavior 480 - 490 Jaideep Chowdhury & Hans Haller Conceptual modeling of Current and Capital Accounts in Central and Eastern European countries 491 - 502 Milivoje Radovic, Serge Shuster, & Milos Vulanovic Currency Hedging Strategies of a Pension Fund 503 - 517 Chuan-San Wang, Jui-Cheng Hung, & Shu-Wei Feng Study on Investor Decision Making: Mediating Roles of Risk Propensity and Risk Perception 518 - 528 Hui-Lin Hsu Transmissions in International Cross-listings 529 -538 Yong-chern Su, Yuan-jay Wu, & Han-ching Huang
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International Research Journal of Applied Finance Vol III Issue 4 April, 2012
ISSN 2229 6891
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Stock Returns and Macroeconomics Factors: An Examination Of The Indonesian Domestic Economy
Alan Harper, Ph.D. College of Business South University Virginia Beach, Virginia 23464
Zhenhu Jin, Ph.D. College of Business Valparaiso University Valparaiso, Indiana 46385
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Abstract This paper investigates the relationships between stock returns, and the macroeconomic variables such as industrial production, inflation, interest rates, money supply, and exchange rates in Indonesia. Our results indicate that a co-integrating relationship exists between the Jakarta Composite Index and the above macroeconomic variables. The results of our study have policy implications and provide insights to investors seeking to invest in the Indonesian stock market. Keywords: Co-integration, Indonesia, Macroeconomic Variables I. Introduction There has been an increasing amount of capital flows into Indonesia in recent years. The World reports that capital flows increased in 2009 and 2010. As a result, the Bank of Indonesia has enacted a set of policies aimed at encouraging investment flows toward less volatile, long-term investments. Financial liberation in Indonesia has opened its capital markets which have become more integrated with other world markets. Generally speaking, increases in capital inflows are good for a country because they aid economic growth and development. However, economic theory suggests that an efficient capital market allows capital to be allocated to where it can be put into most efficient use. In other words, if investor sentiment changes due to some exogenous shocks, capital flows may revert and the effects of massive capital outflows can cause an economic instability. International investors have been attracted to Indonesia markets to seek diversification and higher risk adjusted returns. Diversification provides investors with the benefits of reduced risk without sacrificing the expected returns by investing in diversified assets. The mean variance relationship introduced by Markowitz (1952) and further defined by Sharpe (1964) and Litner (1965) provide the initial theoretical framework for the benefits of diversification. An efficient portfolio is one that provides the highest expected rate of return given the risk level or the lowest level of risk given the expected rate of return. Investors are also attracted to Indonesia by its growing economy. The U.S State Department reports that GDP for Indonesia was $539 billion in 2009, $707 billion in 2010 and is expected to be $823 billion in 2011 signaling a growing economy with an annualized growth rate of 15%. Further examination of components of the GDP reveals that domestic consumption comprised 58.6% of GDP, business investment comprised 31% of GDP, and government consumption comprised 9.6% of GDP, and net export comprised 2.8%. The fact that domestic consumption accounts for 60% of the growing economy is certainly appealing to investors. The purpose of this paper is to study the long-run and short-run relationship between stock returns, and such macroeconomic variables as, industrial production, money supply, interest rates, and exchange rates in Indonesia in recent years. The findings of this study should be of interest to both policy makers and investors. The stock index used in this study is Jakarta Composite Index and macroeconomic variables were retrieved from Yahoo Finance and the International Financial Statistics from January 2001 to December 2010. Monthly returns from the Indonesian stock market and monthly macroeconomic variables are used to evaluate the relationships. The rest of this paper is organized as follows. In section two, I provide a brief review of the literature on macroeconomic variables and stock returns. Section 3 presents the data. Section 4 presents the methodology which is followed by the results. This is then followed by the conclusion.
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II. Literature Review There have been many studies that have investigated the relationships between stock returns and macroeconomic variables. For instance, Fama (1981) studies the relationship between inflation and stock returns. He finds that the negative relationship between stock returns and inflation are caused by real activity. Geske and Roll (1983) found that the negative relationship between stock returns and inflation can be traced to the signaling hypothesis which results in monetary expansion. In a recent study, Yeh and Chi (2009) investigated the comovement of inflation and real stock returns from 12 OECD countries. They find a negative relationship between stock returns and inflation. In an attempt to understand the phenomenon between exchange rates and stock returns, Ajayi and Mougue (1996) evaluated the effects of exchange rates on stock returns by examining the intertemporal relations between stock indices and exchange rates. They found that differences existed both in the short run and long runs. They also found that stock price increases in the short run has negative effects on domestic currency. In a more recent study, Yang and Doong (2004) investigated price and volatility spillovers between stock prices and exchange rates for the G-7 countries. They found movement of stock prices will affect future stock price changes in relation to exchange rates. Choi, Fang, and Fu (2010) also investigated stock returns and exchange rates in New Zealand before and after the Asian financial crisis. Using an EGARCH model, they find unidirectional volatility between stock markets and the foreign exchange markets. Money supply also affects stock returns as evidenced by Rogalski and Vinso (1977). They evaluated the relationship between money supply and stock returns. Using an ARIMA model followed by chi-square test for independence, they found that causality goes from stock prices to money supply in that order. In 2000, Maysami and Koh investigated the relationship between Singapores stock markets and macroeconomic variables. The results from Johansens multivariate vector error correction model and cointegration tests find that money supply growth is not cointegrated with Singapores stock market. Breen, Glosten, and Jagannatan (1989) examined if Treasury bill returns can forecast excess common stock returns from equally weighted and value weighted indices. Using monthly data from April 1954 to December 1986 from the CRSP were employed. A linear regression model was constructed to predict or forecast common stock returns using CumbyModest and HenrikssonMerton test. Breen et al. found that interest rates can forecast excess common stock returns in the value weighted index return of stocks but fails to forecast excess common stock returns in the equally weighted index return of stocks. In more recent study examining stock market volatility and interest rates in Fiji, Mala and Mahendra (2007) investigated the effects of interest rates on stock returns in an emerging market. Daily data stock prices were collected from the South Pacific Stock Exchange which comprised of 15 companies from 2001 to 2005. Interest rates were obtained from the Federal Reserve Bank of Fiji. Employing an ARCH and GARCH model the results are robust. The ARCH model depicts a significant relationship between interest rates and stock market volatility. The implications are that monetary policy officials must understand the effects that monetary policy has on emerging stock markets. Industrial production should be positively related to stock returns. In order to answer this question Schwert (1990) replicated an earlier study conducted by Fama (1981) to investigate the relationship between stock returns and future production growth rates using different data. Fama used data from 1953 to 1987. Schwert (1990) used data covering a much larger period, 1889 1988. The findings revealed that the results are close to Famas (1990) study and indicated that a strong positive relation between stock returns and industrial production was shown. On the other 428
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hand, Poon and Taylor (1991) evaluated the relationship between industrial production and stock returns using monthly data from January 1965 to December 1994 in the UK. Monthly stock returns were collected from the London Share Database. Industrial production data was collected from the Industrial Production Index supplied the UK Central Statistic Office. Using a two-stage regression model, they found that macroeconomic factors do not affect stock market prices. Kavussanos, Marcoulis, and Arkoulis(2002) evaluated the impact of news on international equity markets with respect to stock returns and industrial production as one of the macroeconomic variables. Monthly price indices were obtained from the Morgan Stanley Capital International (MSCI) and Industrial production data was obtained from DataStream International Service. Kavussanos et al. (2002) cover the period from March 1986 to October 1997 for 22 countries and 38 international industries. Kavussanos et al. found that industrial production is positively related to stock returns. This coincides with economic theory and suggests that growth in leading indicators such as industrial production should translate into increased corporate earnings and increased stock prices. III. Data The Index used in this study is the Jakarta Composite Index (JKSE) from January 2001 to December 2010 retrieved from Yahoo! Finance. The macroeconomic variables used in this study are industrial production, interest rates, exchange rates, inflation and money supply retrieved from International Financial Statistics. The natural log of each time series is then calculated. III.1 Proxies for the determinants of macroeconomic variables 1. Exchange Rate: per U.S. dollar end of period 2. Interest Rate: Rate on one day loans between commercial banks. 3. Inflation: Consists of 45 major urban areas through Indonesia and basket items between 283- 397. Inflation index is based on 2002 CLS (cost of living survey). 4. Manufacturing Production: Measure changes in real production of large and medium non-oil manufacturing establishments. 5. M2: M2 comprises M1, quasi-money, and securities issues by other depository corporation held by other FIs, state and local government, public non financial corporations, and the private sector. III.2 Preliminary Data Results Table 1 displays monthly returns, standards deviations and coefficients of variation for each index series. The coefficients are calculated by differencing the natural log of the indexes. What is interesting amongst the variables is the Jakarta yielded a return of 2.6% and a standard deviation of 13.65%. Inflation during the sample period was non-existent at .068% while interest rates averaged 2.03%. Manufacturing production averaged .54% while the exchange rate was .02%. The evidence is suggestive that the capital controls enacted by the Bank of Indonesia have been effective at stabilizing the effect of portfolio inflows on the domestic economy during the sampling frame. Insert Table 1 about here Table 2 displays the correlation matrix among the Jakarta and the stated macroeconomic variables. It is interesting that the correlation between the Jakarta and inflation is negative and supports earlier findings of Fama (1981); Geske and Roll (1983); Yeh and Chi (2009). It is also interesting that exchange rates share a negative relationship with the Jakarta. The negative relationship between exchange rates and Jakarta returns maybe a result of intervention by the Indonesian Central Bank to manage their currency. It is not surprising that industrial production 429
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shares a positive relationship with the Jakarta Index. This also supports the seminal findings of Fama (1981). Insert Table 2 about here IV. Methodology The question addressed by this paper, is whether a long-run and short run relationship exists among the Jakarta Index and macroeconomic variables. This study will employ a multivariate co-integration framework and vector error correction model (VECM) to answer this question. Our study is similar to Mahmood and Dinniah (2009), who examined stock returns and macroeconomics variables in six Asian countries and Mohammad and Ali (2009) who examined stock prices and the macroeconomic variables on the Karachi Stock Exchange. However, our study uses different economic variables, time frames, databases and Indonesia. In order to employ this framework, three steps must be performed. The first step involves conducting the augmented Dickey-Fuller (ADF) unit root test for non-stationary in order examine if the data series are integrated of order I(1). After determining that the series are integrated of order one I(1), co-integration analysis is conducted to determine whether a long-run relationships exist between the returns of the Jakarta and selected macroeconomic variables. The Johansen (1991) method is used to examine the cointegrating relationships. If a cointegrating relationship is found, then an error correction model will be developed to examine the short-term dynamics of the variables. V. Empirical Results Table 3 provides the results of augmented Dickey-Fuller (ADF) unit root tests at levels with trend and intercept and at first differences with only with trend. The appropriate lag length was selected by using the Akaike Information Criterion (AIC). As indicated all of the variables possess a unit root at levels and fails to reject the null hypothesis of non-stationary. By not accounting for non-stationary the results could be misleading due to spurious regression and model misspecification. Insert Table 3 about here Since the market index series (first differences) are integrated of order I(1) , Cointegration analysis is performed to uncover whether the index series (first differences) become linear (stationary) when combined. The test used to perform cointegration analysis is the Johansen (1990) procedure. Table 4 indicates the results of this test. Two test statistics are used to determine the number of cointegrating relationships, the trace statistic and the maximum eigenvalue statistic. Interestingly, both the trace and maximum eigenvalue test statistic indicate identical results at both 5% and 1%. The trace statistic and maximum eigenvalue test statistic at the 5% and 1% level of significance indicate 2 co-integrated variables. So, we can conclude that non-stationary (levels) can be combined into stationary (first differences) to form at most 2 integrated series. In essence, these series are co-integrated and move together in the long run with short run deviations corrected toward their long run equilibrium relationship. Insert Table 4 about here Table 5 displays the long run cointegrating equation normalized by the Jakarta Stock Index. This equation shows the long run relationships between the Jakarta Index and industrial production, money supply, manufacturing production, exchange rates, and inflation. Table 4 shows three statistics. The first statistic is the regression coefficient; the second number in parenthesis is the standard error of the estimate. The third number is the t-statistic. The results in table 4 indicate that there is a positive long run relationship between the exchange rate and the Jakarta, while manufacturing production and the Jakarta share a negative relationship. The negative relationship 430
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between inflation and the Jakarta is expected and supports the seminal findings of Fama (1981). For example, a 1% increase in inflation causes the Jakarta to decrease by 6.1%. Table 6 displays the coefficient of error correction terms and more specifically the speed of adjustment. For example, the Jakarta adjusts by 15.74 % in the absence of shock. Insert Table 5 about here Insert Table 6 about here VI. Conclusion This study investigates the relationship among the Jakarta Composite Index and 5 macroeconomic variables. The relationship between stock returns and macroeconomic variables has been studied extensively in the literature. However, most studies have focused on developed markets. The empirical findings from this study indicate a long term cointegrating relationship and short run dynamics that adjust back to their long run equilibrium. Our findings also indicate at least two cointegrating relationships exist between the macroeconomic variables and the Jakarta Composite Index. Furthermore, an error correction models was developed that indicates that short run deviations return to their long run properties. This study should aid monetary policy officials and investors that seek to invest in the Indonesian economy. Future research should apply granger causality to examine a more temporal cause and effect relationship between the stated macroeconomics variables and the Jakarta Composite Index. Indonesia is a growing open market economy that has implemented capital controls to ensure its continued growth. Proper controls should ensure steady growth. References Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7(1), 7791. Ajayi, R. A., & Mougue, M. (1996). On the dynamic relation between stock prices and exchange rates. Journal of Financial Research, 19(2), 193207. Breen, W., Glosten, L. R., & Jagannatan, R. (1989). Economic significance of predictable variation in stock index returns. Journal of Finance, 44(5), 11771189. Choi, D. F. S., Fang, V., & Fu, T. Y. (2010). Volatility spillovers between New Zealand stock market return and exchange rate changes before and after 1997 Asian financial crisis. Asian Journal of Accounting & Finance, 1(2), 106117. Fama, E. F. (1990). Stock returns, expected returns, and real activity. Journal of Finance, 45, 10891109. Fama, E. F. (1981). Stock returns, real activity, inflation, and money. American Economic Review, 71(4), 545565. Geske, R., & Roll, R. (1983). The fiscal and monetary linkage between stock returns and inflation. The Journal of Finance, 38(1), 133. Kavussanos, M. G., Marcoulis, S. N., & Arkoulis, A. G. (2002). Macroeconomic factors and international industry returns. Applied Financial Economics, 12(12), 923931 Litner, J. (1965). The valuation of risky assets and the selection of risky investments in stock portfolios and capital budgets. The Review of Economic and Statistics, 47(1), 1337. Mala, R., & Mahendra, R. (2007). Measuring stock market volatility in an emerging economy. International Research Journal of Finance and Economics, 8, 126133. Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7(1), 7791. Maysami, R. C., & Koh, T. S. (2000). A vector error correction model of the Singapore stock markets. International Review of Economic and Finance, 9(1), 7996.
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Mahmood, W.N.W., & Dinniah, N.M. (2009). Stock returns and macroeconomics variables: Evidence from the six Asian-Pacific countries. International Research Journal of Finance and Economics, 30, 154- 164. Mohammad, S., Hussain, A., & Ali, A. (2009). Impact of macroeconomic variables on stock prices: Empirical evidence in case of KSE (Karachi Stock Exchange). European Journal of Scientific Research, 38(1), 96103. Poon, S., & Taylor, J. (1991). Macroeconomic factors and the U.K. stock market. Journal of Business Finance and Accounting, 18(5), 619636. Rogalski, R. J., & Vinso, J. D. (1977). Stock returns, money supply, and the direction of causality. Journal of Finance, 32(4), 10171030. Schwert, G. W. (1990). Stock returns, and real activity: A century of evidence. Journal of Finance, 45(4), 12371257. Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), 425442. U.S. Department of State. (n.d.). USSD country and regions [data file]. Retrieved from http://www.state.gov/p Yahoo! Finance. (n.d.). Yahoo! Finance indices [data file]. Retrieved from http:// finance.yahoo.com/intlindicies. Yang, S. Y., & Doong, S. C. (2004). Price volatility spillover between stock prices and exchange rates: Empirical evidence from the G-7 countries. International Business Journal, 3(2), 139153. Yeh, C. C., & Chi, C. F. (2009). The co-movements and long run relationship between inflation and stock returns: Evidence from 12 OECD countries. Journal of Economics and Management, 5(2), 162186.
Table 1: Descriptive statistics of the Jakarta and Macroeconomic variables
Exchange Interest Inflation Production M2 Stock Valid (listwise)
N Range Minimum Maximum Statistic Statistic Statistic Statistic 119 .3398 -.1674 .1724 119 119 119 119 119 N 119 2.2631 .0901 .4748 9.9531 1.6836 -.6190 -.0031 -.2480 -.8947 -.5466 1.6441 .0870 .2268 9.0584 1.1370
Mean Statistic .000244 .020373 .006798 .005445 .078487 .026147
Std. Error .0035764 .0233799 .0008487 .0059628 .0765630 .0125165
Std. Deviation Statistic .0390143 .2550441 .0092585 .0650466 .8352038 .1365387
Variance Statistic .002 .065 .000 .004 .698 .019
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International Research Journal of Applied Finance Vol III Issue 4 April, 2012 Table 2: Correlation Matrix
Exchange Rate Exchange Rate Inflation Interest M2 Production Jakarta 1.0000 -.0538 .0055 .2222 .0021 -.2110 Inflation Rate -.0538 1.000 .0686 .0288 -.0864 -.0618 Interest Rate .0055 .0686 1.0000 -.0378 .3348 -.0435 M2 .2222 .0288 -.0378 1.0000 .0029 -.0246 Production Index .0021 -.0864 .3348 .0029 1.0000 .0261
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Jakarta Index -.2109 -.0618 -.0435 -.0246 .0261 1.0000
Table 3: Unit Root Tests on Level and First Differences with Trend & Intercept and Trend
Variables Jakarta Composite Exchange Inflation Manufacturing M2 Interest RESULTS Index Rate Index Rate Level(Trend & Intercept) -2.5359 -3.4592 -2.3422 -1.9076 -1.7867 -2.8244 Has a unit root First Differences (Intercept) -4.6822 -7.7595 -8.8062 -5.2916 -8.4012 -20.7030 Does not have a unit root
Table 4. Johansens Test for Multiple Cointegrating Vectors for the Long-Run Relationship Among the Jakarta and Macroeconomic Variables
Critical Null Hypothesis A. Trace Test No Cointegrating Vector* At Most 1 Cointegrating Vector** At Most 2 Cointegrating Vector At Most 3 Cointegrating Vector 157.55 93.97 50.07 28.62 103.85 76.97 54.08 35.19 113.42 85.34 61.27 41.20 Critical Value Maximum Eigenvalue Test Statistic Trace Test Statistic 5% 1% Values
Null Hypothesis
5%
1%
B. Maximum Eigenvalue Test No Cointegrating Vector * At Most 1 Cointegrating Vector** At Most 2 Cointegrating Vector At Most 3 Cointegrating Vector 63.56 43.91 21.45 14.74 40.96 34.81 28.59 22.30 46.75 40.30 33.73 27.07
Notes: *, ** signifies a significant relationship
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International Research Journal of Applied Finance Vol III Issue 4 April, 2012 Table 5: Long run cointegrating equation (normalized Jakarta)
Jakarta 1.000 Exchange Rate 1.3858 (0.59816) [2.31673] CPI -6.0592 (2.2467) [-2.6969] Manufacturing Production -0.1729 (2.2467) [-.03053] M2 4.2309 (0.7037) [6.0124]
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Interest Rate 0.1211 (0.1451) [0.8341)
Constant -0.0111
Table 6: Coefficient of error correction terms

D(JAR) -0.1574 (0.0845) [-1.8610] D(ER) -0.1152 (0.0373) [-3.0860] D(INF) 0.0240 (0.0086) [2.7820] D(IR) 0.0043 (0.1842) [2.7820] D(M2) -0.1969 (0.0329) [-5.9870] D(PROD) 0.0498 (0.0445) [1.1192]
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An Examination of the Markets Anticipation of Directors and Officers Liability Insurance
Stephen Perreault Department of Accounting Bryant University 1150 Douglas Pike. Smithfield, RI 02917 sperreault@bryant.edu
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Abstract This article investigates the effect of directors and officers (D&O) liability insurance on the markets reaction to securities class action lawsuit filings. Although the U.S. does not require firms to disclose details of their D&O insurance coverage, I find initial empirical evidence that the market can anticipate when a firms class action settlement will be covered by such a policy. I then show that D&O proceeds are positively related to returns both prior to and concurrent with the filing of a class action lawsuit, suggesting that investors consider the expected proceeds from such policies when determining the impact of litigation on a firms share price. Keywords: directors and officers liability insurance, securities class action law, corporate governance JEL codes: K22, G22, C12 I. Introduction Directors and Officers (D&O) liability insurance covers the monetary costs associated with lawsuits filed against directors, officers, and their respective firms by shareholders or other third parties. This insurance provides a form of redress not only to plaintiffs, who are often the final beneficiaries of the insurance proceeds, but also to the firms themselves, by reducing the out of pocket costs associated with legal proceedings and settlements. It appears that a significant portion of U.S. firms purchase these policies (Towers & Perrin, 2009). Although class action securities lawsuits might be viewed as a means of last resort for investors, this form of redress appears to be used frequently. The Stanford Securities Class Action Clearinghouse (which tracks securities class action litigation) reported a total of 2,647 class action filings for the period 1996-2009 (Cornerstone Research 2010). For firms that are subject to shareholder litigation, details regarding the companys D&O liability insurance would seem to be of interest to investors. That is, to the extent that a defendant firm possesses such insurance, the effect of potential damage awards or settlement amounts on the companys operating cash flows could be reduced or eliminated entirely. Therefore, D&O coverage could impact how the market interprets the class action filing and subsequently values the impacted firm (Gande and Lewis, 2009). In the United States, the SEC does not require disclosure of basic information related to a corporations D&O insurance policies and firms seem unwilling to voluntarily disclose such information. Therefore, it is unclear whether the market can anticipate whether a class action settlement will be substantially covered by insurance or whether it will be funded out of pocket by the firm. While others have argued for mandatory reporting of D&O particulars (e.g., Chalmers et al., 2002; Griffith, 2005), I am not aware of any prior studies that empirically test whether investors incorporate such information into their stock purchase decisions. This research question is important for several reasons. The ability of the market to effectively interpret the impact of class action lawsuits may depend, in part, on who pays the price for the suit (the company itself or the insurer). This information may be difficult to discern in the US, where disclosure of D&O insurance details is not required. Additionally, the class action system is commonly viewed as an instrument not only to compensate investors for damages, but to establish deterrent effects for management malfeasance (Baker and Griffith, 2007). The practical ability of shareholder lawsuits to discipline managers may be weakened if the consequences of class action security lawsuits are mitigated by D&O insurance coverage (Chalmers et al., 2002).
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In this study, I analyze a large sample of shareholder-initiated federal securities class action lawsuits that were filed and settled between the years 1996-2009. For each filing in my sample, I isolate the settlement proceeds that were paid by the firms D&O insurance carrier from the total settlement amount. My analyses indicate that the market incorporates D&O insurance proceeds into its response to class action litigation filings, with these proceeds significantly preserving market value. I also find that the amount of market value preserved by a dollar of insurance proceeds is roughly double the amount of market value destroyed by a dollar of settlement cost. This may indicate that timing differences exist between when settlement costs and reimbursed costs are recognized by the market, possibly due to greater uncertainty regarding firms D&O insurance coverage amounts. This paper provides initial evidence that the market can anticipate which lawsuits will be covered by D&O insurance and which will be funded by the defendant firm, suggesting that information concerning a firms D&O coverage is partially available to the market, despite the lack of a formal mandate that requires it. As a result, I find support for the claim that D&O insurance details are value-relevant to investors. My findings also suggest that the market consequences of class action lawsuits for firms are, to some extent, weakened by D&O insurance. As a result, this paper informs the ongoing policy debate concerning mandatory disclosure of D&O liability insurance details in U.S. markets. The remainder of this paper is organized as follows. The following section reviews the existing literature and develops the major hypotheses. Section 3 describes the data used to perform the empirical tests. Section 4 presents the results, while section 5 concludes. II. Background and Hypotheses Development II.1. Legal Background For public corporations, shareholder litigation (either individual or class action) represents a significant source of legal risk (Baker and Griffith, 2007). Investors may choose to pursue litigation against companies and managers whom they believe have acted contrary to their fiduciary duty to shareholders, either by misrepresentation, or by fraudulent and negligent actions. The typical timeline for the settlement of a class action securities lawsuit is presented graphically in Figure 1. The first event, the class period, refers to the duration of time where the alleged illegal activity is claimed to have occurred. A shareholder typically must be an owner of the defendant companys stock during the class period in order to participate in the class. Subsequent to this period, the actual filing of a class action lawsuit typically occurs as a result of one or more trigger events, which may include restatements, unusual trading, self-disclosure of malfeasance, auditor departures, or significant declines in share price. 1 Insert Figure 1 about Here Once the securities class action lawsuit is filed, very few cases are actually tried to judgment against the defendants. Indeed, Black et al. (2006) examined 3,239 federal securities cases filed against public companies between 1991 and 2004 and found that only 37 cases (1.1%) were tried to judgment against public companies, their officers, or directors. Instead, the plaintiff and defendant typically agree to a settlement, which is subsequently ratified by the court. 2 While a class action filing would seem to be a last resort for injured investors, such lawsuits appear to be invoked with some frequency. Cornerstone Research (2010), using data provided by
1 2
For an excellent discussion of potential trigger events, see Karpoff et al. (2008). Settlements may be more attractive to corporations than adjudication for a number of reasons. In a particular, settlements typically do not require an admission of guilt and also avoid the risk associated with allowing a jury to determine damage amounts.
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the Stanford Securities Class Action Clearinghouse, reported that at the start of 2009, 1.8% of firms listed on the NYSE, NASDAQ, or AMEX were named defendants in one or more federal security class action suits. Additionally, Ryan and Simmons (2010) found that the value of settlements arising from such proceedings exceeded $56 billion during the period 1996-2008. As a result, many corporations elect to purchase D&O liability insurance in order to protect their directors and officers, as well as the company itself, from liabilities which may arise as a result of defending and settling these legal claims. While the typical D&O insurance policy exists to protect individual managers from legal liability, policies can also be structured to reimburse corporations for indemnification of directors and officers, as well as to insure the corporation itself from legal action in which the company is named as a defendant (Towers & Perrin 2009). Thus, corporations that agree to settle class action litigation can have their out of pocket costs reduced or eliminated if they are insured by a D&O policy (at least to the extent of the policy limit). As a result, these policies essentially shift the risk of shareholder litigation from the company to the insurer (Griffith, 2005). Evidence suggests that a substantial number of public corporations purchase D&O insurance, although information on the exact percentage of companies who have policies, as well as the details of these policies is unclear.3 This is largely attributable to the fact that the SEC does not mandate public dissemination of this information for U.S. registrants. This policy stands in contrast to other regulatory regimes, such as Canada, that require detailed disclosure of D&O coverage, deductibles, and premiums in corporate proxy filings and registration statements (Boubakri and Ghalleb, 2008). As a result, information related to D&O coverage types, premiums, and limits is seldom disclosed by U.S. firms in public filings (Chalmers et al., 2002). II.2. Prior Research on Directors and Officers Liability Insurance A number of prior studies have investigated the factors that influence the demand for D&O liability insurance. These studies primarily focus on non-US firms, for which access to corporate insurance purchase information is more easily accessible. For example, using a dataset of D&O purchases by Canadian companies, Core (1997) found that firms with high litigation risk were most likely to purchase insurance, and that their policies were likely to have higher limits. OSullivan (2002) reported that U.K. companies that purchase insurance are likely to be larger, have greater exposure to U.S. litigation, and have greater share price risk. Boyer (2003), again using a sample of Canadian corporations, indicated that the primary factor affecting D&O purchases is whether or not the firm purchased insurance in the prior year. Several prior studies have investigated the effects of D&O insurance coverage on corporate governance and managerial opportunism. Both Holderness (1990) and OSullivan (1997) suggest that insurance providers have an incentive to reduce the risk of the firms they insure. Therefore, they argue that D&O insurers provide an additional layer of monitoring via the scrutiny they provide, which is presumably of benefit to shareholders. However, others have argued that this additional monitoring may come with added cost. Since the class-action lawsuit is the primary disciplining mechanism for fraud, the presence of D&O insurance may weaken the ability of the market to impose a penalty for malfeasance (Coffee 2006 p1545).
A survey sponsored by Towers and Perrin (2004) found that over 90% of respondent corporations had purchased some form of D&O liability insurance; however, as responses were self reported, the accuracy of this percentage may be affected by self selection bias. Within my own sample of class action settlements, I find that 58% were fully paid using D&O proceeds, 30% were paid by a mix of D&O proceeds and corporate funds, and 12% were fully paid by the corporations themselves. However, as my sample is restricted to firms that were subject to class action litigation, these percentages may overestimate the extent of coverage in the broader market.
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For example, Chalmers et al. (2002), investigating U.S. IPO firms, found a significant negative relationship between D&O insurance and three-year post-IPO stock price performance, which they claim may be attributable to opportunistic behavior by managers. Specifically, managers may be more likely to purchase insurance when entering the market with overvalued IPO stocks, since there is a high probability that directors and officers will be sued if a subsequent decline in stock price occurs. Indeed, other studies such as Core (1997) and Boubakri and Ghalleb (2008) all point to a variety of situations in which managerial opportunism seems to be associated with D&O insurance coverage. Therefore, D&O insurance may insulate managers from the consequences of their malfeasance.4 If the D&O purchase decision is affected by managerial opportunism, then mandatory disclosure of D&O insurance details could make such behavior significantly less likely (Chalmers et al. 2002). Additionally, disclosure of a firms D&O policy may contain other information that is valuable to investors. For example, insurance policy premiums may contain information about the perceived quality of a firms monitoring controls (Core 2000), which shareholders could presumably use as a proxy to evaluate the quality of a firms corporate governance (Griffith 2005). Policy details could also provide investors with information that would be useful in determining the impact of litigation costs on company cash flows which could significantly influence how the market interprets the effect of a class action filing (Gande and Lewis 2009). While this suggests that providing detailed D&O disclosures could have benefits to shareholders, I am not aware of any prior research that empirically tests the need for such disclosure.5 II.3. Hypotheses Development The market reaction to class action lawsuits has typically been shown to be negative, despite the fact that lawsuits are partially anticipated (Romano 1991; Gande and Lewis 2009). In addition to the fact that lawsuits may result in future financial liabilities for the defendant firms, lawsuits bring bad publicity and may carry reputational penalties that exceed the dollar impact of the litigation (Karpoff et al. 2008). However, D&O insurers often cover a substantial portion of any resulting settlements, inclusive of legal fees. Therefore, if investors believe that a lawsuit may be covered by a D&O policy, they may impound the portion of the expected settlement amount that will be picked up by the insurer into the security price. Reducing the out of pocket costs to the firm through D&O insurance coverage should therefore alter the effect of the total settlement amount on abnormal security returns surrounding the litigation filing. Therefore, I empirically test whether the market can swiftly disentangle the effects of D&O insurance proceeds from the settlement amount. Specifically, since D&O insurance proceeds offset the cost of shareholder litigation, they should be positively related to abnormal returns surrounding the litigation filing. 6 As a result, I state my first hypothesis in two parts, as follows: H1a: In the anticipatory period of the litigation filing, abnormal returns will be negatively (positively) related to the settlement amount (D&O insurance proceeds). H1b: In the event period of the litigation filing, abnormal returns will be negatively (positively) related to the settlement amount (D&O insurance proceeds).
Note that some policies contain provisions that nullify coverage in cases of outright fraud or illegal action. However, because both the plaintiffs and the defendants incentives are to settle, final adjudication rarely takes place. Therefore, these provisions are seldom invoked. 5 It is not the purpose of this paper to investigate why firms do not voluntarily disclose details of their D&O insurance policies. However, see Griffith (2005 p.1186) for a thorough discussion of potential reasons. 6 Note that other costs to a firm, such as increased insurance premiums or loss of coverage, may increase following the provision of proceeds from insurance companies to cover large settlements.
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Prior research has also demonstrated that losses due to legal penalties are a fraction of a broader penalty imposed by the market for malfeasance (Karpoff, et al 2008; Gande and Lewis 2009). Therefore, I expect that each dollar of settlement creates a loss in market value that exceeds one dollar (i.e., the market losses associated with the class action filing exceed the amount of cash required to settle the case). This implies that the cost of capital increases beyond that of a simple cash flow effect. Therefore, I state my second hypothesis as follows: H2: The loss in firm market value surrounding the litigation filing will exceed the cash required to pay the settlement My third hypothesis relates to the timing of when settlement and D&O remuneration information is incorporated by the market. If the market anticipation is governed simply by the amount the firm is expected to pay to settle the lawsuit, and the information regarding both loss ingredients is equally available to the market, then the settlement amount and D&O proceeds will respond in equal and opposite directions. However, as discussed previously, the SEC does not mandate D&O disclosure for U.S. public filers, although this does not preclude the possibility that companies may voluntarily disclosure this information. Timing differences between when settlement and insurance information is available to the market could lead to differential effects of the two factors. Additionally, differences in the way a dollar of loss is priced could depend on the mix of settlement amount and D&O proceeds to which it relates. To investigate this issue, I state my third hypothesis in the null form: H3: The loss response to a dollar of settlement and a dollar of D&O proceeds is equivalent. Prior to the announcement of a substantial lawsuit, there may be little interest in the existence or limits of D&O insurance policies. If a lawsuit becomes immanent or is formally filed, investors are then likely to seek out the details of such policies. However, it may be difficult for shareholders to access such information since prior research indicates that managers may be unwilling to disclose the loss exposure associated with significant lawsuits (Desir et al. 2010). Additionally, even if an investor does learn that a company has D&O insurance with a substantial policy limit, uncertainty may exist about whether such a policy applies to a given case. This would suggest that the effect of future D&O insurance proceeds are less clearly reflected in market prices than are future settlement amounts. Therefore, I state my final hypothesis as follows: H4: The uncertainty that surrounds D&O proceeds is greater than the uncertainty surrounding settlement proceeds. III. Sample Selection and Methodology My initial sample is composed of 2,763 firms that were subject to federal class action security lawsuits during the period 1996-2009, obtained from the Stanford Securities Class Action Clearinghouse (SSCAC) database. The sample is then restricted to firms that experienced a lawsuit which resulted in a financial settlement, reducing the sample to 1,052. I also require the defendant firm to be included in the Center for Research in Securities Prices (CRSP) returns database as well as the Compustat database as of the filing date. This reduces my sample size to 585 firms. I then hand collect information about the class action filing date, settlement amount, proposed settlement date, D&O proceeds amount, and final court approval date from the legal filings accessed through SSCAC. I delete firms that announce earnings in the (-10, 1) window relative to the class action filing. Firms in the top and bottom 1% of the settlement and loss variables are also excluded to limit the impact of outliers. This further reduces my sample to 384 class action settlements from 1996 to 2009. 440
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Table 1 presents the sample distribution by industry. The largest industry represented in my sample is information technology (31%), followed by health care (20%), consumer discretionary products (17%), industrials (12%), and financials (7%). Figure 2 presents the sample observations by the year in which the class action lawsuit was filed. As demonstrated in the figure, the number of annual filings in my sample peaked between the years 2002-2004 before slightly declining in recent years. I separately classify settlements that were fully covered by D&O proceeds, settlements that were partially covered by D&O proceeds, and settlements that were fully funded out of pocket by the respective firms. As can be seen in the figure, the size of the class action settlements in my sample did not change dramatically over the duration of the sampling window. Insert Table 1 about here Insert Figure 2 about here Following standard event study methodology, I calculate market-adjusted abnormal returns using a CRSP value-weighted benchmark for each firm. Daily abnormal returns are calculated as the actual return less the market return: AR R R (1) where R is the rate of return for stock j on day t and R is the CRSP value-weighted index on day t. I then calculate cumulative abnormal returns over the event window [ , ]: CAR , = AR (2) Following Gande and Lewis (2009), I use three main return windows relative to the filing of the litigation: an anticipatory window of (-10, -1), an event window of (-1, +1), and a subsequent window of (+1,+10). I convert all abnormal returns into losses by computing the daily dollar effect, DE, equal to the daily change in market value: DE P SHARES_OUT AR (3) where SHARES_OUT equals the shares outstanding for firm j at period t-1. Next, I sum the changes over the window from w1 to w2 where w denotes the chosen windows relative to the lawsuit announcement (w1, w2): DE (4) LOSS w , w I then use the following specification to test the hypotheses: LOSS w , w =1+2SETTLEMENT_AMT + 3D&O_PROCEEDS + kCONTROLk+ (5) where LOSS is equal to the change in market value from equation (4). On the right side of equation (5) is the amount the lawsuit was eventually settled for (SETTLEMENT_AMT) as well as the D&O proceeds contributed toward the settlement by the insurance carrier(s) (D&O_PROCEEDS) as well as standard event study control variables. This specification lends itself to an intuitive interpretation; such that the 2 and 3 coefficients represent the impact that one dollars worth of future cash settlement outlays or D&O proceeds, respectively, has on the market loss (i.e. a one dollar increase in settlement amount is associated with a 2 dollar increase on the loss sustained). IV. Results Table 2 presents the descriptive statistics for my sample. As disclosed in panel A, the mean (median) settlement amount was $14,866,627 ($6,000,000), while the mean (median) D&O remuneration was $8,881,768 ($4,650,000). The mean (median) amount of cash paid out of pocket by firms to settle a class action settlement was $5,766,747 ($0), and the mean (median) 441
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insurance remuneration was 76% (100%) of the total settlement amount. This suggests that the cash impact that a settlement typically has on a firm is small and that a significant portion of firms are covered by insurance policies that substantially shield them from directly paying proceeds in securities settlements. Within my sample of settlements, 44 were fully covered by the defendant firm (12%), 116 were partially covered by the firms insurance carrier (30%), and 224 (58%) were fully covered by the insurer. Insert Table 2 about here Consistent with prior research, such as Karpoff et al. (2008), I find that the filing of a class action security lawsuit has a substantial impact on a firms market value. Figure 3 shows that daily abnormal returns begin to drift downwards approximately 10 days prior to the lawsuit filing. For the two-week period leading up to the filing of the lawsuit (-10, -1) the mean (median) amount of market value loss is approximately 135.2 (25.3) million dollars. The event period (-1, 1) is associated with mean (median) three day losses of about 34.8 (5.7) million dollars. Finally, during the subsequent period, the mean (median) change in market value during the subsequent period is a gain of 2 (loss of 3.4) million dollars. Insert Figure 3 about here Table 3 reports the estimates of the regression specified in equation (5) for each of the three return windows. I disaggregate my sample of settlements using three partitions: settlements that were entirely funded by the company (COVERAGE=0%), settlements that were entirely funded by the D&O carrier (COVERAGE=100%) and settlements that were partially funded by both parties (0%<COVERAGE<100%).7 I focus my analysis first on the latter partition, as this allows us to directly compare the effects of D&O proceeds and settlement proceeds for the same sample of litigation. For this sample, I find that market returns are positively related to the D&O proceeds, both during the anticipatory window (coefficient of 9.20) and the event window (coefficient of 17.96), but negatively related to the settlement amount during the anticipatory, event, and subsequent windows (coefficients of -8.39, -9.90 and -4.52, respectively). As a result, H1a and H1b are supported. It appears that the market is able to disentangle the D&O proceeds from the total settlement amount, suggesting that D&O insurance mitigates the negative consequences of securities litigation on firm share price. For firms whose settlements were entirely funded by the defending firm (COVERAGE=0%) I find a negative relationship between the settlement amount and returns during the anticipatory period (coefficient of -4.46), again suggesting that the market punishes firms that it anticipates will have to fund class action settlements out of pocket. Insert Table 3 about here My second hypothesis considers whether the market loss associated with a class action settlement exceeds the cash value of that settlement. For the two partitions where settlement amounts are funded directly by the firms (COVERAGE=0% and 0%<COVERAGE<100%), the magnitude of the response (the SETTLEMENT coefficient) ranges from -$4.46 to -$9.90 for each settlement dollar. This indicates that the market response to an anticipated settlement exceeds the simple cash effects of that settlement on the respective firm. As a result, hypothesis two is also supported. In order to test my third hypothesis, I measure whether the market response to a dollar of settlement and a dollar of D&O proceeds is equivalent. To perform this analysis, I focus on the
7
I first test to see if the structure of the data lends itself to pooling the high, medium and low coverage partitions. The Chow F-test rejects the hypothesis that the coefficients are the same for each group. Therefore, I do not pool the partitions.
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partition for which settlements were partially self-funded and partially covered by D&O insurance (0%<COVERAGE<100%), as this partition allows us to directly compare and . Interestingly, these coefficients differ during the event period, indicating that the effect of $1 of D&O insurance proceeds is interpreted differently than $1 of settlement amount. Specifically, the coefficient estimate of 17.96 for the D&O proceeds versus -9.90 for the settlement amount suggests that a dollar of D&O insurance preserves more value than a dollar of settlement destroys (P[ =- ] <.001, F=46.68) This may indicate that there are timing differences between when settlement amounts and expected D&O proceeds are impounded in the market price of a firms securities. My final hypothesis states that the uncertainty which surrounds D&O proceeds is greater than the uncertainty which surrounds the settlement amount. In the event period, the standard error for 2 (the D&O proceeds coefficient) is 3.29, which is significantly larger than the standard error for 3 (the settlement coefficient) of 2.19. This difference persists for each of the three windows under examination. Thus, my fourth hypothesis is also supported. V. Conclusion This study examines the effect of D&O insurance proceeds on the market reaction to class action lawsuit filings. Using a sample of securities class action lawsuits that resulted in a financial settlement between the years 1996-2009, I explore the relationship between abnormal market returns, the final settlement amount, and the settlement proceeds provided by D&O liability insurers. My results provide initial evidence that the market is able to disentangle D&O proceeds from class action settlement amounts, as I find a significant and positive correlation between such proceeds and market returns during both the anticipatory and event periods. This finding suggests that the market considers the expected proceeds from D&O insurance policies when evaluating the impact of litigation on a firms share price. As a result, such proceeds appear to be an important ingredient in determining how shareholders will respond to class action securities litigation. I also find that the market response to expected settlement proceeds significantly exceeds the cash value of the settlement. Specifically, my results suggest that the magnitude of the markets response is approximately four to ten times greater than the simple cash effects of the settlement on the respective firm. This finding is consistent with prior research (e.g., Karpoff et al. 2008; Gande and Lewis 2009) which indicates that penalties imposed by the market on malfeasant firms significantly exceed those of the legal system. My results also indicate that, during the event period, the amount of market value preserved by a dollar of insurance proceeds is roughly double the market value destroyed by a dollar of settlement, suggesting that timing differences may exist between when expected settlement and D&O coverage information is available to the market. Additionally, I find that there is greater uncertainty in the markets response to D&O proceeds than to settlement amounts, presumably due to the fact that D&O particulars are more difficult for market participants to access. These findings have significant implications for academic researchers and policy makers. They provide initial empirical evidence to support the claim that D&O particulars are value-relevant to investors and should inform the ongoing policy debate as to whether mandatory disclosure of D&O particulars should be required by U.S. regulators. While my market response measures suggest that information concerning a firms D&O coverage is partially available to the market, the significantly greater response to D&O proceeds suggest that timing differences may exist between when both ingredients are impounded in the market price of a firms securities. This is also supported by the finding that the market incorporates D&O proceeds with greater uncertainty than settlement amounts. As a result, my study provides initial evidence that 443
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mandatory disclosure of D&O particulars could potentially increase the efficiency by which such information is reflected in market prices. My results also indicate that D&O insurance proceeds significantly preserve the market value of firms shares, which suggests that such coverage partially mitigates the negative market consequences of shareholder litigation. Thus, if the market is viewed as an important mechanism through which malfeasant firms are penalized, the existence of D&O insurance coverage may weaken the ability of the market to impose sanctions on firms found guilty of corporate misconduct (Chalmers et al. 2002; Baker and Griffith 2006). My study also offers a number of possibilities for future research. For example, I focus on the effects of shareholder litigation and D&O insurance proceeds on firm market value, however I do not examine how the two variables combine to penalize individual managers. Additionally, I do not examine how the filing of shareholder litigation penalizes firms through indirect mechanisms such as higher financing costs, or increased insurance premiums. Examinations into these areas may shed additional light into the ways shareholder litigation and D&O insurance jointly impact the operation of the capital markets. Overall, this study provides initial evidence that the market can anticipate when firms subject to litigation will be indemnified by D&O insurance. As a result, insurance coverage appears to be an important ingredient that investors consider when making trading decisions. As a result, regulators and policymakers should be careful to consider the impact of this variable when establishing disclosure rules and penalties for financial misconduct. References Baker, T. and S.J. Griffith, 2007, Predicting corporate governance risk: Evidence from the directors and officers liability insurance market, Chicago Law Review, 74: 487-544. Black, B.S., B.R. Cheffins, and M. Klausner, 2006, Outside director liability, Stanford Law Review, 58: 1055-1159. Boubakri, N. and N. Ghalleb, 2008, Does mandatory disclosure of directors and officers liability insurance curb managerial opportunism? Evidence from the Canadian secondary market, Working paper, HEC Montreal and King Fahad University. Boyer, M..M., and M. Delvaux-Derome, 2002, The demand for directors and officers insurance in Canada, Working paper, HEC Montreal. Boyer, M.M. 2003, Is the demand for corporate insurance a habit? Evidence from directors and officers insurance, Working paper, HEC Montreal. Chalmers, J.M.R., L.Y. Dann, and J. Harford, 2002, Managerial opportunism? Evidence from directors and officers insurance purchases, The Journal of Finance, 57: 609-636. Coffee, J.C. 2006, Reforming the securities class action: An essay on deterrence and its implementation, Columbia Law Review, 106: 1534-1586. Core, J.E. 1997, On the corporate demand for directors and officers insurance, The Journal of Risk and Insurance, 64: 63-87. Core, J.E. 2000, The directors and officers insurance premium: An outside assessment of the quality of corporate governance, The Journal of Law, Economics, and Organization, 16: 449-476. Cornerstone Research, 2010, Security class action filings: 2009 a year in review, http://securities.stanford.edu/clearinghouse_research/2009_YIR/Cornerstone_Research_F ilings_2009_YIR.pdf
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Desir, R., K. Fanning, and R. Pfeiffer, 2010, Are revisions to FAS 5 needed? Accounting Horizons, 24: 525-545. Gande, A. and C.M. Lewis, 2009, Shareholder initiated class action lawsuits: Shareholder wealth effects and industry spillovers, Journal of Financial and Quantitative Analysis 44: 823850. Griffith, S.J., 2005, Uncovering a gatekeeper: Why the SEC should mandate disclosure of details concerning directors and officers liability insurance policies. University of Pennsylvania Law Review 154: 1147-1207. Holderness, C.G., 1990, Liability insurers as corporate monitors. International Review of Law and Economics, 10: 115-129. Karpoff, J.M., D.S. Lee, and G.S. Martin, 2008, The cost to firms of cooking the books. Journal of Financial and Quantitative Analysis, 43: 581-461. OSullivan, N., 1997, Insuring the agents: The role of directors and officers insurance in corporate governance, Journal of Risk and Insurance, 64: 545-556. ___________., 2002, The demand for directors and officers insurance by large U.K. companies, European Management Journal, 20: 574-583. Romano, R., 1991, The shareholder suit: Litigation without foundation? Journal of Law, Economics, and Organization, 7: 55-87. Ryan, E.M. and L.E. Simmons, 2010, Securities class action settlements: 2009 review and analysis, Cornerstone Research. Towers & Perrin, 2004, Directors and officers liability: Understanding the unexpected. http://www.towersperrin.com/tillinghast/publications/reports/2004_D_O/2004_DO_Exec _Sum.pdf Towers & Perrin, 2009, Directors and officers liability: 2008 survey of insurance purchasing trends.http://www.towersperrin.com/tp/getwebcachedoc?webc=USA/2009/200908/DO_S urvey Report_2008_FINAL.pdf
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Table 1: Sample Observations by Industry Represents all firms included in the COMPUSTAT and CRSP databases that were subject to a class action securities lawsuit which resulted in a financial settlement. Firms in the top and bottom 1% for settlement amount or cumulative abnormal returns are excluded in order to limit the impact of outliers. GICS Code 10 15 20 25 30 35 40 45 50 55 Industry Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials Information Technology Telecommunications Utilities TotalFirms 7 8 46 64 17 75 25 121 11 10 n = 384
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International Research Journal of Applied Finance Vol III Issue 4 April, 2012 Table 2: Descriptive Statistics
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This table provides descriptive statistics for all 384 firms in my sample. Panel A includes all sample firms while Panel B provides statistics for the three relevant subsamples: firms whose settlements were fully, partially, and not at all covered by D&O proceeds.
Panel A: All Firms Mean SETTLEMENT DO FIRM PAID MKVALT COVERAGE TOTAL ASSETS CAR (-10,1) MV Change (-10, -1) MV Change (-1, 1) MV Change (2, 10) 14,866 8,882 5,766 1,925 76% 3,655 -0. 17 -135,222 -34,776 1,986 Median 6,000 4,650 0 321 100% 336 -0.07 -25,259 -5,682 -3,361 Std. Dev 27,795 12,860 20,461 5,376 37% 16,184 0.16 313,215 291,255 365,761
Panel B: By Amount of D&O Coverage COVERAGE=0% Mean Median SETTLEMENT DO FIRM PAID MKVALT COVERAGE TOTAL ASSETS CAR (-10,1) MV Change (-10, -1) MV Change (-1, 1) MV Change (2, 10) N 14,809 0 14,809 7,194 0% 8,229 -0.11 -49,277 -61,415 9,872 44 200 0 200 458 0% 425 -0.05 -18,874 -10,290 557 Std. Dev 31,712 0 31,712 24,627 0 29,135 0.38 225,540 206,675 527,937 0%< COVERAGE <100% Mean Median Std. Dev 28,106 15,194 12,759 2,107 62.3% 2,842 -0.23 -151,361 -34,715 -7,396 116 11,575 8,740 2,694 401 65.5% 390 -0.18 -30,007 -4,261 -2,088 38,779 17,847 27,851 5,181 .25 6,930 0.30 350,593 470,516 462,618 COVERAGE =100% Mean Median 7,497 7,497 0 1,229 100% 4,487 -0.21 -147,613 -28,651 15,478 224 4,750 4,750 0 253 100% 288 -0.13 -25,328 -4,985 -4,058 Std Dev. 9,040 9,040 0 3,411 0 21,155 0.30 309,798 157,690 242,308
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International Research Journal of Applied Finance Vol III Issue 4 April, 2012 Table 2 (continued)
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Variable definitions: SETTLEMENT = The total amount of the class action settlement, expressed in thousands DO = The settlement amount which was paid by the firms D&O insurer(s), expressed in thousands FIRM PAID = The settlement amount which was paid by the respective firm (i.e., not by the firms D&O insurers), expressed in thousands MKVALT = The firms market value as of the event date (the class action filing) COVERAGE = The settlement amount which was paid by the firms D&O insurer(s) expressed as a percentage of the total amount of the class action settlement TOTAL ASSETS = The firms total assets as of the event date (the class action filing) CAR (window) = The firms total cumulative abnormal returns for the event window MV Change (window) = The change in the firms market value for the event window
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Table 3: Regression Results a This table provides the results of separate regressions of cumulative abnormal returns for the three relevant subsamples (firms whose settlements were fully, partially, and not at all covered by D&O proceeds) by event window.
COVERAGE=0% Return Window Intercept D&O_PROCEEDS SETTLEMENT MKVALT Adjusted-R2 p(2=-3) -4.46
**
0%< COVERAGE <100% (2,10) (-10,-1) (-1,1) -105,994 -72,436 9.20* 17.96***
***
COVERAGE =100% (-10,-1) (-1,1) 3,181 2,781 -7.99*** -6.06***

***
(-10,-1) 15,338*
(-1,1)
(2,10) -5,414 5.46 -4.52

***
(2,10) 113,628** -0.95 -11.62

***
-18,597 12,230 -0.14 1.66 -106.35 0.58
-8.39
-9.90
***
-26.75***
***
-17.10* 40.47*** -57.16 0.23
-33.88*** 16.69* -187.64 -254.56 0.23 .98 0.33 .000
16.00 -104.22 -0.045 .86
-50.30*** -2.98 -36.97 0.33 63.27 0.21
LAG_ACCRUALS -623.76 0.29
240.06** 0.13
a= Year fixed effects are included but unreported in the analysis. Their inclusion alters the explanatory power (Adj-R2) of the equations by approximately 4%. Variable definitions: D&O_PROCEEDS = The settlement amount that was paid by the firms D&O insurer(s) SETTLEMENT = The total amount of the class action settlement MKVALT = The firms market value as of the event date (the class action filing) LAG_ACCRUALS = The firms lagged discretionary accruals
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Figure 1: Securities Class Action Timeline This figure represents the typical chain of events surrounding the filing of a class action securities lawsuit which results in a financial settlement.
Figure 2: Sample Class Action Filings by Event Year Represents all firms included in the COMPUSTAT and CRSP databases which were subject to a class action lawsuit which resulted in a financial settlement. Firms in the top and bottom 1% for settlement amount or cumulative abnormal returns are excluded in order to limit the impact of outliers.
50 42 40 37 31 30 25 27 24 36 32 28 42 37
20 14 10 9
0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
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Figure 3: Daily Abnormal Returns Figure represents the daily cumulative abnormal returns for my sample of 384 firms relative to the filing of the class action security lawsuit.
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Determinants of bank failures? Evidence from US failed banks
Abdus Samad Department of Finance and Economics Utah Valley University 800 W. University PKY UT abdus.samad@uvu.edu
Lowell M. Glenn Department of Finance and Economics Utah Valley University 800 W. University PKY, UT
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Abstract This paper analyzes how internal bank operations factors can be used to predict the potential for U.S. bank failures during the years 2008-2009. The authors use a Probit statistical model to analyze factors obtained from bank balance sheets and income statements to determine which of those specific factors have the most influence in predicting bank failures. Among the CAMEL variables used in the analysis it was determined that, T1RBCATA, TRBCRWA, ROA, ASTEMPM and EFFICR were all found to be highly significant in predicting bank failures during 2009. The five factors described above were found to correctly predict 86.4 percent of total bank failures as well as 86.4 percent of why non-failed banks survived the economic conditions extant during the same period. These variables also provided an accurate prediction for combined failed and non-failed banks, again with an 86.4 percent level of accuracy. Policy prescriptions are suggested. Keywords: Bank failure, Capital, Assets, Management, Efficiency and Liquidity JEL Classification: F21, G20, G21 I. Introduction A large number of commercial bank failures occurred during the years 2008 and 2009 resulting in the most severe example of this phenomenon in the financial history of the United States since the Great Depression of 1929-1933. There were twenty-five (25) bank failures in 2008 and another eighty-two ( 82) banks that failed during the first nine months of 2009. This expansion in the number of bank failures has resulted in a significant increase in the costs to taxpayers because of the processes involved in resolving bank failures in the United States. Therefore, there is real value in being able to predict these types of phenomenon and develop public policies to better deal with these types of costs. That is why this analysis of the determinants of bank failures and the development of processes for predicting techniques to avoid failure is so important. If these processes can be implemented to reduce the number of bank failures millions of dollar losses of bank assets and taxpayers money to deal with these issues can be avoided. The analysis suggests that bank failures occur for a variety of factors aside from the deterioration of general macroeconomic conditions. Identifying those factors that result in the failure of a particular bank is an important first step in reducing the types of problems that occur. The detecting and understanding of the underlying factors associated with bank failures will assist bank manages better manage their institutions. It will also assist bank regulators supervise banks more efficiently if they have the ability to predict failing verses successful processes in bank operations and thereby take appropriate regulatory actions to reduce the occurrence of bank failures. The ability to better predict bank success/failure using these financial data has the potential of reducing the cost of monitoring banks, improving the efficiency of on-sight examinations, and reducing FDIC expenditures in resolving bank failure situations. (Thomson, 1991; Whalen and Thomson, 1988). Commercial banks along with other business firms are subject both to external risk (systematic risk) and firm specific risk (often characterized as internal risk). External factors such as recession, natural catastrophes, etc., affect all institutions equally. Given these general economic conditions, then it is the managers of these entities and their ability to control internal factors or combinations of factors that best determines how some banks fail while others succeed. Identifying these factors is important for bank managers, bank regulators, and bank examiners to better accomplish their purposes. There are a variety of alternative CAMEL ratios that have the potential for identifying bank performance issues. (See Appendix A) Identifying which factors among those CAMEL variables have the potential for better predicting bank failures as contrasted to suggesting continued successful operations, is an important contribution of this paper. 453
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The paper includes the following organizational elements. Section II provides a survey of relevant literature. Section III describes data and methodology. Section IV provides the empirical results, some conclusions and policy recommendations. II. Survey of the literature There is an extensive volume of literature on bank failure/closing, therefore, it is inappropriate to provide a complete review of that material for this paper. Instead, the authors will limit the review to those materials that directly relate to the more specific criteria and processes that are evaluated in this analysis. Thomson (1991) studied the factors that influenced commercial bank failures during 1980s. In his paper, he estimated the factors influencing his model using logit regression methods and found the probability of a bank failure was related to, among others, the variables affecting its solvency, and asset and management quality. He also found that the economic environment in which banks operated affected the probability of bank failure. In predicting bank failures, Meyer and Pifer (1970) examined the causes of bank failure using an OLS linear regression model which was subject to various criticisms. Subsequent research suggested that the OLS linear regression approach was less effective in its predictive powers than alternative approaches. Even so, their empirical paper found that internal bank data explained many of the reasons for the failure of these institutions. Many failures resulted from such factors as embezzlement and other financial irregularities, as contrasted to normal financial concepts that are generally used to measures the relative strength of banks. They found that with a lead time of one or two years, approximately eighty percent of the observations are correctly classified, and the R2 is about 0.70 (p.867). Based on the 1988 Basel Capital accord, Estrella, Park, and Perustuani (2000) examined the effectiveness of three capital ratios as a means for analyzing bank failures. Using the 19881993 data for U.S. banks, they observed that the simple leverage and gross revenue ratio, were the best two of the three ratios for predicting failure over a single year or two-year horizon. Martins (1977) paper sought to construct an early warning model for bank failure as a function of several variables classified into four categories: asset risk, liquidity risk, capital adequacy, and earning and asset risk. He used a logit regression model and found that each of these factors had an impact on a banks likelihood of failure. The model used historical data for U.S. banks which were members of the FED. The two most significant factors in predicting failures were gross capital to risk assets, ( significant at a 0.99 level) and commercial loans to total loans also at the .99 level of significance. Pantalone and Platt (1987) also analyzed issues causing bank failure during the period following deregulation in the 1980s. In their model, they used management efficiency profitability, leverage, risk diversification, and the economic condition of the state. They found that the principal cause of bank failure was basically the same during the post deregulation period as it was prior to deregulation, i.e., poor bank management, resulting in excess risk taking or lack of controls that permits fraud and embezzlement. (p. 38). Sinkey (1975) applied univariate and bivariate (risk-return analysis) statistical procedures to the United States National Bank of San Diegos (USNB) balance-sheet and income statement characteristics prior to its collapse. He found that USNB had several performance measures that were below average compared to the California control banks. In another study (1975) by the same author, he focused on the identification and characteristics of problem banks compared with non-problem banks. Empirical results suggested there were statistically significant differences between the two groups. The average problem bank had specific financial difficulties one year prior to the detection of those problems by bank examiners. Apilado and Gies (1972) examined and performed capital adequacy hypothesis testing using several measures of capital adequacy for the period 1935-1969. Their test found some differences in the aggregate comparisons of capital adequacy, but there were problems in using 454
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the measures for determining how capital adequacy was useful in measuring the causes of why individual banks or groups of banks failed. Samads analysis (2011) examined failed and non-failed banks using ANOVA and KrosKal Wali tests and found there were significant differences in capital adequacy ratios between failed and non-failed banks. Failed banks had significantly lower capital ratios. This survey of the literature (exclusive of Thomson (1991) and Meyer and Pifer (1970)), demonstrates that the current analysis is different from previous studies in several respects. First there is the use of the Probit statistical model and secondly by identifying CAMEL variables as significant factors in predicting bank failures. There are two additional perspectives which this analysis contributes to the historical bank failure literature. This analysis directly identifies failed banks whereas almost all the previous studies used banks that were classified as problems banks. In addition, this paper uses a cross sectional analysis with a large number of bank failures whereas all previous studies dealt with a small number of banks classified as problem banks. The previous studies had to pool the failure across several years to obtain a sufficiently large sample of failed bank data, whereas this study directs the analysis to a more specific period of time and directly assesses the issues that led to the failure of these institutions. III. Data and Methodology This analysis addresses data on bank failures that occurred in 2009. The data was drawn from three different time frames prior to the date on which each of the varied banks actually failed. The information was obtained from the call reports of the FDIC using the agencys web site: www.fdic.gov A total of 280 banks were studied in this paper. Of that 280 banks, 140 failed during the period the data was collected and an equal number of 140 continued to operate successfully. In order to avoid any bias related to external economic factors that could result from the impact of state conditions on the failed banks, an equal number of non-failed banks was taken from the same states where the failed banks were located. Thus, the number of failed banks from each state is matched by an equal number of successful banks from the same state with similar sizes and characteristics. The internal variables analyzed in this study are those which were within the control of bank management. All the internal variables used in this paper were obtained from bank balance sheets and income statements. Data were collected for three periods prior to the date of the failure of the bank: six months previous to closing, one year previous to closing, and year and half before closing to see which of the three periods better predicts the banks failure. Thus, if a bank were officially declared as a failure in June 2009, the data variables for the bank were taken from the balance/ income statements of December 31, 2008, June 30, 2008 and December 2007. Eternal factors such as the unemployment rate, income growth within the state, etc., are outside the control of bank management and are, therefore, excluded from this analysis. The objective of this paper is to identify factors that have a significant impact on bank failure. To this end, the probit statistical model is relatively more useful in evaluating these issues than the Logit model. Because the conditional probability Pi approaches zero or one at a relatively higher rate in Probit than in the Logit approach. (Gujrati, 2003). The specifics of the Probit Model are: Pr Yi=1|Xi, )= 1-(-Xi )= (Xi ) (1) Where is the cumulative density function of the standard normal distribution which takes a real value ranging between zero and one The probability function used in the probit model is the standard normal distribution. The assumption of this distribution function, is that it is symmetric around 0 with a variance equal to 1, and bounded between 0 and 1. (Amemiya, 1981). Using the conventions of notation, the estimated model can be written in general form: 455
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Pr(Yi=1) = F(xi1, xi2,xiM, 1, 2,) (2) Where Yi is the dependent variable which represents the final outcome: Yi = 1 for failed banks, Yi=0 for successful banks. Xi are the number of explanatory variables that have impact on bank failure or success; Xij the value of ith variable for the ith observation. 1, 2 coefficients associated with explanatory variable Xi are estimated in the sample. In compact notation, (2) can be stated as: Pr(Yi=1) =(Xit+ Ut) (3) Where Y=1, Y=2, Y=3 are dependent variables representing failure or success ( Yi = 1 for failed banks, Yi=0 for successful banks) Xit is a (1x k) vector of explanatory variables used and is a (k x 1) vector of unknown parameters to be estimated. Ut is the white noise. Then the observed dependent variable Yi*, is determined by whether y exceeds a threshold value, 0.5, in this paper. That is, Yi .. Robustness i.e. expectation prediction of the model as well as the likelihood ratio (LR) statistics will be examined. The LR statistics tests the joint null-hypothesis that all slope coefficients are simultaneously equal to zero and is computed as -2(l()/l(). Bank failures may occur for a variety of factors. These factors may be classified into two broad categoriesexternal and internal. External factors are the general conditions of economy, economic condition of the county or city where banks operate, the growth rate of population and employment, etc. Since the general condition of the economy affects all business firms, including banks, in a similar fashion and banks have no control over them, this paper focuses on the internal factors of bank performance. Internal factors are bank specific factors and are derived from the balance sheets and income statements of banks. These factors play an important role in the survival or failure of a bank and referenced in the literature of bank failure analyses (both failures as well as identifying problem banks). This study specifically uses CAMEL rating factors (variables for estimating the prediction of bank failures). Regulators use these variables during on-site examinations to determine a banks condition. These variables are drawn from the extensive literature on bank failures and are defined as: Dependent variable: Yi is binary variable: Y=1 for failed banks; Y=0 for survived banks Independent variables/regressors: Capital adequacy The following two measures are considered for capital adequacy: T1RBCATA = Tier 1 risk based capital to risk weighted assets. TRBCRWA= Total risk based capital as a percentage of risk weighted assets. All of the above ratios are expected to have negative relation with bank failures, Y=1 i.e. the higher the ratio, the lower the bank failures i.e. <0 and <0 Asset quality Two measures are considered for asset quality. NCOFFL= Net charge off to loans. Gross loan and lease financing receivable chargeoffs, less gross recoveries, (annualized) as a percent of average total loans and lease financing receivables. NPLTA= Noncurrent assets as a percent of total assets. Noncurrent assets are defined as assets that are past due 90 days or more plus assets placed in nonaccrual status plus other real estate owned (excluding direct and indirect investments in real estate). 456
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Both of the two ratios, NCOFFL and NPLTA , are expected to be positively related to bank failures. >0 and >0 i.e. the higher the ratio the higher bank failures, Y=1. Management quality The two most widely used measures of management quality are: ROA= Net income to total assets. It measures net income per $ asset. ROE= Net income to equity capital. It measures net per $ bank equity capital. Both ROA and ROE are expected to have a negative relationship with bank failures, Y=1. That is, <0 and <0. The higher the ratios, the lower the bank failures, Y=1. Efficiency Two measures of inefficiency are considered: Efficiency ratio (EFFICR) and assets per employee (ASTEMPM) ratio. EFFICR= Noninterest expense, less the amortization expense of intangible assets, as a percent of the sum of net interest income and noninterest income. ASTEMPM= Total assets in millions of dollars as a percent of the number of full-time equivalent employees. It is expected that <0 and 0 or 0. EFFCR is expected to have negative impact on bank failures, i.e. the higher the ratio the higher the inefficiency of a bank and the greater the bank failures, Y= 1. Similarly, ASTEMPM is expected have negative or positive relation with bank failure depending upon economies of asset utilization. Liquidity risk NLNLSD= Net loans and leases to deposits. Loans and lease financing receivables net of unearned income, allowances and reserves as a percent of total deposits. NLNLSCD= Net loans and leases to core deposits. Loan and lease financing receivables, net of allowances and reserves, as a percent of total domestic deposits, less time deposits of $100,000 or more held in domestic offices. While the assumption is made that all demand, savings and time deposits under $100,000 are 'core', there is no way of determining the degree of interest rate sensitivity of various categories of deposits. Both these variables, NLNLSD and NLNLSCD, are expected to be positively related to bank failure, Y. >0 and >0 i.e. the higher the ratio the higher bank failures, Y=1.
Non CAMEL variable SIZE= Natural logarithm of total assets. We include SIZE in our model to control for the too big to let fail doctrine (Thomson, 1991). Two models are estimated with the above variables to see which of the CAMEL variables provides a more accurate prediction: 457
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Yi = + 1T1RBCATA + 2NCOFFL + 3ROA + 4EFFICR + 5NLNLSCD+ U (4) Yi = + 1TRBCRWA + 2NPLTA + 3ROE + 4ASTEMPM + 5NLNLSD+ U (5) Both models are estimated by EVIEW. Results of the models are provided in the empirical section. IV. Empirical Results Results of two Probit models are presented in Table 1 and Table 2 and the predictive power of the variables are presented in Table 3 and table 4 respectively. Table 1 (insert here) shows that three of the five CAMEL variables such as Tier 1 risk based capital to average assets, T1RBCATA, return on assets, ROA, and efficiency ratio, EFFICR are significant factors in explaining bank failures. Statistical significance for T1RBCATA, ROA, and EFFICR factors is determined by their respective probability 0.0000, 0.0000 and 0.0068. The high p- value 0.3958 and 0.3917 associated with liquidity measure, NLNLSCD and net charge off to loans, NCOFFL respectively suggests that they are not significant factors for explaining bank failure, although their signs are consistent as expected in the model. Signs for all five variables are consistent as per expectation of the model. The negative signs for T1RBCATA, ROA, EFFICR, and NCOFFL suggest that the higher the T1RBCATA, ROA, EFFICR, and NCOFFL the lower probability of bank failures. The test of null hypothesis that all the slope coefficients are jointly equal to zero is rejected. Collectively, all the coefficients are statistically significant, since the value of LR statistic is 211.16 with a p-values of 0.0000. Although NCOFFL and NLNLSCD are not statistically significant, together all regressors have a significant impact on bank failure as LR statistic is highly significant. Table 2 (insert here) shows that three of the five CAMEL variables such as total risk based capital as a percentage of risk weighted assets, TRBCRWA, noncurrent assets a percentage of total assets, NPLTA and efficiency ratio, ASTEMPM are significant factors in explaining bank failures. Among these three variables, TRBCRWA and NPLTA are highly significant factors with p-values 0.0000 and 0.0000 respectively. ASTEMPM are significant with a p-values 0.04. The high p- value 0.8371 and 0.3957 associated with ROE and the liquidity measure, NLNLSD suggest that they are not significant factors for explaining bank failure, although their signs are consistent as expected in the model. Signs for all five variables are consistent except for ASTEMPM . The test of null hypothesis that all the slope coefficients are jointly equal to zero is rejected. Collectively, all the coefficients are statistically significant, since the value of LR statistic is 209.56 with a p-values of 0.0000. Although ROE and NLNLSD are not statistically significant, together all regressors have a significant impact on bank failure as the LR statistic is highly significant. Table 3 (insert here) shows that the estimated model correctly predicts 86.43 percent of total bank failures. Out of total 140 failed banks, the model correctly predicts the failure of 121 banks. The models correct prediction for the successful banks is equally distributed. It correctly predicts 86.43 percent of dependent variable when Y=0 . With regard to combined prediction for failed and survived banks i.e. when Y=1 and Y=0 combined, the variables of the model provides 86.43 correct prediction. The models wrong prediction is only 13.57 percent. The estimated model improves on the Y=1 prediction by 86.43 percentage points, but does poorly on the Y=0 prediction (-13.57 percentage points). Overall, the estimated equation is 36.43 percentage points better at predicting responses than the constant probability model. This change represents 72.86 percent improvement over the 50 % correct prediction of the default model.
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The bottom portion of the equation contains analogous prediction results based upon expected calculations. Table 4 (insert here) shows that the estimated model correctly predicts 85.71 percent of the observations, 240 out of 280. The models correct prediction is equally distributed. It correctly predicts 85.71 percent of dependent variable, Y=1 and Y=0 observations. The estimated model improves on the Y=1 prediction by 85.71 percentage points, but does poorly on the Y=0 prediction (-14.29 percentage points). Overall, the estimated equation is 35.71 percentage points better at predicting responses than the constant probability model. This change represents 71.43 percent improvement over the 50 % correct prediction of the default model. The bottom portion of the equation contains analogous prediction results based upon expected calculations. V. Conclusions CAMEL variables are used in the Probit model for estimating their statistical impact on U.S. bank failure. The results of two models with their predictions are presented in Table 1 through Table 4. The analysis of two estimated models suggests that two measures of capital adequacy (Tier 1 capital to risk weighted assets,T1RBCATA and total risk based capital as a percentage of total assets, TRBCRWA), Return on assets (ROA), and two measures of efficiency (EFFICR and ASTEMPM) are significant factors for explaining the US bank failures. The estimated models correctly predict 85.71 percent to 86.43 percent of total observations. The correct prediction for Y=1 and Y=0 are both in the range between 85 and 86 percent. As both models suggest that the higher the capital adequacy ratio (T1RBCATA and TRBCRWA) the lower the bank failure potential. Bank regulators and bank managers should consider this variable as one of the significant factors for a sound bank management policy. References Amemiya, Takeshi. 1981. Qualitative Response Models: A Survey, Journal of Economic Literature, Vol. XIX, (December), pp.1483-1536. Apilado, V. R and T.G. Gies. 1972. Capital adequacy and commercial bank failure, The Bankers Magazine, (155), pp.24-30. Estrella, Arturo, Sangkyun Park, and Stavros Perustuani . 2000. Capital ratios as predictors of Bank Failure, Economic Policy Review, Vol. 6, (2), pp. 33-52. RFBSF Economic Letter. 1999. The Federal Reserve Bank of San Francisco, 99-19, pp.1-4. Gujrati, Damodar N. 2003. Basic Econometrics, McGraw-Hill Irwin, New York. Martin, Daniel. 1977. Early Warning of Bank Failure, Journal of Banking and Finance, Vol.1, pp. 249-276. Meyer, Paul A. and Howard W. Pifer. 1970. Prediction of Bank Failures , The Journal of Finance, Vol. 25, (4), pp. 853-868. Pantalone, Coleen C and Marjorie B. Platt. 1987. Predicting Commercial Bank Failure Since Deregulation, New England Economic Review, July/August, pp.37-47. Samad, Abdus. 2011. Is Capital Inadequacy a Factor for Bank Failure, Journal of Accounting and Finance, Vol. 11(4). Sinkey, Joshep F. 1975. Problem Banks; Identification and Characteristics, Journal of Bank Research, Vol. 5, pp. 208-217. Sinkey, Joshep F. 1975. The Failure of United States National Bank of San Diego, Journal of Bank Research, Vol. 6, pp. 8-24. Thomson, James. 1991. Predicting Bank Failures in the 1980s, Economic Review, Federal Reserve Bank of Cleveland, Vol. 27, (1), pp.9-20. Whalen, Gary and James Thomson. 1988. Using Financial data to Identify Changes in Bank Condition, Economic Review, Federal Reserve Bank of Cleveland, Vol. 27, (2), pp.1726 459
Tabular Presentations Table 1 Result of Probit for equation 1 : Dependent variable: Y (ML Method) Convergence achieved after 6 iterations Variable T1RBCATA NCOFFL ROA EFFICR NLNLSCD C Mean dependent var S.E. of regression Sum squared resid Log likelihood Restr. log likelihood LR statistic (5 df) Probability(LR stat) Obs with Dep=0 Obs with Dep=1 Coefficient Std. Error -0.343088 -0.057728 -0.359623 -0.003598 0.002369 3.141486 0.500000 0.319408 27.95380 -88.50005 -194.0812 211.1623 0.000000 140 140 0.047019 0.067977 0.072443 0.001329 0.002765 0.624948 z-Statistic -7.296835 -0.849228 -4.964214 -2.706473 0.856561 5.026797 Prob. 0.0000 0.3958 0.0000 0.0068 0.3917 0.0000 0.500895 0.675000 0.752889 0.706242 -0.316072 0.544005
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S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Avg. log likelihood McFadden R-squared
Total obs
280
Table 2 Result of Probit for equation 2 : Dependent variable: Y (ML Method) Convergence achieved after 6 iterations Variable TRBCRWA NPLTA ROE ASTEMPM NLNLSD C Mean dependent var S.E. of regression Sum squared resid Log likelihood Restr. log likelihood LR statistic (5 df) Probability(LR stat) Obs with Dep=0 Obs with Dep=1 Coefficient Std. Error -0.281689 0.143492 -3.40E-05 0.059992 -0.004515 2.436321 0.500000 0.322048 28.41796 -89.29974 -194.0812 209.5629 0.000000 140 140 0.041583 0.027657 0.000166 0.029758 0.005316 0.712133 z-Statistic -6.774180 5.188232 -0.205557 2.015981 -0.849271 3.421157 Prob. 0.0000 0.0000 0.8371 0.0438 0.3957 0.0006 0.500895 0.680712 0.758601 0.711954 -0.318928 0.539885
S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Avg. log likelihood McFadden R-squared
Total obs
280
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Table 3 Prediction evaluation for model 1 (success cut off C: 0.5). Dependent variable: Y Estimated Equation Constant Probability Dep=0 Dep=1 Total Dep=0 Dep=1 Total P(Dep=1)<=C P(Dep=1)>C Total Correct % Correct % Incorrect Total Gain* Percent Gain** 121 19 140 121 86.43 13.57 -13.57 NA 19 121 140 121 86.43 13.57 86.43 86.43 140 140 280 242 86.43 13.57 36.43 72.86 140 0 140 140 100.00 0.00 140 0 140 0 0.00 100.00 280 0 280 140 50.00 50.00
Dep=0 E(# of Dep=0) E(# of Dep=1) Total Correct % Correct % Incorrect Total Gain* Percent Gain**
Estimated Equation Dep=1 Total 28.60 111.40 140.00 111.40 79.57 20.43 29.57 59.14 140.13 139.87 280.00 222.93 79.62 20.38 29.62 59.23
Dep=0
Constant Probability Dep=1 Total 70.00 70.00 140.00 70.00 50.00 50.00 140.00 140.00 280.00 140.00 50.00 50.00
111.53 28.47 140.00 111.53 79.66 20.34 29.66 59.33
70.00 70.00 140.00 70.00 50.00 50.00
Table 4 Prediction evaluation for model 1 (success cut off C: 0.5). Dependent variable: Y
Dep=0 P(Dep=1)<=C P(Dep=1)>C Total Correct % Correct % Incorrect Total Gain* Percent Gain** 120 20 140 120 85.71 14.29 -14.29 NA
Estimated Equation Dep=1 Total 20 120 140 120 85.71 14.29 85.71 85.71 140 140 280 240 85.71 14.29 35.71 71.43
Dep=0
Constant Probability Dep=1 Total 140 0 140 0 0.00 100.00 280 0 280 140 50.00 50.00
140 0 140 140 100.00 0.00
Dep=0 E(# of Dep=0) E(# of Dep=1) Total Correct % Correct % Incorrect Total Gain* Percent Gain**
Estimated Equation Dep=1 Total 28.61 111.39 140.00 111.39 79.57 20.43 29.57 59.13 140.19 139.81 280.00 222.98 79.64 20.36 29.64 59.27
Dep=0
Constant Probability Dep=1 Total 70.00 70.00 140.00 70.00 50.00 50.00 140.00 140.00 280.00 140.00 50.00 50.00
111.59 28.41 140.00 111.59 79.70 20.30 29.70 59.41
70.00 70.00 140.00 70.00 50.00 50.00
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Appendix A Definition of Terms A description of CAMEL factors used within the commercial bank industry and associated regulators is outlined in an article in the Federal Reserve Bank of San Francisco. Among the factors analyzed in this article are the following: T1RBCATA - Tier 1 risk based capital to risk weighted assets. TRBCRWA - Total risk based capital as a percentage of risk weighted assets. ROA Net income to total assets. ASTEMPM Total assets in millions of dollars as a percent of full-time equivalent employees EFFICR Noninterest expense, less amortization expense of intangible assets as a percent of the sum of net interest income and noninterest income.
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Optimal Time Varying Asset Allocation with Actuarial Life Expectancies in Retirement
Gordon Irlam Santa Clara, California gordoni@gordoni.com
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Abstract We consider the problem of optimizing asset allocation as a function of time for a retirement portfolio. We find a +0.5% improvement in safe withdrawal rates for optimal time varying asset allocation relative to the best fixed asset allocation. We also explore the use of actuarial longevity data rather than the use of a fixed time period for retirement portfolio planning. On average this results in a -1% adjustment to withdrawal rates. The acceptance of a small amount of risk, such as the 99% equal risk at age 50 solvency time weighted measure described here, is necessary, and prevents a further -2.5% decline in withdrawal rates. Such metrics can also be used to allow the individual to vary withdrawal rates in response to the likelihood of portfolio success. We suggest the use of such success metrics may be superior to formulaic withdrawal rate adjustment strategies. I. Introduction Since the original Trinity study (Cooley, Hubbard, and Walz (1998)), constant withdrawal rate retirement portfolios have been well studied. However most of this work, including the Trinity study, only considers retirement portfolios with a fixed stock/bond asset allocation. The existing works also only consider fixed life expectancies. Here we consider the impact of relaxing these assumptions, allowing asset allocations to vary over time, and using variable length actuarial life expectancies. Like the Trinity study we utilize overlapping time period sample data. This paper has three main themes. First one is optimal time varying asset allocation in retirement. The second is use of actuarial life expectancy data for retirement portfolio planning. And finally, providing investors with feedback on how their portfolio is doing relative to their chosen risk level, and allowing them to adjust their portfolio withdrawal rate accordingly. A literature review has turned up no direct references on any of these three themes. II. Methods II.1. The Time Varying Asset Allocator We have developed a retirement asset allocator called Time Varying Asset Allocator (TVAA). Our retirement asset allocator is not a Monte-Carlo simulator that uses a random number generator to analyze portfolio success. Instead, analogous to the Trinity study it evaluates the complete problem space of overlapping time periods drawn from the annual historical record. All calculations made by the asset allocator and reported by us are in real, inflation adjusted, terms. The operation of the asset allocator needs a little explanation. An asset allocation is considered optimal if it minimizes the risk of portfolio failure. The optimal asset allocation, aa(t, wr), at a given point is a function of t, the time period we are in, and wr, the withdrawal rate relative to the portfolio size. The asset allocator core computes the portfolio size at time t + 1 as a function of the portfolio size and composition at time t and the stock and bond market returns for a single overlapping time period. The asset allocator core is very simple, but it operates inside a special harness, one which uses recursion. To compute aa(t, wr) we proceed as follows. For each possible asset allocation choice we evaluate all of the overlapping time periods and sum the resulting success probabilities, then based on this we pick the best asset allocation choice for time t. To evaluate each overlapping time period we rebalance using the asset allocation choice being evaluated, perform a single time step of the asset allocator core, retrieve aa(t + 1, wr'), rebalance accordingly, and then perform the next time step of the asset allocator core, retrieve aa(t + 2, wr''), rebalance, and so on. wr' and wr'' are scaled versions of wr that reflect the then relative
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withdrawal rate to portfolio size needed to maintain the constant withdrawal amount. The recursion ends when the time reaches max_years. One way to think of the asset allocator is that if we know aa(t + 1, wr'), aa(t + 2, wr''), ... for the full range of wr', wr'', ... values, it is possible to work backwards and compute aa(t, wr) for any wr through a process of experimental first step asset allocations, followed by aa(t + 1, wr'), aa(t + 2, wr''), ... subsequent step asset allocations. Forward recursion is simply used to determine which wr', wr'', ... values are actually needed. The scheme described could lead to a combinatorial explosion of computations. To prevent this we maintain a cache of aa(t, wr) values. We use exponentially increasing bucket intervals for caching wr. An inter-bucket scaling factor of 1.02 is found to give relatively good performance and results for the problems at hand. Note that aa(t + 1, wr) is a recommendation. In addition to an asset allocation aa(t + 1, wr) does not return a success probability that is then used to compute the success probability for time t. Doing this wouldn't work, because it would merge the success probabilities of the different overlapping time periods. Instead the success probability for time t is computed precisely using each of the overlapping time period returns and each of the asset allocation recommendations. It is worth mentioning that when run at a high resolution, the system sometimes displays local maxima success probabilities as a function of equity allocation. E.g. for an equity allocation of 25%, 99.14% might be the maximum for the equity range 15-100%, but at 10% there is a new maximum of 99.17%. This makes it impossible to use a variety of optimization techniques when finding the optimal equity allocation. It isn't clear if this is inherent in the problem, results from our quantization of the problem in withdrawal rate and equity allocation space, or our use of real world returns or longevity data. Coded in Python on a 2GHz CPU, the system takes from a few seconds for the individual validation runs to around 2 hours for the time varying increased asset allocation resolution runs utilizing actuarial longevity probabilities. The source code to TVAA is freely available (AUTHOR (2012)). The primary stock and bond market returns data used by the asset allocator are provided by Shiller (2005, updated). They are for US stock market returns, and constant maturity 10 year US treasury notes for the period 1872-2010. For validation we used the SBBI data from Morningstar (2007). It comprises US stock market returns, and high grade long term corporate bond market returns for the period 1926-1995. II.2. Validation The asset allocator was validated against the Trinity study, using a fixed asset allocation, the SBBI data covering 1926-1995, non-wrapping time periods, annual rebalancing, a constant portfolio withdrawal each year, and portfolio success being defined as not becoming insolvent over the specified time period, as shown in Table I. Comparing the fixed asset allocations there is an excellent correlation across the board between TVAA and the Trinity study. The small discrepancies that do exist probably have two sources. TVAA's quantization of withdrawal rates means we are not measuring at precise withdrawal rate values, but the closest negative power of 1.02. Second discrepancies in the SBBI data. Data values reported in the SBBI year books are known to be revised from time to time. II.3. The 4% rule benchmark The 4% rule is often quoted as the safe withdrawal level for retirement, and was first promulgated by Bengen (1994). Assuming that the 4% rule applies to a retiree with a 20 year lifespan, then the optimal performance comes from a 75/25 asset allocation, and it is 100% success. For a retiree with a 30 year lifespan, a 4% withdrawal rate applied to a 75/25 (or 100/0) asset allocation gives 98% success. In fact based on our validation data, the 4% rule is 465
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actually a 4.6% rule for a retiree with a 20 year lifespan, and a 3.9% rule for a retiree with a 30 year lifespan, provided they both commit to a fixed 75/25 asset allocation. These values, 4.6% and 3.9%, shall be one of our benchmarks for measuring and comparing portfolio success. III. Results III.1. Time Varying Asset Allocator performance Table I also shows the performance of the asset allocator in time varying asset allocation mode. Like the Trinity study, the asset allocator is configured to use stock allocations of 0, 25, 50, 75, and 100%. Because of the danger that the asset allocator could learn that overall the non-wrapping samples comprise a series of say more bad years followed by more good years, we have produced a second set of wrapping results. That the wrapping results are occasionally better than the non-wrapping results suggests the motivating concern isn't an issue. The slight improvements in performance could be caused by different total weightings given to the different years. To avoid the learning problem entirely from now on we will utilize a wrapping data set. Additionally allowing time periods to wrap helps deal with actuarial data sets studied latter which potentially have a much longer period lengths reducing the number of time periods available for study. The maximum withdrawal rates for the 75/25 fixed asset allocation, is unchanged between the wrapping and non-wrapping cases. The time varying results exceed the non-time varying performance. This both validates the optimization model of the asset allocator, and verifies a central thesis of this paper. That by varying asset allocation over time, better portfolio outcome can be achieved than with a constant asset allocation. The extent of the improvement is shown by taking the best fixed asset allocation, a 75/25 asset allocation, and comparing it to the time varying performance. For 20 and 30 year payout periods, at safe withdrawal rates of 5.1% and 4.4%, the time varying asset allocation provides a +0.5% and +0.5% improvement over the best fixed asset allocation of 4.6% and 3.9%. The time varying non-wrapping result for 30 years with a 7% withdrawal rate is 53%, while the non-varying pure stock allocation success probability is 54%. This represents something of an anomaly. The asset allocator is meant to be optimal but here it is generating an inferior result. One explanation for this is that the asset allocator is only optimal within the context of the data that has been presented to it. The asset allocator decides on optimality at time t + 1 based on the first elements of a set of data values, while when determining optimality at time t it calculates portfolio returns for time t + 1 using the second elements of that set of data values. For the wrapping case the two sets of data values are the same and so the optimal allocation is being used. In the non-wrapping case it is possible that the asset allocation that was found is not optimal for the data values being used. A second possible explanation for this anomaly has to do with the quantization of wr space. An asset allocation may be optimal for a particular wr value, but sub-optimal for nearby wr values, despite them all being included in the same wr bucket. As evidence for this for the wrapping 30 year 7% withdrawal rate scenario we get success probabilities of 58% and 62% for the time varying and pure stock cases. This indicates that the anomaly persists even after correcting for wrapping. But when we switch to a higher resolution wr inter-bucket spacing of 1.021/2, we get 63% and 62% as the success probabilities, indicating the anomaly has been resolved. That time varying asset allocations are superior to fixed asset allocations might seem obvious, but isn't. A challenge to the validity of claim is known as Merton's portfolio problem (Merton (1969)) as described by Smith and Gould (2007). Samuelson (1963, 1969) and Merton (1969) show that a rational risk-averse investor's optimal bond-stock allocation for a fixed horizon of length T does not depend on the value of T. Samuelson (1994) writes that `ìt is an exact theorem that 466
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investment horizons have no effect on your portfolio proportions. Nonetheless, many financial advisors believe that investors should hold more bonds as they grow older ... However, this appears to be missing in context. Merton's portfolio problem requires utility functions of a particular form, to value one's estate using the same utility function, and does not address solvency, but expected value, as the issue at hand. Hence Merton's results do not apply. III.2. Increased sample size To make the asset allocator more realistic, we extend the simulation years from 1926-1995 to 1872-2010 using the Shiller data set. This has a small impact on safe withdrawal rates; -0.1% and +0.1% over 20 and 30 years resulting in safe withdrawal rates of 5.0% and 4.5% respectively. It must be remembered at this point that the two bond series are different. SBBI uses high grade long term corporate bonds. Shiller uses 10 year treasury notes. We will use the Shiller data set for the period 1872-2010 for all subsequent analysis. III.3. Solvency Time Weighting So far we have been following the Trinity studying and measuring portfolio success in terms of not running out of money before death. But there is clearly a big difference between running out of money a year before you die and ten years. This is captured by the idea of solvency time weighting, which measures the number of years in which the subject is solvent divided by the total number of years lived. Portfolio failure doesn't sound as bad if it is realized that when it occurs it will typically only be for the last years of life. The prospect of insolvency can be detected by looking at the odds of portfolio success, and in such a case it might be possible to cut back on portfolio expenditures earlier to avoid a catastrophic failure later on. Henceforth, in addition to the 100% portfolio success metric, we will use solvency time weighted (STW) measures of portfolio success. A 99% STW success is equivalent to a 1 in 10 chance of being insolvent for 10% of your life expectancy, which had it been anticipated could probably have been managed by a small reduction in portfolio withdrawal rates. This seems like a very reasonable and conservative bound. Table II shows the withdrawal rates supported at various measures of portfolio success. These measures are hard cutoffs and do not involve rounding (e.g. 99% represents values starting at 99.0% and not 89.5%). The discrepancy between the previous and present withdrawal rates for 100% success is the presumably the result of of differences in asset allocation at subsequent time periods resulting from the different measures of portfolio success. As can be seen, accepting even a small amount of non-guaranteed success can provide a dramatic boost to withdrawal rates. Somewhere in the range of 0.9-3.1%. This suggests that payout smoothing techniques could hold great promise. III.4. Equal Risk 50 STW There is a flaw in our specification of solvency time weighting which we would like to correct. At age 50, mean life expectancy in the US is 31 years, while at age 65 it is 19 years. Thus it would seem reasonable to use 20 and 30 year time periods as indicative of an individual aged 65 or 50. Unfortunately one cannot aim for say 90% STW success at age 50, and then for 90% STW success at age 65. This is because there is a lack of correspondence between the 90% STW withdrawal rate at age 50 and 65. They each denote a 90% chance of portfolio success, but the future risk to be taken at age 65 is not getting downwardly adjusted for risk that has already been taken and successfully navigated during ages 50 through 64. A correct correspondence would reflect this and demand a 90% STW success rate at age 50 correspond to some higher, say 94% STW success rate, at age 65. In this way the risk to be taken is balanced out over the lifetime.
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To overcome the problem we propose an equal risk at age 50 solvency time weighted measure (ER50STW). It is called equal risk because it attempts to spread out the risk taken in accordance with the life expectancy, and map it back to the risk level embarked upon at age 50. The ER50STW value, E, is defined as S e(50) / e(curent_age) where S is the STW success probability, and e(age) is the remaining life expectancy for the given age. This has the right properties. When S equals 0 it maps to 0. 1 maps to 1. When current age is 50, it yields S. As current age increases, it yields a smaller and smaller number, reflecting the fact that, say, 90% is no longer good enough. One way to think about this function is it divides a given E value, such as 90%, into e(50) equal multiplicative pieces, and demands we have yet to see e(current_age) of them. By selecting a constant withdrawal rate at age 50 below say the withdrawal rate corresponding to the 90% ER50STW value we will meet or exceed 90% success probability. At an age greater than 50, using the relevant 90% ER50STW value, our success rate from that point on will be proportionately greater, in proportion to the amount of life expectancy that has passed. This proportion reflects the equal spreading of risk over the life expectancy. Maximum withdrawal rates for ER50STW values are shown in Table II. As can be seen the ER50STW and STW withdrawal rates for 30 years are, as would be expected, the same. While the ER50STW withdrawal rates for 20 years are 0.0-0.4% less than STW. The greatest impact of equal weighting is likely to be at higher ages. Also note the 100% ER50STW and 100% STW withdrawal rates are the same. This is to be expected. Once again the impact of switching from 100% success to 90-99% success is a dramatic 0.82.7%. This again suggests the importance of expenditure smoothing techniques. III.5. Actuarial life expectancy The US Government produces the US Life Tables (Arias (2011)) that report the probability of death by age. The analysis here is based on the US Life Tables for 2007 using the combined male/female all racial/ethnic groups table. To provide meaningful results near but below age 100, the life expectancy table is naively extended from age 100 to age 109 using the death rate given for age 99 (30% per year). At age 110 certain death occurs. Retirement success is all about trying to avoid poor portfolio returns and trying to avoid a long life expectancy. We know about portfolio performance, but what about life expectancy? The 20 and 30 year time periods used for analysis above are reasonable mean life expectancies for an individual aged 65 or 50, but for retirement planning we need to aim for the 90th or 95th percentile, and life expectancies there could be quite a bit longer. To get a better handle on the impact of life expectancy on portfolio success it makes sense to combine actuarial data directly into the asset allocator. Death while remaining solvent is considered a portfolio success. The asset allocator combines the probabilities of death with year by year solvency to compute the total probability of solvency. No random numbers or Monte-Carlo techniques are involved. First the probability of death in each particular year assuming you made it that far as reported in the US Life Tables is massaged to give the probability of dying in a particular year without any preconditions. The solvency vector is then used. It contains 0 for insolvent years, 1 for solvent years, and some fractional value for insolvency first occurring within a particular year. The vector dot product of the probability of dying vector and the solvency vector are then computed to give the probability of portfolio success for a particular first step asset allocation. These success probabilities are then compared to select the optimal first step asset allocation. Once life expectancy is factored in, portfolio success rates appear significantly worse as shown by Table III. There is a dramatic decline of around 2.5% in going from a fixed time periods to actuarial time periods at the 100% success level. This is because the definition of 100% success requires that the portfolio survive worst case longevity of living to age 110 with 100% success. We consider 468
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this requirement unreasonable, and find the 99% ER50STW standard far more reasonable. The 98 and 99% ER50STW success levels have a withdrawal rate much closer to that of the fixed time period 100% non-TW success level measure. We will utilize actuarial life expectancies from now on. Because of the problem of potentially living forever we will eschew the goal of 100% portfolio success in favor of ER50STW success metrics. When required we will use the 99% ER50STW level as our target metric, simply because it captures a majority of the gains to be had when switching from a 100% metric, and is the most conservative of the metrics we considered. III.6. Optimal asset allocation When we plot a heat map of equity choice against age and withdrawal rate we get a graph of asset allocation for the actuarial longevity data shown in Figure 1. This graph can be used to determine the optimal asset allocation, but there isn't a single line to follow. Instead the optimal asset allocation will depend upon portfolio performance, and the resulting withdrawal rate, year upon year. For this graph to be meaningful the portfolio withdrawal amount is expected to be constant in real terms, only the portfolio size varies, causing the withdrawal rate to vary. The first thing to know about the data is it noisy. Rather than a uniform region of asset allocation values it comprises a tessellation of differing values. It isn't clear whether this instability is inherent to the problem, or merely our approach to the problem. We get around this issue when constructing a heat map by averaging out the data values at a given location with the data values one year before and after and two withdrawal rate steps above and below. There is a broad region of absolute safety where there is 100% portfolio success in the bottom right. In the top left is the region of near utter despair, where the only chance that exists at all is to bet everything on stocks. Between these two regions lies the upward diagonally slopping middle region where all of the interesting things happen. To the lower left equities play a slightly larger role. To the upper right bonds. There are also the ER50STW lines plotted on top of the data. The ER50STW 100% success line lies just above the pure stocks region of absolute safety. Switching to ER50STW 99% success buys close to a 2% increase in the withdrawal rate. The remaining ER50STW lines add smaller, but not insignificant amounts to the withdrawal rates, with ER50STW 90% being perhaps slightly more than 1% from ER50STW 99%. Mapping the heat map shading to asset allocation recommendations requires a certain amount of approximation. In the region of most interest, the 90% ER50STW though 100% ER50STW region, a 50/50 asset allocation is recommended for ages 50-80, and a 25/75 allocation is recommended for ages 80-100. Neither a pure stock nor pure bond asset allocation is recommended. Life-cycle, or target retirement funds, adjust asset allocations in accordance with distance from retirement date. On theoretical grounds such funds might be criticized since they overlook the relative size of the portfolio as a key second factor. Empirically we find support for the idea of adjusting asset allocation in the broad region from 90% ER50STW through 100% ER50STW. In this region there is little variability in asset allocation for a given age. Above (graphically below) the 100% ER50STW level, asset allocations move quickly to a pure stock asset allocation. Individuals in such a situation may wish to manage their asset allocation directly. Our results indicate that asset allocation needs to continue to be managed once retirement is reached. Vanguard's terminal life-cycle fund, the Target Retirement Income fund, maintains a 30% equity allocation, when it would be better to ramp down from 50 to 0% equities over ages 50-100. This makes clear a flaw in life-cycle funds. They group investors according to retirement date, while our research suggests a better way of grouping them would be year, or decade, of birth.
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Another popular idea is "age in bonds". As a rough approximation, our historical data tends to support this rule with, as we have just said, equities ramping down from 50-0% percent over ages 50-100. The same caveat applies. This is only for an investor below the 100% ER50STW success line (graphically above). Above the line, asset allocations should move rapidly in favor of equities. III.7. Variable withdrawal rates The ER50STW success lines can be used to determine how a portfolio is doing. If one is above (graphically below) their chosen ER50STW success line, they can remove assets or increase the withdrawal rate to match the ER50STW success line, and still meet their target risk allocation. Conversely if one is below their chosen ER50STW success line, some long term belt tightening is in order to meet the ER50STW success line withdrawal rate, or failing that take on an excessive amount of portfolio success risk. It is as simple as reading off the target withdrawal rate, WR, from the graph, and either adjusting the current withdrawal rate, wr, to match that, or taking out or adding a sum equal to p x (wr - WR) / WR where p is the portfolio size. We believe that by telling the investor how they are doing in terms of a success metric, and letting them adjust their consumption / withdrawal rate accordingly, is a better approach than the broad body of literature on variable withdrawal rate portfolio adjustment strategies (author unknown (2011)). III.8. Increased asset allocation resolution The original Trinity study considered 5 asset allocation choices, and so that is how many we have considered for comparison purposes up to this point. But might we not get smoother results if we increase the number of choices to say, 21. This increases the run time from 20 minutes to 2 hours, but may produce more meaningful results. As it turns out that the difference in withdrawal rates between 5 and 21 asset allocation choices is only +0.1% and +0.1% for ages 65 and 50, indicating that asset allocation doesn't need to be precise. It also means we can normally safely compute using the smaller set of asset allocation choices. Additionally, we don't believe selection between 21 asset allocation choices is something the typical investor can manage. We will be using 5 asset allocation choices in the remainder of our analysis for simplicity and computational expediency. III.9. Inflation protected bonds What is the role of the bond component of a portfolio in general? We can address this question, by switching out the nominal bond component, and replacing it by a stable bond fund yielding 0%. It can be thought of as a TIPS ladder yielding 0%. The withdrawal rates for nominal bonds are +0.2% and +0.1% better than a 0% TIPS ladder for ages 65 and 50 respectively. This low performance is a little surprising since over the period 1872-2010, nominal bonds have yielded geometric mean real returns of 2.5% per annum after inflation. The variability of real returns makes nominal bonds less suited to their role as a stable store of value than otherwise would be the case. What impact would a TIPS ladder yielding 2% have? This is something which has been readily available in the short history of TIPS, but isn't at the present time due to low bond yields overall. The withdrawal rates for a 2% TIPS ladder are +0.3% and +0.1% better than nominal bonds for ages 65 and 50 respectively. However, due to the lack of current availability of a 2% TIPS ladder, and its relative novel, we will not consider inflation protected bonds any further. III.10. Projections So far we have just been analyzing past performance. What is equally interesting is considering future performance. The future is likely to be difficult from the past in ways that 470
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are difficult to predict. Historically equities have returned a geometric mean of 6.5% per annum over the period 1872-2010, but this seems unlikely to continue. Estimates of future real returns for equity based on professional surveys are for 4.8% per annum ((Whitehouse (2005)). While an estimate based on market data is for 4.0-5.5% real return (Warusawitharana (2010)). Thus a reasonable best guess for future real returns from the US stock market is probably around 5%. We consider the returns for nominal bonds and 5% equity returns. At 4.6% and 4.0% withdrawal rates are -0.5% and -0.7% worse than the unadjusted equity returns case for ages 65 and 50 respectively. Maximum forward looking withdrawal rates for the ER50STW measure are shown in Table IV. Figure 2 shows the suggested forward looking asset allocation in retirement. Note the increased role played by bonds in an optimal portfolio as indicated by the lighter shading. We also get the following asset allocation recommendations. Within the 90-100% ER50STW region, a 50/50 allocation ages 50-70, and a 25/75 allocation ages 70-100, except a 0/100 allocation ages 90-100 for the 95-100% ER50STW region. Below (graphically above) the 90% ER50STW region a 50/50 allocation, slowly transitioning to a 75/25 allocation. Above (graphically below) the 100% ER50STW region, a 75/25 allocation, rapidly transitioning to a 100/0 allocation. As can be seen the most appropriate asset allocation depends slightly on the odds of portfolio success. This data summarization also provides more precise support for the "age in bonds" rule in the 90-100% ER50STW region for ages 50-100. To aid in withdrawal rate planning the ER50STW graphs are plotted alone in Figure 3. IV. Discussion IV.1 A history of the 4% rule We have seen that taking in a range of factors, primarily actuarial longevity data, but also time varying asset allocation, the 4% rule is closer to a 2.5% rule. If however we are willing to use as our benchmark a 99% chance of portfolio success in accordance with the ER50STW measure, we can regain the 4% rule. These changes are summarized in Table V. IV.2. Future directions A better understanding of the reasons behind the tessellation of asset allocation values we observe and the corresponding bumpiness of the success probabilities and withdrawal rate values would be useful. Understanding this would allow us to determine whether noise is standing in the way of us discovering the truly optimal asset allocations and withdrawal rates. Such an understanding would probably allow us to do something about this noise, but even without such an understanding it might be possible to feed smoothed data back into the asset allocator and see if it yields an improvement in the results. A preliminary investigation of feeding smoothed data back into the asset allocator suggests that it doesn't alter the overall asset allocation or withdrawal rate results. It would be relatively easy to extend our work to include more than two asset classes. TIPS, nominal bonds, and stocks, would make an interesting combination for comparison. As would bonds, US, and international stocks, provided data on the later can be obtained. It should also be possible to extend our work to cover non-retirement portfolios. The most difficult aspect of this is how to parameterize things in a meaningful way, since real savings rates are likely to increase over time. Our crude analysis, performed by extending retirement back to age zero without any savings, shows that at younger ages in the 90-100% ER50STW region a 50/50 portfolio is optimal. This is no different than for ages 50-80. The number of asset allocator core steps for our approach is given by: #(withdrawal rates) x #(equity choices) x #(overlapping periods) x 1/2 x #(ages)2 Plugging in some rough numbers for a typical run: 471
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200 x 5 x 140 x 1/2 x 602 = 250M asset allocator core steps Each step of the asset allocator core takes around 5 microseconds on a 2GHz machine, for a total run time of 20 minutes. The problem we are attempting to solve is highly parallelizable. Based on the experience we have gained we believe rearchitecting the simulator to get rid of the recursion and build the results in a bottom up fashion would allow this parallelism to be exploited on a multiprocessor machine, or across multiple machines. The use of a network key value store that supports work queues, such as Redis, would appear well suited to assist in this task. IV.3. What we have learned The present work yields a number of valuable lessons: It is computationally feasible to analyze time varying asset allocation. Time varying asset allocation offers a +0.5% improvement to safe withdrawal rates in retirement. The use of actuarial longevity provides around a -1% adjustment to withdrawal rates in retirement. The actual adjustment is less for earlier ages and greater for later ages. TIPS work slightly more effectively than nominal bonds in a retirement portfolio. Optimal portfolios in retirement are dominated by bonds when the portfolio is likely to succeed but there is still some portfolio risk. Outside of this region optimal portfolios are dominated by stocks. "Age in bonds" appears a good rule of thumb for a retirement portfolio in the 90-100% ER50STW success region for ages 50-100. For ages prior to this our preliminary analysis brings this rule into question and suggests a 50/50 asset allocation may be optimal at younger ages. Solvency time weighting adjusts success probabilities for the duration of insolvency. The equal risk measure adjusts portfolio risk over the lifetime so that it isn't repeatedly taken. Telling the investor how they are doing in terms of a success metric, and letting them adjust their consumption / withdrawal rate accordingly, appears a better approach than expecting them to apply a formulaic withdrawal rate adjustment strategy. The refusal to accept some risk, such as a 99% chance of portfolio success, can, when using actuarial life expectancies, have a dramatic -2.5% effect on withdrawal rates in retirement. References Arias, Elizabeth, 2011, United States Life Tables, 2007, National Vital Statistics Reports, 59:9, 2011-1120. http://www.cdc.gov/nchs/products/life_tables.htm author unknown, 2011, Variable Withdrawals in Retirement. http://www.bobsfinancialwebsite.com/VariableWithdrawals.html Bengen, William P., 1994, Determining withdrawal rates using historical data, Journal of Financial Planning, 7:1, 171-180. Cooley, Phillip L., Carl M. Hubbard, and Daniel T. Walz, 1998, Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable, American Association of Individual Investors Journal, 10:3, 16-21. AUTHOR, 2012, Time Varying Asset Allocator. http://www.AUTHOR.com/economics/tvaa/tvaa-0.4.source Morningstar, 2007. Stocks, Bonds, Bills, and Inflation: 2007 Yearbook Classic Edition (Morningstar, Inc., Chicago, IL). Merton, Robert C., 1969, Lifetime portfolio selection under uncertainty: the continuous time case, Review of Economics and Statistics, 51, 247-257. Shiller, Robert J., 2005, updated. Irrational Exuberance (Princeton University Press, Princeton, NJ). http://www.econ.yale.edu/~shiller/data.htm 472
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Smith, Gary and Donald P. Gould, 2007, Measuring and Controlling Shortfall Risk in Retirement, Journal of Investing, 16:1, 82-95. Warusawitharana, Missaka, 2010, The Expected Real Return to Equity, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2011:14. http://www.federalreserve.gov/pubs/feds/2011/201114/201114pap.pdf Whitehouse, Mark, 2005, Social Security Overhaul Plan Leans on a Bullish Market, The Wall Street Journal, February 28, 2005, C1.
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Table I. TVAA validation and time varying success probabilities. The portfolio success probabilities for the Time Varying Asset Allocator with a fixed asset allocation are compared to the Trinity study using the non-wrapping SBBI data and found to be in close agreement. Results for TVAA in time varying asset allocation mode are also presented for both non-wrapping and wrapping SBBI data. Trinity study Payout years 20 30 20 30 20 30 20 30 20 30 20 30 20 30 Asset allocation Stock 75/25 50/50 25/75 Bond Withdrawal rate 3% 100% 100% 100% 100% 100% 100% 100% 100% 100% 80% 4% 5% 6% 75% 68% 75% 68% 75% 51% 47% 20% 20% 12% 7% 63% 59% 61% 49% 55% 17% 31% 5% 14% 0% 3% 100% 100% 100% 100% 100% 100% 100% 100% 100% 80% 100% 100% 100% 100% 100% 88% 95% 85% 100% 90% 98% 83% 100% 90% 95% 76% 100% 82% 71% 27% 90% 47% 20% 17% 4% 100% 98% 100% 98% 100% 95% 100% 79% 97% 20% 100% 100% 100% 100% TVAA Withdrawal rate 5% 90% 85% 91% 84% 91% 73% 85% 30% 53% 13% 100% 95% 100% 94% 6% 7% 75% 63% 68% 54% 76% 62% 66% 46% 75% 56% 51% 16% 54% 32% 16% 5% 4% 0% 21% 14% 94% 76% 80% 53% 94% 85% 77% 58%
Time varying (no wrap) Time varying (wrap)
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Table II. Maximum withdrawal rates under various measures of portfolio success. Maximum withdrawal rates for the solvency time weighted and equal risk at age 50 solvency time weighted metrics for time varying asset allocation using the wrapping Shiller historical return data. STW Success level 100% 99% 98% 95% 90% Payout years 20 5.2% 6.5% 6.8% 7.5% 8.3% 30 4.4% 5.3% 5.6% 5.9% 6.5% ER50STW Payout years 20 5.2% 6.4% 6.8% 7.3% 7.9% 30 4.4% 5.3% 5.6% 5.9% 6.5%
Table III. Maximum withdrawal rates for fixed and actuarial life expectancies. A sharp drop in maximum withdrawal rates is seen when switching from a fixed to actuarial life expectancy at the 100% success level. This drop can be made up for by using a non-100% success measure. Life expectancy mode Fixed 20/30 years Success measure 100% non-TW 100% ER50STW 99% ER50STW Actuarial 98% ER50STW 95% ER50STW 90% ER50STW Age 65 5.0% 2.5% 5.1% 5.3% 5.9% 6.6% 50 4.5% 2.3% 4.7% 4.9% 5.3% 5.9%
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Table IV. Forward looking maximum withdrawal rates. Maximum forward looking withdrawal rates are presented for various levels of the ER50STW success measure using the historical record but with the return on equities adjusted to 5% geometric mean returns. Success level 100% 99% 98% 95% 90% Age 65 2.5% 4.6% 4.9% 5.4% 6.0% 50 1.8% 4.0% 4.4% 4.8% 5.2%
Table V. Changes in maximum withdrawal rates described in this paper. A boost from time varying asset allocation fails to offset a drop from the use of actuarial life expectancies. But even in the event of a decline in return on equities to 5%, the 4% rule can be maintained in the future by switching from a 100% to a 99% success measure. Payout years/age 20/65 Trinity-like 100% safe withdrawal rate time varying asset allocation extended sample size (Shiller; 139 years) switch to ER50STW (needed for actuarial) switch to 99% ER50STW from 100% ER50STW actuarial longevity Historical 99% success withdrawal rate 5% geometric mean equity return Future looking 99% success withdrawal rate 4.6% +0.5% -0.1% +0.2% +1.2% -1.3% 5.1% -0.5% 4.6% 30/50 3.9% +0.5% +0.1% -0.1% +0.9% -0.6% 4.7% -0.7% 4.0%
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Figure 1. Asset allocation for actuarial longevity data. Heat map showing optimal asset allocation based on the historical return and actuarial longevity data as a function of age and withdrawal rate. Overlaid are the equal risk at age 50 solvency time weighted withdrawal rates as a function of age as described in the text.
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Figure 2. Forward looking asset allocation. Heat map showing optimal asset allocation based on forward looking returns and actuarial longevity data as a function of age and withdrawal rate. Overlaid are the ER50STW withdrawal rates as a function of age.
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Figure 3. Forward looking withdrawal rates. ER50STW withdrawal rates based on forward looking returns and actuarial longevity data as a function of age.
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Debt Financing and Output Market Behavior
Jaideep Chowdhury Department of Finance and Business Law James Madison University Harrisonburg, Virginia 22807, USA. chowdhjx@jmu.edu
Hans Haller Department of Economics Virginia Polytechnic Institute and State University Blacksburg, Virginia 24061, USA. haller@vt.edu
*We thank Hans Gersbach for an instructive conversation and a co-editor and referee for benecial critique.
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Abstract This paper revisits the seminal article of Brander and Lewis who have shown that exogenously given or strategically chosen debt can lead to more aggressive firm behavior in the output market. We find that (i) debt financing of production costs leads to more aggressive output market behavior when the level of upside risk is higher and (ii) debt financing of production costs leads to more aggressive product market behavior than equity nancing without debt. Our ndings prove robust across several industry structures: Cournot duopoly, Stackelberg leadership, and monopoly. Keywords: Product Markets, Capital Markets, Limited Liability Eect JEL Classication: L13, G32 I. Introduction We investigate the linkage between capital market and product market decisions of rms, which places our study at the interface of theoretical corporate nance and theoretical industrial organization. Traditionally, there has been a fruitful division of labor between nancial theory and economic theory. In nancial theory, the consequences of nancial decisions of the rm are analyzed typically without considering their impact on product market decisions and vice versa. The product market is treated as exogenous and assumed to simply oer a random return that is unaected by the debt-equity positions of the rms under consideration. In economic theory, the nancial situation of rms tends to be ignored when product market decisions (on quantity, quality, prices, etc.) are analyzed. I.1 The Limited Liability Eect In their seminal contribution, Brander and Lewis (1986) stress and examine important linkages between nancial markets and product markets, in particular the eect of leverage on equilibrium output in Cournot duopoly with demand or cost uncertainty. They assume that the rm is a residual claimant to (high) earnings while it is protected from losses by limited liability. The latter causes risk shifting which leads a more leveraged rm to behave in a more aggressive manner in the product market. Brander and Lewis call this the limited liability eect which obtains in their normal or standard case when marginal prot of output is larger in better states. Moreover, a leveraged monopolist (duopoly) will choose higher outputs than an unleveraged monopolist (duopoly). I.2 Endogenous Debt and Investment On the one hand, we specialize and consider industries with a linear demand curve and constant marginal costs. On the other hand, we amend and extend the Brander and Lewis analysis and, in section 4, qualify and substantiate some of their results. We examined three dierent industry structures, Cournot duopoly, Stackelberg leadership, and monopoly and nd that our main results are robust with respect to industry structure. However, the analysis of the Stackelberg case is not included in the paper. And most of the discussion and some of the extensions are conned to Cournot duopoly, the leading case in the literature. In our rst innovation in the Brander-Lewis framework, we follow Povel and Raith (2004) and concentrate on endogenous debt incurred by Cournot duopolists to nance their variable costs. But in contrast to Povel and Raith, we refrain from designing sophisticated liquidation schemes. Rather, we explore the possibility that rms can obtain funds in a competitive loan market. In all other respects, our model is very close to the original Brander and Lewis (1986) model. Indeed, our model proves closer to the Brander and Lewis model than their own interpretation suggests: Their formal analysis is based on debt-nanced production costs whereas their narrative suggests equity-nanced production costs. We nd in Proposition 2 that debt nancing of production costs leads to more aggressive product market behavior than equity nancing without debt. This conclusion shows that the opposite result obtained by Povel and Raith is mainly due to firm-specic debt contracts and liquidation costs and not 481
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to endogenous debt per se. The Brander and Lewis result that a more leveraged rm behaves in a more aggressive manner in the product market is rather an assumption than a conclusion in our basic model: By assumption, variable costs are debt nanced whereas there is no prior or exogenous debt. In turn, variable costs are increasing in output and, therefore, debt is increasing with output and vice versa. Therefore, while the particular Brander and Lewis result obtains, it is not caused by limited liability in our model. This does not mean, however, that the limited liability eect is not at work at all. To get a better understanding how it works in our context, notice that the limited liability eect can prove sensitive to both the type of imperfect competition and the nature of uncertainty faced by the oligopolists: Showalter (1995) considers Bertrand competition instead of Cournot competition and nds that while debt yields a strategic advantage under demand uncertainty, it does not under cost uncertainty. In our model, rms are quantity setters and face demand uncertainty. A priori, this creates a bias in favor of the limited liability eect. Our second major innovation consists in performing comparative statics with respect to the magnitude of upside risk, in order to further scrutinize the impact of risk on output market behavior when limited liability applies. We nd in Proposition 1 that greater upside risk increases the benets from risk shifting and, consequently, induces the rm(s) to choose more output and debt. I.3 Related Literature The limited liability eect can have further implications in dynamic scenarios like in Maksimovic (1988), who argues that (again in the standard case) high levels of debt may prevent a rm from credibly committing itself not to engage in disruptive competitive practices; in other words, high levels of debt may prevent the rm from achieving optimal tacit collusion with its rivals. In contrast, Glazer (1994) argues that in the standard case, high levels of debt can render rms temporarily less aggressive and can be conducive to tacit collusion. He analyzes a two-period model where debt is issued for two periods while rms choose output every period. Firms use operating prots to pay back debt before paying dividends. Therefore, high rst period prots reduce the remaining (short-term) debt(s) and by the Brander-Lewis result second period output(s). Thus Glazer nds that with long-term debt, rms may prefer lower rst period output than without debt, followed by higher second period output. More generally, with long-run debt and several periods, rms may choose low outputs and tacitly collude in the early stages. The limited liability eect becomes obsolete when rms are assumed to maximize total value rather than equity/shareholder value. Most notably, Modigliani and Miller (1958) investigate how the total value of the rm depends on the mix of debt and equity nancing of investments and nd that under certain assumptions, total value is independent of the nancial structure. Brander and Lewis (1988) intentionally rule out the limited liability eect by assuming total value maximization rather than equity value maximization. The corporate nance and economic theory literatures have developed models of rm-specic debt contracts. Contractual stipulations can take into account the needs and opportunities of the rm as well as the interests of its creditor(s). In particular, rm specicity allows the contract to condition the probability of bankruptcy and/or liquidation on the amount of actual repayments. Such contracts help avoid or alleviate the moral hazard problem that the rms unscrupulous management diverts without penalty some or all of its cash ow when cash ow or operating prot is unveriable by third parties. Such contracts may also alleviate risk shifting and mitigate the limited liability eect. By and large, this literature nds that capital market imperfections and predatory behavior of competitors put nancially constrained or distressed rms at a disadvantage and induce more leveraged rms to behave less aggressively in output markets. See, e.g., Fudenberg and Tirole (1986), Poitevin (1989), Bolton and Scharfstein (1990), Maurer (1999), Faure-Grimaud (2000). 482
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Most of the debt contract literature assumes that a rm or entrepreneur has to nance a xed start-up or project cost. Povel and Raith (2004) depart from that tradition and consider a Cournot duopoly where one of the rms, say rm 1, is nancially constrained and has to nance all or part of its variable cost by borrowing from an investor. Financing and production decisions are made before the realization of uncertain inverse market demand. Firm 1 has a positive continuation value after the Cournot duopoly takes its course. The continuation value may be reduced if the rm is liquidated. An optimal debt contract minimizes the expected liquidation cost. It assumes the form of randomly liquidating the rm in the case of default. The stipulated probability of liquidation is decreasing in the amount repaid. The contract induces the rm to borrow not more than it needs to, to produce at most the Cournot equilibrium output it would choose as a nancially unconstrained rm, and to always repay as much as it can. Thus the optimal contract is designed in such a fashion that the limited liability eect is neutralized by the countervailing threat of liquidation. An obvious question is whether both the rm and the investor would have a full understanding of the rms nancial and economic situation so that a contract could be designed exactly that way and, more importantly, whether the contract provisions (random liquidation) would be carried out as stipulated. II. Preliminary Analysis The limited liability eect à la Brander and Lewis (1986) has the following explanation: The rms debt holders are residual claimants in case of bankruptcy. In the absence of bankruptcy, the rms equity holders are residual claimants. Hence the equity holders of the rm are only concerned with its returns in the good states of nature. The manager of the rm caters to the equity holders of the rm. The manager pursues risky strategies which provide higher return in the good states of nature because the rm does not have to pay back the entire debt in case of bankruptcy. The rm is said to be protected by the limited liability eect of debt nancing. The limited liability protection induces the levered rm to undertake more risky projects and behave more aggressively in the output market. In the Brander-Lewis model, firm i is assumed to have returns of the form (1) Ri ( z; qi , q- i ) - Di where z is an ex ante uncertain state of nature, qi 0 is rm is output and Di 0 is is exogenously given debt. The standard assumptions are that z belongs to an interval [ z , z ]
and
2Ri R i > 0 . qi stands for the output of the other > 0 . In the standard or normal case z qi z rm (duopolist) if there is one and can be omitted or put equal to 0 otherwise. It is implicitly assumed that there exist an inverse market demand P( z; q) at industry output q = qi + q i and a
cost function Ci ( z; qi ) so that Ri ( z; qi , q- i ) = P ( z; qi + q- i )qi - Ci ( z; qi ) . A further crucial ( assumption is that for each (qi , qi ) , there exists a unique state z = z qi , qi ) ( z , z ) such that (2) Ri ( z , qi , q i ) Di = 0 Limited liability means that equity holders are protected from making losses. That is, their return is Ri ( z; qi , q i ) Di if z z and 0 if z z . Therefore, a manager who maximizes equity or shareholder value, maximizes
[Ri ( z , qi , q i ) Di ]F (dz )
(3)
with respect to qi, given q i, where F is the distribution of z. In the case of a monopolist, qi = 0. The lucida calligraphy Di and Ri always refer to the respective terms in the Brander-Lewis model. In principle, the rm might incur a total debt of Ci ( z; qi ) + Di if its costs of production are
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debt-nanced. Brander and Lewis (1986) and subsequently Maksimovic (1988) and Glazer (1994) presume that the rms production costs are equity-nanced. However, we beg to disagree: The formal analysis in Brander and Lewis (1986) relies on debt-nanced production costs. We refer to subsection 4.3 for a detailed discussion of this discrepancy. Povel and Raith (2004) assume that the rm nances production internally to the extent that it can and resorts to debt nancing for the rest. In our basic model in section 3, we assume absence of exogenous debt (for simplicity), zero xed, set-up or sunk costs, and marginal cost of production c 0 . We further assume that the rm issues debt to nance its operating cost so that it will have debt equal to Di = cqi (4) Thus there is a direct linkage between the nancial decision and the output decision. Remark 1. The cost of production (4) includes interest payments. The rm pays its suppliers kqi , the market value of debt, for factors of production. Constant marginal costs assume constant returns to scale and competitive markets for factors of production. For instance, if there is only one factor of production, the production function is of the form f ( y ) = ay for input y 0 and the factor price is p , then k = p / a . The rm, if it debt-nances its input requirements, owes its creditors the amount cqi , the face value of debt, where c = (1 + r )k and r is the rate of interest. We think of bank credit in the rst place, although supplier or trade credit also plays an important role in practice. When production is equity nanced, cqi is the rms opportunity cost, if the interest rates (or rates of return) for borrowing and saving (alternative investments) are the same. Propositions 2 and 4 are shown under this assumption. If the rates are dierent but the spread between borrowing and saving rates is not too large, the conclusions of Proposition 2 and 4 still hold. For details, we refer to Remark 5. Remark 2. In models of the credit market, two polar market structures of the banking (creditor) sector are pre-dominant. On one end of the spectrum, a borrower deals with a monopoly lender. On the other end, borrowers deal with a perfectly competitive banking sector. Needless to say, there exist models of imperfectly competitive credit markets as well. Here we assume an exogenously given market interest rate r . We refrain from endogenizing r by imposing a break-even constraint on banks. The rationale is that banks may not be fully informed about the model parameters k and e, z , z below. They may lend to many similar but not identical rms. While a bank need not break even on the loan to a particular rm, it can still break even on its loan portfolio. The latter condition could be used to endogenize r which would conceivably include a market risk premium. We indicate in Appendix D how this might be done. Incomplete information about industry parameters in addition to competition among creditors and other impediments to complete contracts is also a reason why lenders cannot always impose rm-specic contracts à la Povel and Raith (2004). Thus we presume that banks use a relatively unsophisticated rating procedure so that many dierent rms end up in the same rating category and are charged the same interest rate. The application of sophisticated rating and risk management tools by commercial banks to credit markets is a recent development, mainly driven by regulatory requirements of the Basle accords and recommendations. Now this sort of banking regulation is not concerned with the pricing of loans per se but rather with adequate loan loss provisions. Yet if the sophisticated techniques were costless, they would be widely used even beyond regulatory requirements, since more detailed rating and loan assessment allows a more dierentiated pricing of loans. However, advanced statistical and computational tools do not make up for poor data quality. The accurate assessment of the risk of specic commercial loans and individual rms requires costly industry-specic expertise and front o ce input. Therefore, while the trend is towards more sophistication, cost-benet considerations may still favor traditional simpler rating 484
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procedures that refrain from too detailed investigations of individual loans and companies. For an elaboration on these issues, see Part III of Basle Committee on Banking Supervision (1999). Further, there is an inverse market demand of the a ne-linear form P( z; q ) = + z q for q + Z where c is a positive constant and z is a random parameter. We further assume that z is uniformly distributed on a non-degenerate interval [ z , z ] with constant density f = 1 / ( z z ) . Then the rm has operating revenue (5) Ri ( z , qi , qi ) = ( + z qi qi ) qi and operating prot (6) Ri ( z; qi , q i ) Di = ( + z c qi qi ) qi Now the counter-part of (2) is Ri Di = 0 or, if qi > 0 , z = c + qi + q i (7)
provided that c + qi + q i ( z , z ) Remark 3. Suppose ( c) (< ) z . Then c + qi + qi ( <) z for qi + qi = 0 . Assuming ( c) > z rules out that possibility and guarantees that c + qi + q i > z for all qi + qi 0 . Suppose next that ( c) z . Then c + qi + q i z for all qi + qi 0 in which case the rm can never serve its debt and makes zero expected prot. To rule out that possibility, we are going to assume ( c) < z . Accordingly, we make the additional assumption (8) z < ( c) < z Remark 4. Note that (8) implies that c + qi + q i has range [ c , ) for qi + qi 0 , with
c ( z , z ) . In particular, (8) does not rule out that c + qi + q i z for suciently large values of qi + qi . But whenever c + qi + q i z , the rm cannot serve its debt in any state of nature and makes zero expected prot. In that case, we can set z = z so that the maxim and (9) becomes zero. Then with limited liability, the rms manager maximizes
z
[ R ( z; q , q
i i z
) Di ] fdz
(9)
with the same qualications as (3). III. Demand Uncertainty and Endogenous Debt We assume that the rms are issuing debt to nance production thereby interlinking debt with output as expressed by equation (4). Further, we assume that the rms perfectly foresee the switching state of nature z which is given by equation (7) if c + qi + q i ( z , z ) and by z = z if c + qi + qi z . A firm with perfect foresight should know that z is a function of
q = qi + q i and hence treat z as endogenous. In the sequel, we are considering three market structures: Cournot duopoly and monopoly. In previous versions of the paper, we also considered Stackelberg leadership. COURNOT DUOPOLY For rm i =1, 2, the manager maximizes the rms equity value (9), that is, solves
z z
max qi Vi = ( Ri Di ) fdz = ( + z q1 q2 c) qi fdz

z z
(10)
where Ri is the prot of rm i and debt Di is given by equation (4). The Cournot Duopoly solution is given by 485
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c+ z
4
(11)
Proof : See Appendix A. MONOPOLY OUTPUT A monopolist with perfect foresight solves the following problem:
z z
max q V = ( R D) fdz = ( + z q c)qfdz
(12) where R is the revenue of the monopoly rm and debt D is given by (4): D = cq . The monopoly output is given by c+ z * (13) qm = 3 Proof : See Appendix B. Main Conclusions As an immediate conclusion of the foregoing equilibrium analysis we obtain the following Proposition 1 For both Cournot duopoly and monopoly, the debt-nanced rm(s) produce(s) more output at a higher level of upside demand risk measured by z . Ceteris paribus, an increase of z expands the good states of nature which reinforces the limited liability eect. More detailed analysis shows: Proposition 2 For Cournot duopoly and monopoly, debt-nanced rms will choose higher outputs than equity-nanced rms. Proof: See Appendix C. We have performed the analysis for the case of Stackelberg leadership as well and arrived at the same conclusion.
z z
IV. Reexamination of Brander and Lewis In this section, we rst determine the Cournot equilibrium outputs when rms do not assume any debt and then for rms à la Brander and Lewis (1986). The ensuing equilibrium outputs allow us to reassess the Brander and Lewis ndings. 4.1 No Debt In case of no (exogenous or endogenous) debt, the rm solves the following problem:
z z
max qi Vi = ( Ri Ci ) fdz = ( + z q1 q2 c)qi fdz

z z
= ( + ( z + z ) / 2 q1 q2 c)qi Firm is first order condition is given by + ( z + z ) / 2 c 2qi q i = 0 The reaction function of firm 1 is given by c z + z q i qi (qi ) = + 2 4 2 The Cournot solution is c z + z qic* = + , i = 1, 2 3 6 4.2 Exogenous Debt In the Brander and Lewis case, where debt is exogenous, the manager of rm i solves
z z z
(14)
(15)
max qi Vi = (Ri Di ) fdz = ( + z q1 q2 c)qi fdz Di fdz

z z z
(16)
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where z is defined by
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Di = Ri ( z; q1 , q2 )
(2)
and Ri is the operating profit of firm 1, with analogous stipulations as in Remarks 4 and 5. Maximizing (16) with respect to qi, we get the first order condition as follows: z Vi R 1 1 1 (17) = . i dz = ( z z )( 2qi qi c) + ( z z )( z + z ) = 0 qi z z z qi zz 2( z z )
Vi z comprises the additional term [Ri ( z; q1 , q2 ) Di ] which is zero because of qi qi (2). It follows that the reaction function of firm i is given by c z + z q i (18) + qi (qi ) = 2 4 2 With D1 = D2 = D , the equilibrium outputs are given by c z + z (19) qi = + , i = 1, 2. 3 6 For qi > 0 , equation (2) amounts to ( + z (qi + q i ) c)qi = Di or z = c + (qi + qi ) + Di / qi . With D1 = D2 = D , q1 = q2 , and (18), the equilibrium output satisfies 0 = 4qi2 ( c + z ) qi D or
Notice that
qi* = [ c + z + ( c + z )2 + 16D ] / 8
(20)
4.3 Reexamining Brander and Lewis Comparison of (15) and (19) yields that rms in the Brander and Lewis settings with exogenous debt D1 = D2 = D choose higher outputs than firms that do not incur any debt. This follows from z ( z , z ) . The explicit determination of Cournot equilibrium outputs in the Brander and Lewis setting with exogenous debt D1 = D2 = D yields expression (20), which conrms the Brander and Lewis nding that more leveraged rms take a more aggressive output stance. Moreover, expression (20) converges to expression (11) as D tends to 0 which shows: Proposition 3 A duopoly with D > 0 produces higher equilibrium outputs than a duopoly with D =0. This is also the formal result of Corollary 1 in Brander and Lewis (1986). However, contrary to the interpretation of Brander and Lewis, this result by itself does not prove that a completely equity-nanced industry will produce a lower output than the corresponding leveraged industry. The reason is that D = 0 does not mean that the industry is equitynanced. Namely, the model we analyze in section 3 exhibits zero exogenous debt, D = 0, whereas production is debt-nanced. Hence our model is the limit case, for D 0 of the Brander and Lewis model with exogenous debt. To substantiate our claim, let us reexamine the Brander-Lewis assumption that the payoff to equity holders is max{0,Ri ( z; qi , q i ) Di } . With our model specification, their assumption means that equity holders receive max{0, Ri ( z; qi , q i ) [ Di + Di ]} where Di is the endogenous
cost of production, given by (4). That is, limited liability applies to both exogenous debt Di and the cost of production, Di = cqi . That is, limited liability applies to both exogenous debt
Di and the cost of production, Di = cqi . Thus, the Brander and Lewis analysis incorporates
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both exogenous and endogenous debt and obtains our model with zero exogenous debt yet debt-financed production as a limit case. Nevertheless, the combination of Propositions 2 and 3 does yield the Brander and Lewis assertion--- as does direct comparison of (15) and (20). Proposition 4 A completely equity-nanced industry will produce a lower output than the corresponding leveraged industry. The analysis underlying (20) still applies when D becomes negative, that is, when the rms have some positive nancial reserves to begin with and debt nance only part of their production costs. Hence: Proposition 5. There exist D < 0 < D such that symmetric Cournot duopoly equilibrium output is increasing in D [D ,D ]. Remark 5 (interest rate differentials). Suppose the opportunity cost of a self-financing firm i producing output qi is cqi = (1 + r )kqi where r < r is the rate of interest or rate of return on funds put to alternative uses. If r rather than r is used in (20), then the comparison between (15) and (20) can be reversed and Proposition 4 needs no longer hold. To see this, put D = 0 in (20) and consider the following numerical example: k = 1, = 5 / 4, c = 9 / 8, c = 33 / 32, z = 0, z ( c) = 7 / 32 so that r = 1/ 8, r = 1/ 32. Then (20) amounts to qi* = ( c + z ) / 4 = (1/ 8)(1/ 4) = 1/ 32 and (15) with c instead of c amounts to qic* ( c) / 6 = (1/ 6)(7 / 32) = (7 / 6)(1/ 32) . This yields qic* > qi* which means that without exogenous debt, the completely equity-financed duopoly produces a higher output than the corresponding debt-financed duopoly. However, Proposition 4 still holds if r < r is sufficiently close to r . In the example, let us replace c and r by c = 35 / 32 and r = 3 / 32 respectively. More generally, the conclusion of Proposition 4 persists as long as c > c > c ( c + z ) / 2 and z ( c) . Notice that c + z > 0 because of ( c) < z . Further, and z ( c) implies ( c) / 3 + ( z + z ) / 6 ( c + z ) / 6 c > c > c ( c + z ) / 2 implies ( c + z ) / 6 < ( c + z ) / 4 .Hence c* * c > c > c ( c + z ) / 2 and z ( c) yield qi < qi when c is replaced by c in (15). V. Concluding Remarks Our analysis is conned to a model with linear demand and uniformly distributed demand shocks. This limitation has the advantage that equilibrium or expected prot maximizing outputs can be determined explicitly which facilitates output comparisons. As mentioned earlier, we have also analyzed the case of Stackelberg leadership among two quantity-setting rms. This analysis is not included in the current paper, in part to save space, in part because the timing of production decisions and debt repayment becomes more subtle in the Stackelberg case. The most prominent industry structure in the economics and nance literature is Bertrand competition. Because of the Bertrand paradox, the Bertrand model with homogeneous products is not well suited for the comparative statics required for our purposes. Like Showalter (1995), one would have to resort to a model with dierentiated or heterogeneous products to investigate the limited liability eect of debt-nanced production under Bertrand competition. For many businesses, supplier or trade credit is an essential funding source in addition or in lieu of equity or credit from nancial institutions. In our context, supplier credit would be interesting, since it is directly linked to the provision of inputs. However, bank credit, if available, may be preferable in terms of interest and duration. Incorporating trade credit becomes complicated if there are multiple suppliers. Then a linear cost as in (2) may no longer be justied.
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VI. Proofs Remark 6. The expression in (26) below is a cubic in the monopoly output q and goes to infinity as q tends to infinity. However, the relevant domain for q is [0, z + c] , since the monopolist makes zero profit and we can set z = z if q z + c , see Remark 4. The first and second order conditions show that (26) has a local minimum at q = z + c and a local maximum at q = ( z + c) / 3 . Hence the latter is the monopoly output. Mutatis mutandis, this remark also applies to the analysis in 4.2 and 6.1.
VI.1 Appendix A: Cournot Duopoly For firm i = 1, 2, the firm's equity holder or manager solves the following problem:
z z
max qi Vi = ( Ri Di ) fdz = ( + z q1 q2 c)qi fdz

z z
(21)
where Ri is the revenue of firm i and Di = cqi . Using (6) and replacing z by c + q , we get z z z +z z z z + c + q Vi = [( c q)qi + qi ] = [( c q)qi + qi ] zz 2 zz 2 z z 1 1 = [ c q + z ]qi = ( z z ) 2 qi = ( c q + z ) 2 qi (22) 2( z z ) 2( z z ) 2( z z ) Hence firm i ' s best response is the solution of the problem max qi ( c q + z )2 qi (23)
The first order condition is ( z z )( c + z qi 3qi ) = 0. Vi = 0 at z = z ; hence the latter can be ruled out at the maximum and i ' s best response is given by qi (q i ) = ( c + z qi ) / 3 . (24)
Checking the SOC confirms that Vi is maximized when (24) holds and minimized when z = z . The reaction functions (24) imply (11).
VI.2 Appendix B: Monopoly Output For the monopolist, the firms equity holder or manager solves
z z
max q V = ( R D) fdz = ( + z q c) fdz

z z
(25)
After replacing z by c + q , finding monopoly output can be reduced (similar to the above treatment of duopoly) to solving the problem max q ( c q + z )2 q (26) with corresponding first order condition ( c q + z )( c 3q + z ) = 0 . Checking the SOC confirms that V is maximized at q = ( c + z ) / 3 and minimized when z = z . Hence (13) as asserted. VI.3 Appendix C: Proof of Proposition 2 In the case of duopoly, condition (9) and comparison of (11) and (15) show the assertion.
With equity financing, the monopolist maximizes ( c( z + z ) / 2 q ) q . The first order condition yields monopoly output ( c) / 2 + ( z + z ) / 4 . Comparison with (13) yields the assertion in the case of monopoly.
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VI.4 Appendix D: How to Endogenize the Interest Rate Here we indicate how the interest rate r might be endogenized. For the sake of expositional simplicity, we consider the monopoly case. In our model, monopoly output is given by (13), * qm = ( c + z ) / 3 . Let z0 be given by the condition Ri = 0 , given the monopoly output. Then
* * + z0 qm = 0 or z0 = qm = ( z (2 + c)) / 3 . Moreover, at the monopoly output, * z = c + qm = ( z 2( c )) / 3 . In the states z [ z , z ] , the bank (creditor) receives full * payment of Di = cqm . In the states z [ z0 , z ] , the bank is the residual claimant to * * Ri = ( + z qm ) qm 0 . In the states z < z0 , the bank receives zero payment from the monopolist. Hence the bank has the expected gross return z 1 1 * * * Rb = [ z z ].cqm + ( + z qm )qm dz zz z z z0 Suppose the creditor pays interest at the rate (or has to guarantee a rate of return ) for the * funds it raises. Then its cost of financing the amount kq* it lends is Cb = (1 + )kqm . The m creditor breaks even on the loan to the monopolist if Rb = Cb . If the bank extends credit to many firms, say local monopolists, with varying values of k , , z , z , then Rb and Cb ought to be replaced by the respective expected values Rb and Cb . The values of r such that Rb = Cb holds are the candidates for an interest rate at which the bank breaks even.
References Basle Committee on Banking Supervision, 1999. Credit Risk Modeling: Current Practices and Applications. http://www.bis.org/publ/bcbs49.pdf Bolton P, Scharfstein DS, 1990. A Theory of Predation Based on Agency Problems in Financial Contracting. American Economic Review, 80, 93-106. Brander JA, Lewis TR, 1986. Oligopoly and Financial Structure: The Limited Liability Eect. American Economic Review, 76, 956-970. Brander JA, Lewis TR, 1988. Bankrupcy Costs and the Theory of Oligopoly. Canadian Journal of Economics, 21, 221-243. Faure-Grimaud A, 2000. Product Market Competition and Optimal Debt Contracts: the Limited Liability Eect Revisited. European Economic Review, 44, 1823-1840. Fudenberg D, Tirole J, 1986. A Signal-Jamming Theory of Predation. Rand Journal of Economics, 17, 366-376. Glazer J, 1994. The Strategic Eects of Long Term Debt in Imperfect Competition. Journal of Economic Theory, 62, 428-443. Maksimovic V, 1988. Capital Structure in a Repeated Oligopoly. Rand Journal of Economics, 19, 389-407. Maurer B, 1999. Innovation and Investment under Financial Constraints and Product Market Competition. International Journal of Industrial Organization, 17, 455-476. Modigliani F, Miller M, 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48, 261-297. Poitevin M, 1989. Collusion and the Banking Structure of a Duopoly. Canadian Journal of Economics, 22, 263-277. Povel P, Raith M, 2004. Finanical Constraints and Product Market Competition: Ex-ante vs Ex-post Incentives. International Journal of Industrial Organization, 22, 917- 949. Showalter D, 1995. Oligopoly and Financial Structure: Comment. American Economic Review, 85, 647-653.
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Conceptual modeling of Current and Capital Accounts in Central and Eastern European countries
Milivoje Radovic University of Montenegro Jovana Tomaevia 37, 81000 Podgorica, Montenegro Rmico@t-com.me
Serge Shuster Graduate Center City University of New York 365 Fifth Avenue, New York SShuster@gc.cuny.edu Milos Vulanovic* Western New England University School of Business, 1215 Wilbraham Road 01119 , Springfield , MA mvulanovic@wne.edu
*Corresponding Author
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Abstract New approach to building of economic models is described on the example of Current Accounts of Eastern European countries during their transition to market-based economies. Among ten countries, which acceded to the EU in 2004, there are eight previously socialist states. These Central and Eastern European (CEE) countries have changed not just their production systems but also completely redesigned their political and social environments to conform to EU standards. During transition years CEE countries were affected by specific developments, which have no close analogs in OECD or in developing world. Throughout this paper we develop a conceptual model of current accounts, financial /capital accounts and exchange rates, which allows for their joint determination. We use this model to consider economic and social factors that were influencing Balance of Trade (BOP) components in CEE countries during their transition from socialist regimes to free market democracies. Key words: Current Accounts, Eastern Europe, Privatization, Capital Accounts I. Introduction Eight Central and Eastern European (CEE) countries, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia, acceded to the European Union (EU) in 2004. In order to join EU, CEE countries had to change not just their production systems but also completely redesign their political and social environments to conform to EU standards. They opened their domestic markets to international competition, created private banking systems and free capital markets. The CEE countries eliminated central planning of their economies in favor of reliance on private initiatives and free market philosophy. To accomplish these monumental changes, CEE countries needed vast amounts of financial resources in var io us fo r ms su c h a s: foreign direct investment (FDI), portfolio investments and bank loans. The convergence of CEE economies with Western European EU members required rapid privatization of inefficient and technologically outdated government enterprises. The privatization was originally the main attraction for FDI into Central and Eastern European economies. International investors focused on the acquisition a n d the technological upgrading of existing businesses. In addition to economic changes, CEE countries introduced wide ranging measures affecting c o he sio n o f social systems, labor and unemployment legislation and pensions and healthcare sustainability. This paper considers a conceptual framework of balance of trade, specifically current and financial accounts, attempting to incorporate into the analysis some non-traditional, social and political factors. Our focus is on the period of time from the collapse of socialist regimes in the early 90-ies up to 2004 when these countries became members of European Union. The paper is organized as follows: After the motivation and the review of literature in section 2, we present and develop the conceptual model of current accounts, financial/capital accounts and exchange rates in section 3. Section 4 extends the conceptual model to incorporate employment protection and unemployment benefits. Section 5 provides the conclusion. II. Motivation, developments and previous literature To justify our interest in this topic we first briefly outline institutional changes that affected the developments in financial markets in the eight countries in our sample. The Czech Republic ent ered cha nges wit h significa nt devaluation in its currency in early 1990-ies (Horvath, 2000, and Nuti 2000). While this measure was critical for the increasing the rate of growth in the short-run, it also could be credited for the delays in restructuring of the Czech economy. The banking system was still controlled by the state and was providing easy credit to domestic enterprises. The Czech Republic also needed new
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regu lat ion regarding corporate governance and capital markets. In addition majority of domestic companies were not competitive in new opened markets which increased pressure on trade deficit. Consequently, in the spring of 1997, the country suffered currency crisis. Beeg (1998) and Calvo and Mishkin (2003) elaborat e on the government policy actions after the crisis. The government quickly reacted by introducing two stabilization packages and abandoned fixed exchange rates, introducing managing floating regime against German Mark. The authorities included several unpopular measures, including fiscal tightening, the control of wage growth, a considerable increase in regulated prices and announced plans for rapid privatization of the banks and state-owned companies. The Czech National Bank adopted an inflation-targeting approach. These r espo nse s caused a slowdown of the Czech economy and po s sib l y a c c e le ra t e d start of the recession of 1997-1998. The inflation was reduced from 10.7% in 1998 to 2.1% in 1999. The improvements attracted substantial capital inflows which in turn caused Czech Koruna to appreciate. Our model presented in the next section is precisely predicting above outcomes (equations 22, 23, 24), therefore The Czech R e p u b l i c situation conforms to the conceptual model. In general, up to 1998, fiscal policy was used to achieve a balanced budget and to reduce role of the government in the economy. In 1998 fiscal policy was changed to accommodate the stabilizing economic role of the government. Budget deficits rose because of increased spending on infrastructure, housing and social transfers. Hungary entered changes where its monetary policies pursued active management of a currency peg with a narrow band. C o r k e r e t a l . ( 2 0 0 0 ) , s h o w s t h a t this monetary policy was aimed at a real appreciation of the Hungarian Forint in order to reduce domestic inflation. The inflation was considered a major cause of the falling competitiveness of Hungarian exports and trade deficit. This policy failed and the Hungarian current account and government deficits in 1993 and 1994 were 9% and 7% of GDP respectively. The twin deficits and growing foreign debt started raising questions about the solvency of Hungary. The government lowered expenditures, increased tariffs on imports, reduced borrowing, devalued the Forint 9% and announced the introduction of a crawlingband exchange rate regime in March 1995.These measures decreased the government and current-account deficits and inflation declined from 9.2% to 5.3%. Our model in equations 14 and 15 would be able to capture these relations. Therefore economic growth accelerated after initial slowdown. The private sector wages did not adjust quickly enough to lower inflation. Consequently, the adjustment took place in manufacturing employment. In other words, Hungarian firms reduced employment first and only then attempted to reduce wages. Despite to the lack of change in the official fiscal policy, the fiscal deficit has increased to 9.2% in 2002 according to the reports from National Bank of Hungary. Similar is the experience of the remaining countries that we consider and further we expose our conceptual model of which empirical testing could be done in the future development of the literature III. Conceptual Model of Current Accounts In this part of the paper we present our mo d e l which is t he c a nd id at e t o explain relationship among current and financial accounts of CEE countries during the time under consideration. The conceptual model is expressed with the following numbered equations: Model:
CA = F (F DI, P I, OI, e, t, x ) e = G(C A, F DI, P I, OI, t) (1)
(2)
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(3) F A = H(CA, x ) F DI = F DI(x ); P I = P I(x ); OI = OI(x ); (4) (5)
where : e = exchange rate (units of domestic currency per unit of foreign) F, G, H = proper relationship functions CA, FA = current account and financial accounts PI, OI = portfolio investment and other Investment FDI = foreign direct investment x = set of all other factors possibly affecting balance of payments components (time subscripts are omitted). We are going to denote partial derivatives with respect to i-th argument as Fi, Gi, Hi. According to the equation (1), current account is determined simultaneously by the trade in goods (through the exchange rate e), and financial account components FDI, PI and OI, including their own effects on exchange rate e (through the equation (2)). The exchange rate determination equation (2) states that the ex change rate is also determined by the trade in goods (current account CA) and the trade in financial assets (financial account components FDI, PI, OI). Equation (3) represents the composition of financial/capital account. Equation (4) says that the financial account, similarly to current account and exchange rate, is simultaneously determined by the trade in goods and services (CA) and the investment opportunities and exchange rates (e). This model is an extension of Gaske (1992) approach to the joint determination of the current account, capital account and the exchange rate. Therefore the major goal of this paper is to identify which factors should be included in the set { x }. To completely determine what should be included in the set {} is of the crucial importance x for few reasons. First and most importantly previous literature on current accounts and modeling of them was usually inclined to conduct studies in developed countries with market economy. This is not quite the case with these eight countries that in relatively short period of time were changing their economic system from command to capitalist one. Therefore variables those were of the crucial importance while analyzing current account issues in developed economies may not play important role for CEE countries. Lets first consider equation (1). According to the relevant statistics and plenty of papers in the literature, the abundance of business opportunities and investment choices in CEE countries during their transitional stage have led to the surge in inflowing foreign capital. The amounts o f c a p it a l i n flo w s ha ve exceeded the amount necessary to finance the deficits of current accounts. This created the excess of liquidity in CEE economies and, as it frequently happens when capital markets and banking systems are underdeveloped, caused overinvestment and excess consumption (Rajan, 1999). The excessive inflows of international capital are capable of affecting both advanced and developing economies. The transitional CEE economies are special in a sense. On one side, their human capital levels are relatively close to those of OECD countries. On the other side, the levels of development and sophistication of their financial systems resemble the situation in the developing world. The undeveloped financial system is prone to 494
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misdirecting the surges of capital inflows into unproductive projects and bubbles in real estate and financial assets. FDI related capital inflows tend to be followed by the increase in the imports of the manufacturing equipment. This results in the negative short-term effect on the trade balance. Long-term effects of FDI on the current account depend on the nature of FDI. If FDI is market seeking and oriented towards domestic market, then the product diversity and consumption may increase in the future. In this case both short-term and long-term effects of FDI on current account are negative
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In the short-run:
C At F DI t seeking market
< 0 ( F1
< 0)
(6)
In the long-run:
C At+n F DI t seeking market < 0 (7)
Where C At+n is the expected current account n periods into the future. If FDI is export oriented the short-term effect is same as in case of market seeking FDI (??), but the long-term effect is opposite. This is because export oriented FDI can be expected to increase future exports and consequently improve the future current account. In the short-run:
C At F DI t oriented export
< 0 ( F1 < 0)
(8)
In the long-run:
C At+n F DI t oriented export > 0 (9)
Portfolio Investments (PI) consist of equities and fixed income securities. In the short-term, PI inflows tend to increase the levels of prices in domestic equity and fixed income markets. The values of investment portfolios held by domestic residents are going to rise creating so called wealth effect. This, in turn, will increase domestic consumption leading to the decline in current account. The long- term effect of PI inflows on current account is also negative since it involves future outflows of dividends for equities and coupons for bonds.
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In the short-run:
C A t < 0 F2 P It
<0
(10)
In the long-run:
C A t+n <0 P It
(11)
Foreign bank loans or Other Investments(OI), are increasing amount of the credit in the economy but can be risky for the economic stability because their possible outflows can be rapid and destructive. Part of the increased credit tends to be directed towards consumer lending and the financing of real estate speculation. The short-term effects of the increased consumption and wealth effect created by real estate boom tend to decrease current account balance. The longterm effects of OI inflows on current account are also negative because of the future regular payments on loans. In the short-run:
C At < 0 F3 OIt
<0
(12)
In the long-run:
C A t+n <0 OIt
(13)
The appreciation of national currency (e ) tends to produce positive wealth effect (Deutsche Bundesbank, 2006). As usual, wealth effect leads to the increase of consumption, and consequently to decline in current account in the short-term. In the long-term, currency appreciation leads to declining competitiveness of locally produced goods, resulting in long-term decline in current account.
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In the short-run:
C At > 0 F4 et
>0
(14)
In the long-run:
C A t+n >0 et
(15)
There is an expectation that levels of development of CEE economies and levels of life of their citizens over time will converge to Western European standards. The specifics of catching-up process make it possible to suggest that current accounts of CEE countries should be increasing functions of time t:
C At t > 0
(16)
Several factors explain this relationship. Consumption smoothing behavior of consumers implies that current account should be moving from the biggest deficit at the beginning of the convergence to the biggest surplus at the end of the convergence process. Both public and private savings must increase in order for pay back accumulated government and consumer debts. Empirical research shows that low GDP per capita in CEE countries negatively affects their savings rate (Deutsche Bundesbank, 2006). It follows that low GDP per capita negatively affects current account. As convergence proceeds, this negative effect should disappear. Furthermore, according to Herrmann and Jochem (Deutsche Bundesbank, 2005), underdeveloped banking and capital markets depress the rate of private savings, effectively reducing current account balance. Since the levels of development of banking system and financial markets can be expected to increase over time, this should lead to the increase of current accounts in CEE countries. The conceptual model does not use fiscal balances among determinants of current accounts. As Fidmurc notes:the relation between the current account and the fiscal balance is unclear ... for the transition economies. Aristovnik (2006) presents a different view: ...shocks in public budget rates are likely to be accompanied with current account balance deterioration, confirming the validity of the twin deficit hypothesis in the region. Based on the research by Aristovnik (2006) we include in the set { x } such variables as GDP levels G and GDP growth rates g as negative factors for current account balances in CEE countries :
C A t G t < 0 C A t <0 gt
(17) (18)
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Obviously, we have to include in the set { x } savings rate S and investment rate I , having correspondingly positive and negative effects on current account:
C A t St > 0 C A t It <0
(19)
(20)
Now, lets consider equation (2). The decrease in current account balance tends to increase the demand for foreign currencies relative to the demand for the domestic currency. This leads to the depreciation of national currency (e ):
et > 0 G1 C At
>0
(21)
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The increases of inflows of FDI, Portfolio Investments (PI) and Other Investments (OI) produce similar effects on the value of national currency. They increase the demand for the domestic currency relative to the demand for foreign currencies. This leads to the appreciation the domestic currency (e ) :
et < 0 G2 F DIt < 0 G3 et P It < 0 G4 et OIt
<0 <0 <0
(22)
(23) (24)
As convergence process goes on, the CEE currencies can be expected to appreciate (e ) (BalassaSamuelson effect). Thus, exchange rate is expected to decline (appreciate) over time:
et t
< 0 G1 <0
(25)
Finally, lets consider equation (4). The decline in the current account implies the increasing need for the inflows of foreign capital. Usually, this is referred to as the need to finance current account deficit. Therefore, the decline in the current account tends to increase the financial/capital account:
F A t < 0 H1 C At
<0
(26)
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 There is no explicit dependence of the financial account on time t since it is imposible to predict future changes of FDI, Portfolio Investments or Other Investments (bank loans). IV. Labor Markets The flexibility of labor markets in CEE countries has significantly increased interestingly; these changes are different among CEE countries and also differ with the OECD countries. The phenomenon specific to CEE countries i s that significant numbers o f p e o p l e h a v e second job and sometimes even multiple jobs. Compared to the situation in OECD, in CEE countries part-time employment is very scarce. Labor market flexibility, as measured by labor turnover, is also very different between CEE and OECD. New hiring and voluntary quits in the OECD countries behave pro-cyclically, increasing when economic growth accelerates and decreasing during economic downturns. This pattern is not observed in CEE countries. The centrally planned system was focused on providing support to unproductive government enterprises. Since all citizens in socialist countries were guaranteed employment, there were no western-style public assistance institutions which mostly provide assistance to unemployed. The CEE countries had to change this social setup leading to drastic decline in employment protection. The resulting new employment insecurity has substantially increased the fear to change jobs or seek more satisfying carrier. In many of CEE countries the percentage of unemployed who receive unemployment insurance benefits is low and this leads to low labor market participation. Therefore, contrary to the arguments of flexible labor market proponents, in case of CEE countries extension of generosity of unemployment benefits In could increase labor market participation and contribute to economic growth. terms of the conceptual model, this means that a quantitative measure/index of unemployment benefits should be included in set { x }. The effect of this variable on current account and other components of Balance of Payments (BOP) is unclear and depends on other factors. V. Conclusion The Central and Eastern European (CEE) countries went through complete rebuilding of their production, political and social systems and currently satisfy major requirements necessary for becoming the members of EU. During the transition period the CEE countries were affected by specific developments, which have no close analogs in OECD or in developing world. This justifies the design of the model of the Balance of Payments components that has specific features relevant for the transitional countries. We present such conceptual model and develop it throughout this paper. This model could be applied to the development of CEE countries as far as their current accounts, financial /capital accounts and exchange rates are concerned.
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 References Aristovnik, A., 2002. What determines the current account balances in Central and Eastern Europe?, Nase gospodarstvo (Our Economy), 48(5/6): 450-467 Aleksander Aristovnik, 2006, The Determinants and excessiveness of the current account deficits in Eastern Europe and the Former Soviet Union, MPRA Paper No. 483. Begg, David. 1998. Pegging out: Lessons from the Czech exchange rate crisis. Journal of Comparative Economics 26:66990. Calvo, Guillermo, and Frederic S. Mishkin. 2003. The mirage of exchange rate regimes for emerging market countries. Journal of Economic Perspectives 17 (4): 99118 Corker R., C. Beaumont, R. van Elkan and D. Iakova (2000), Exchange rate regimes in selected and advanced transition economies - Coping with transition, capital inflows, and EU accession, IMF Policy Discussion Paper, PDP/00/3 Deutsche Bundesbank, 2006, Determinants of the current accounts in central and east European EU member states and the role of German direct investment, Monthly Report January 2006 Fidrmuc, Jarko, 2004. The endogeneity of the optimum currency area criteria, intraindustry trade, and EMU enlargement. Contemporary Economic Policy 22, 1-12. Fidrmuc, Janko, 2003. The Feldstein-Horioka Puzzle and Twin Deficits in Selected Economics Econo mics of Planning 36, pp 135-152. Gaske, Dan, 1992. Teaching Interactions between Foreign Exchange Markets and Balance-of- Payments Flows: An Alternative Graphical Approach The Journal of Economic Education, Vol 23, No 1 Horvath, Julius, Rtfai, Attila, 2004. Supply and demand shocks in accession countries to the European Monetary Union. Journal of Comparative Economics 32, 202211. Mishkin, F.S. 2000b. "Inflation Targeting in Emerging Market Countries," American Economic Review, May, 90,#2: . National Bank of Hungary. 2001. Quarterly report on inflation. Budapest: National Bank of Hungary, August. Nuti Domenico, Mario 2000. The Polish Zloty, 1990-1999: Success and Underperformance The American Economic Review Vol. 90, No. 2, Papers and Proceedings of the One Hundred Twelfth Annual Meeting of the American Economic Association pp. 53-58 Rajan, Ramkishen 1999. Capital Inflows, Bank Intermediation and Lending Booms in Emerging Economies with reference to East Asia, University of Adelaide, Australia.
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Currency Hedging Strategies of a Pension Fund
Chuan-San Wang* Department of Accounting Taiwan University wangcs@ntu.edu.tw
Jui-Cheng Hung Department of Finance Chinese Culture University
Shu-Wei Feng Management Board of the Public Service Pension Fund Minister of Civil Service
*corresponding author We appreciate helpful comments from the Management Board of the Public Service Pension Fund. Wang acknowledges the financial support from the National Science Council, Taiwan (NSC 97-2410-H-002025- ). Any remaining errors are our own.
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 Abstract We investigate whether currency hedging improves the performance of international bond and/or stock portfolios from the perspective of a pension fund in a developing country, Taiwan. The fund had bond and/or stock investments in the UK, US, Japan, and Taiwan between January 1993 and June 2005. We find that adding currency forwards can significantly improve the risk-return performance of the fund, but considerable differences exists among the four hedging strategies investigated in this study. Starting from static hedging strategies, we find that imposing restrictions on short sales and hedge ratios substantially decrease risk-adjusted return of a portfolio. Dynamic hedging strategies outperform static hedging. In addition, currency hedging is more beneficial for global bond than global stock investment. Keywords: Portfolio choice; Currency hedging; Performance evaluation; Pension fund JEL classification: F31; G11; G23.
I. Introduction The benefits of international investments are widely recognized. However, the literature seldom discusses currency hedging from the viewpoints of a market in a developing country. The forward markets of developing countries are immature and currency exposures are cross-hedged via a third currency, often the US dollar.8 Besides, stock market capitalization of a developing country is often small. For example, the only active currency forward market in Taiwan is for US dollar, and its stock market constitutes only one percent of the total world stock market capitalization. To make this study more concrete, we use the Taiwan Public Service Pension Fund (PSPF) as an example. But results in this study can be easily generalized to any of mutual funds in developing countries. To maximize and stabilize investment performance, the PSPF started its overseas investment at the end of 2001. The effect of currency hedging to the fund is still unclear so far. It has being debated whether the benefit of currency hedging, which is commonly discussed in the literature from a US investors perspective, can apply to the PSPF. This is because Taiwan forward markets are undeveloped, and therefore the markets of underlying currencies are less efficient than the markets in developed countries (see, for example Liu 2007). Besides, US investors are not representative of investors in developing countries, because US investor has a strong belief in the global meanvariance efficiency of the U.S. market portfolio, known as home bias (see, for example, Herold and Maurer 2003). In this study, we investigate four potential forward hedging strategies for a Taiwan pension fund. First, the PSPF considers an unrestricted mean-variance optimization approach. In this strategy, the global asset allocation and the optimal currency hedge ratio are determined simultaneously, without any restrictions. The second hedging strategy extends the first one by adding restrictions on short sales, maximum hedging position, and minimum annual return, because these restrictions are common to most of fund managers in developing countries like Taiwan. In addition to the restrictions, the third strategy of the PSPF uses interest rate differentials between two countries to forecast foreign exchange returns. In the fourth (final) strategy, the PSPF can only use
The findings of Liu (2007) suggest that a sound forward market increases the efficiency of the underlying currency markets, because trading on currency derivatives is likely to release new information to the market. Due to this reason, currency value of a developing country tends to be volatile.
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 information from the past 60 months to forecast foreign exchange returns for the forthcoming month, and then decide on the hedge ratio accordingly. To detect whether the above four hedging strategies increase investment performance, we compare each of the four hedging strategies with an optimal portfolio that employs one of the following three hedging strategies. First, the benchmark optimal portfolio has a hedge ratio of zero. Second, the benchmark optimal portfolio is fully hedged against currency risks (i.e., unitary hedge or a hedge ratio of 100 percent). Finally, the benchmark portfolio utilizes Blacks (1990, 1995) universal hedging strategy (i.e., a constant hedge ratio of 61.05% in this study).9 We test the significance of the performance improvements by an F-statistic or simulations of 10,000 sets of hedge ratios randomly selected between zero and one. When short selling is allowed, Gibbons, Ross, and Shanken (1989) show that the test statistic of performance improvement for currency forward hedge has an F-distribution. On the other hand, when short selling is not allowed, Glen and Jorion (1993) suggest the use of simulation to test the performance improvement because the distribution of null hypothesis is unknown. In the first of the PSPFs four hedging strategies, one-step static hedging without any restrictions significantly outperforms the three benchmark portfolios that adopt unhedging, complete hedging, and universal hedging strategies. However, in the second hedging strategy, when short sale and currency speculation restrictions are not allowed, the Sharpe ratio (i.e., the excess return per unit of risk in an investment) of the static hedging portfolio is similar to an unhedged portfolio.10 The simulation p-values further confirm that there is no significant improvement on performance from adding currency forwards to the second strategy. In the third strategy, the PSPF uses interest rate parity theory to determine its monthly hedge ratio to be either one or zero; the Sharpe ratio of the PSPF improves significantly and outperforms 10,000 randomly selected hedge ratios. The conclusion that dynamic hedging strategies improve the investment performance of the PSPF remains unchanged when an ex ante dynamic hedging strategy is adopted in the fourth strategy. In this strategy, both investment and hedging decisions are determined only based on past information of the prior 60 months. A random sample of 10,000 hedge ratios still shows evidence supporting the superiority of the ex ante dynamic hedging strategy. However, keeping hedge ratio to be one for every month has an adverse impact on investment performance during the sub-period of January 1998 to June 2005.11 The overall evidence from the perspective of the PSPF in Taiwan is interesting in three aspects. First, under static hedging strategies, restrictions on short sales, over hedging, and reverse hedging can substantially decrease the risk-adjusted return of a portfolio. Second, because of a high volatility in the currency value of a developing country, dynamic hedging strategies, both ex post and ex ante, significantly improve portfolio performance. Third, currency hedging is more beneficial for global bond than global stock investment, in particular when short sales and currency speculations are prohibited.
9
We do not report the ingredients in calculating the Blacks universal hedge ratio, but it is available on request. 10 We use Sharpe ratio as our major performance measure, but the results are qualitatively the same if we use other performance measures. Eling (2008) shows that the Sharpe ratio is adequate for funds performance measure, even when investment funds have a nonnormal return distribution. 11 The result that fully hedging strategy (i.e., unitary hedge) does not enhance investment value is consistent with the argument of Van Inwegen, Hee, and Yip (2003). They recommend the use of optimalhedging-ratio strategy, when investors are willing to forecast the returns from currency hedging decisions.
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 II. Data Sources and Definitions We assume a Taiwan fund (e.g., the PSPF) to invest in four markets: the UK, the US, Japan and Taiwan, which is the domestic country. The empirical analysis uses monthly data over January 1993 to June 2005 (150 months). The data of spot exchange rate and one-month forward rate are retrieved from National Exchange Rates in Datastream. However, due to lack of active forward markets between New Taiwan Dollar (NT$) and British Pound, and between NT$ and Japanese Yen, assets in UK and Japan markets are cross-hedged via a third currency, US dollar, which are retrieved from Barclays Bank International via Datastream. To calculate stock returns, we first collect the stock return index data, which include reinvested dividends, from Morgan Stanley Capital International via Datastream. The data provide national stock indices, measured in the local currency. The excess stock returns in terms of NT$ are then computed using the return index data and spot rate data. The bond return data are collected from Datastream and the Central Bank of China (CBC, Taiwan). Datastream Bond Indices provide benchmark bond index for bond markets of the UK, the US and Japan, based on a single representative bond with a remaining maturity of ten years at each point of time. The bond index we collect is total return index, which includes cash flows (coupons and serial redemptions) re-invested into the index on the day of occurrence. However, similar to forward information, Datastream has no data regarding Taiwan government bond indices. Therefore, we collect Taiwan government bond yields with a remaining maturity of ten years from the CBC, Taiwan. The monthly returns on Taiwan government bonds are then calculated from the changes in yields, based on a ten-year maturity, and zero coupon bonds. Furthermore, Taiwan risk-free rate is also provided by the CBC, Taiwan. Once again, unlike developed countries, Taiwan has no active monetary market for government Treasury bills. Therefore, from the CBC, Taiwan, we collect and calculate the average one-month deposit rate over five major Taiwan commercial banks as the risk free interest rate, instead of using Treasury bills. From the viewpoint of a Taiwan fund, the excess return of an unhedged asset is equal to the return of the asset measured in NT$ minus the risk free interest rate. On the other hand, the excess return of a hedged asset is equal to the excess return of an unhedged asset measured in NT$ minus the product of hedge ratio and the return of a long forward contract. This measurement is consistent with Paape (2003), who argue the importance of domestic currency returns from global asset portfolios when we are evaluating the success of fund managers. The first column of Table 1 reports average NT$ returns and volatilities (standard deviations of the returns) for a long forward position in a foreign currency. The average return for a long forward position is between 1.20% and 9.44% per year. Because the return of the long forward contract is positive, a fund will earn lower returns if managers fully hedges currency exposure through selling forwards (i.e., unitary hedge or hedge ratio equal to one). This can be verified in the last four columns of Panel A, Table 1, where the returns are less when assets are fully hedged than when the assets are not hedged for foreign bond or stock investments. Table 1 is inserted here The contrasts of the second and third columns of Panel B in Table 1 indicate that a fully hedging strategy substantially reduces the volatility of foreign bond investments. However, the differences of the last two columns of Panel B in Table 1 show that the volatility does not decrease for fully hedged UK and US stock investments. This is because the correlations between the two countries stock returns and the returns of
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 forward contracts are relatively lower than the other corresponding correlations.12 Thus, a fully hedged strategy does not necessarily reduce the volatility of an investment and it is suboptimal to hedge currency exposure without incorporating the correlations between exchange rates and foreign investment returns. Van Inwegen, Hee and Yip (2003) also argue that a fully hedging strategy is suboptimal, when investors are willing to forecast the returns from currency hedging decisions. III. Three Benchmark Portfolios To contrast the efficiency of the hedging strategies used by a Taiwan fund, we need benchmark portfolios. We consider three benchmark portfolios. The first benchmark is an unhedged portfolio. The second benchmark is a fully hedged portfolio. The final benchmark portfolio employs Blacks (1990, 1995) universal hedging strategy, which is 61.05% in this study. However, when the distribution of test statistics is unknown for comparing the differences in efficiency between the benchmark portfolios and the funds investments, we perform a simulation of 10,000 optimal portfolios with different hedging ratios. The underlying assets of each of the randomly hedged portfolio are determined by maximizing the Sharpe ratio, according to the modern portfolio theory. As shown by Eling (2008), the Sharpe ratio is adequate for the performance measure of investment funds. It is the ratio of excess return, which is the return on a portfolio minus the (Taiwan) risk free interest rate, to standard deviation. The risk free interest rate represents an opportunity cost of investing in the portfolio. Besides, a fund like the PSPF is usually required to have minimum required rate of return (i.e., the two-year domestic interest rate in this study). Therefore, in addition to one-month interest rate, we use the two-year deposit interest rate retrieved from the CBC, Taiwan as the risk free interest rate to address the minimum return requirement. Strategy #1: Static Hedging A static hedging strategy without any restrictions is a mean-variance optimization approach; both global asset allocation and optimal currency hedge ratios are determined simultaneously. We then examine whether the investment performance of this strategy is better than the performance of a benchmark hedge ratio portfolio. The test statistic is an F-statistic (see, for example, Glen and Jorion 1993). Large values of F imply that the performance of the optimal static hedged portfolio is significantly improved by entering into forward contracts. The large values of F therefore lead us to conclude that the optimal static hedged portfolio outperforms benchmark portfolios. Table 2 reports the composition and risk-return characteristics of six optimal portfolios: three of them are determined by pure underlying investments (i.e., zero hedge), and the other three are determined by the static hedging strategy without any restrictions. By contrasting the Sharpe ratio of zero hedged portfolios with that of optimal hedged portfolios, Panel A shows that adding currency forward contracts substantially improves portfolio performance. This result holds regardless of the portfolios underlying asset classes. The improvement on the Sharpe ratio, in decreasing order, is 110.43% for stock portfolios, 63.57% for bond portfolios and 39.51% for bond and stock combined portfolios.
12
There are higher correlations between returns of forwards and bond investments than between returns of forwards and stock investments, because of a close relation between interest rates (for bonds) and exchange rates. These higher correlations lead to a greater benefit for hedging foreign bond investments than for hedging foreign stock portfolios. For examples, correlations between a UK, US, Japan stock investment and a long forward contract are 0.309, 0.183, and 0.421, respectively. However, corresponding correlations between a bond investment and a long forward contract is 0.760, 0.664, and 0.850, for UK, US and Japan, respectively.
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 Table 2 is inserted here Panel B of Table 2 reveals that the optimal hedge ratios are often far greater than one or far less than minus one. This means that, to achieve an optimal static hedging, it is necessary to be either over hedging or reverse hedging. Moreover, concerns arise over the huge differences in mean return between unhedged and optimal hedged portfolios in Panel A, because the performance improvement reported in Table 2 comes from currency speculation rather than currency hedging. As shown in Panel A of Table 2, the difference in mean monthly return between zero hedged and optimal hedged bond investment is 3.02%, which is 84.69% of the returns on hedged bond investment. Similarly, 76.52% (92.84%) of the returns on hedged stock (mixed bond and stock) investments result from forward contracts, although Panel C of Table 2 reports statistical evidence, that forward currency hedging improves portfolio performance. The hypothesis of no differences in the Sharpe ratio between static hedging strategy and the three benchmark portfolios (i.e., unhedged, fully hedged, and partially hedged with a universal ratio) is rejected at the 5% or 1% level. The above results and conclusions are qualitatively the same, if we replace the onemonth risk free interest rate with the two-year deposit interest rate. This means that the minimum return restriction does not fundamentally affect the optimal underlying asset allocation and currency hedging strategy of a pension fund. A possible explanation of the insensitivity of the minimum return requirement is that the Taiwan one-month interest rate is very close to the two-year interest rate during the sample period. Therefore, in this study we use separately the two different interest rates as the opportunity cost of underlying asset investment, but only report the results using the one-month interest rate. Strategy #2: Static Hedging with Restrictions This hedging strategy is the same as the first one (i.e., static hedging strategy without restrictions), because the underlying assets and hedge ratios of both strategies are determined simultaneously. However, in this strategy, the PSPF, as many other funds in Taiwan, is not allowed to short sell underlying assets. This non-negativity restriction also applies to currency forward contracts. Moreover, the PSPF is not allowed to hedge more than 100% of the value of a foreign investment (i.e., the prohibition of over hedging). We perform a simulation to test the superiority of this hedging strategy, because a wellknown distribution of the test statistic is unavailable under the restrictions of short sale and currency speculation (see, Glen and Jorion 1993). We, first, derive expected returns, variances and covariances of underlying assets from historical data over the sample period. Using these expected returns, variances and covariances, we form a portfolio of underlying assets that maximizes the Sharpe ratio, where only positive asset weights are allowed. In the second step, we modify the expected returns of forward contracts so that the Sharpe ratio of a forward contract is the same as the Sharpe ratio of the optimal portfolio, which is the null under investigation. Finally, 10,000 random samples of joint returns are drawn from a multivariate standard normal distribution with the parameters estimated in the previous two steps. From these simulated returns, a new set of means and a new variance-covariance matrix are estimated. The optimization is performed as we din in the first hedge strategy, and the value of the statistic is recorded. The empirical distribution of the statistic is tabulated under the null by repeating this process 10,000 times. Table 3 reports the performance of static hedging with restrictions on short selling, reverse hedging, and over hedging. For bond investments, Panel A shows that the
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 Sharpe ratios of hedged and unhedged portfolios are almost identical at the level of 0.23. Moreover, Panel B indicates that the optimal asset weights for unhedged and hedged bond portfolios are also similar. Although an optimal bond portfolio is to invest in all the four countries, only US bond investment is fully hedged against currency risk. For stock investments, Panel B also indicates that the optimal hedging strategy is not to hedge all its foreign stock investments. Therefore, the optimal hedged and unhedged stock portfolios have identical underlying asset allocations and the Sharpe ratios. Similar patterns appear in the optimal mix of stocks and bonds (and forwards): the Sharpe ratios of hedged and unhedged optimal bond and stock portfolios are alike. Only assets in the US market are hedged. Table 3 is inserted here Compared to the results reported in Table 2, the Sharpe ratios in Table 3 are substantially lower, especially for optimal hedged portfolios. This reflects the fact that restrictions on short selling, reverse and over hedging often bind a Taiwan funds investment decisions. Consequently, static currency hedging with restrictions cannot effectively improve total portfolio performance, as the Shape ratios are either similar or identical between the zero hedged and optimal hedged portfolios. The simulated pvalues at the bottom of Table 3 (i.e., Panel C) also indicate that this strategy leads to an insignificant performance improvement for the hedging strategy. The results are unchanged, if we add the two-year minimum return requirement to this strategy. Strategy #3: Ex Post Dynamic Hedging In this strategy, we assume that spot exchange rates follow a random walk; the current spot rate is the best forecast of the next periods spot rate. Therefore, the sign of the forward premium (i.e., forward rate minus spot rate divided by the spot rate) is useful for making hedging decisions (see, for example, DeRoon, Nijman, and Werker 2003). An investor should not hedge when the forward contract is at a discount (i.e., the sign of the forward premium is negative). This is because next periods exchange rate is likely to be higher than the forward rate. Hedging at the forward rate reduces a portfolios return in terms of NT$. On the contrary, when the forward contract is at a premium (i.e., the sign is positive), it is better off to sell foreign assets in advance with a forward contract. In this situation, selling forwards is likely to enhance a portfolios overall return, as the forward rate may be higher than the future spot rate. In addition to the random walk assumption, the interest rate parity theory suggests that the movement of funds between two currencies to take advantage of interest rate differentials is a major determinant of the spread between forward and spot rates. When the forward discount (i.e., negative forward premium) is greater than the expected difference in the interest rate between foreign and domestic countries, the PSPF should not hedge its foreign asset in that currency. In this case, the foreign assets of the PSPF are likely to create more values (in terms of NT$) in the next period due to a higher next periods spot rate, if the assets are not hedged. In contrast, when the expected interest rate difference between foreign and domestic is greater than the forward discount, hedging foreign assets rewards the PSPF higher returns in terms of NT$. The hedging strategy explained above is a conditional hedging strategy because managers use the information on forward discount and interest rate differentials to make hedging decisions. This hedging strategy is also a dynamic hedging strategy that allows managers to vary their forward positions every month over the sample period. In this strategy, the PSPF sets its hedge ratio equal to one when deciding to hedge currency exposure. Conversely, the hedge ratio is zero for a month, if the PSPF decides not to hedge at the beginning of that month. In summary, we maximize the Sharpe ratio of
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 underlying assets with prohibition of short selling on asset holdings, and with prohibition of reverse hedging, and over hedging. Given this optimal underlying asset portfolio, the PSPF has a hedge ratio equal to one (zero) for a month if deciding to hedge (not to hedge). Table 4 indicates three sets of results. For each of the bond and/or stock investments, we report the Sharpe ratio and its components. Judging from the Sharpe ratios of the four hedging strategies listed in Panel A of Table 4, a dynamic hedging strategy has the best performance. Moreover, fully hedging foreign assets over the whole sample period may result in a considerably low portfolio performance measured in terms of the Sharpe ratio. Panel B of Table 4 shows that none of the 10,000 sets of random hedge ratios has a greater Sharpe ratio than that of the dynamic hedging strategy. This is strong evidence supporting the superiority of dynamic hedging, and consistent with the argument of VanderLinden, Jiang, and Hu (2002), among others. Table 4 is inserted here Although the results highlight the benefits of hedging dynamically, this ex post strategy uses data over the whole sample period to determine a hedge ratio to be either one or zero for each month, according to a forward premium or discount. Therefore, a remaining question is whether the performance gain reported in Table 4 still exists when investment decisions are only based on past information. Strategy #4: Ex Ante Dynamic Hedging Unlike the ex post dynamic hedging strategy, the PSPF in this strategy can only use past information to make decisions, including whether or not to hedge for a given month, and how many percentages of underlying foreign assets to hedge. Starting from January 1998, we use the data over the past 60 months (i.e., from January 1993 to December 1997) and interest rate parity theory to predict the expected forward premium or discount of the forthcoming month (i.e., January 1998). If the forward discount for the forthcoming month is greater than the expected difference in the interest rate between foreign and domestic countries, the pension fund (e.g., the PSPF) does not hedge that foreign asset for that month, and vice versa. We then roll the previous 60-month window month by month from the first period between January 1993 and December 1997 to the last period between June 2000 and May 2005 to make monthly hedging decisions for a fund between January 1998 and June 2005. In addition to deciding whether or not to hedge, we estimate a variance-covariance matrix, using data over the past 60-month period, and move month by month to the last 60-month period. The variance-covariance matrix is used to simultaneously decide the global asset allocation and optimal currency hedge ratio for each month. Then, the actual performance of each month is recorded as a benchmark for tests of significance. The design of this strategy is to examine hedging effectiveness under more realistic conditions. Compared to the previous three ex post hedging strategies, where the optimal underlying asset weights and hedge ratios are estimated using data over the whole sample period, this ex ante hedging strategy is only based on past information. Therefore, this strategy addresses the issue that whether currency hedging still increases portfolio performance when investment decisions are based only on prior information. Like Table 4 where asset weights and hedge ratios are determined using data over the whole sample period, Table 5 shows that the ex ante dynamic hedging rule adds substantial value to a portfolio. However, unlike Table 4 that shows the ex post dynamic hedging generates the highest Sharpe ratio among the zero, random, fully and dynamic hedging strategies, Table 5 shows that the ex ante dynamic hedging does not necessarily outperform an unhedged portfolio. This result suggests that a Taiwan fund should either
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International Research Journal of Applied Finance ISSN 2229 6891 Vol III Issue 4 April, 2012 not hedge its foreign assets at all or make its hedging decision conditional on forward premium or discount. Besides, a fund is more likely to attract negative expected excess return, if adopting fully hedging strategy. Table 5 is inserted here Panel B of Table 5 adds further evidence supporting the superiority of dynamic hedging. For bond portfolios, only 792 out of 10,000 sets of random hedge ratios can outperform the ex ante hedging strategy. Similarly, only 341 (474) out of 10,000 sets of random hedge ratios in stock (mix of stock and bond) portfolios have higher Sharpe ratios than the ex ante strategy. IV. Conclusion We examine the performance improvement of adding currency hedging to bond and/or stock investments from the perspective of a pension fund in a developing country, Taiwan. The sample period covers January 1993 to June 2005. The results are applicable to other funds in a developing country. The first of the four hedging strategies considered in the study is one-step static hedging without any restrictions on short sales and currency speculation. This strategy significantly outperforms three benchmark portfolios that adopt unhedging, complete hedging, and Blacks (1990, 1995) universal hedging strategies. However, the second strategy that imposes short sale and currency speculation restrictions to the first strategy has a Sharpe ratio similar to that of an unhedged portfolio. The third strategy is an ex post dynamic hedging. In this strategy, the Taiwan fund uses the theory of interest rate parity to determine its monthly hedge ratio to be either one or zero. Similar to the second strategy, there are restrictions on short sale and currency speculation. Empirical evidence shows that the Sharpe ratio of this hedging strategy improves significantly and outperforms 10,000 randomly selected hedge ratios. The conclusion that dynamic hedging strategies improve the investment performance does not change when the fund uses an ex ante dynamic hedging strategy. In this ex ante strategy, both investment and hedging decisions are determined based on information from the past 60 months. Similar to the ex post strategy, a random sample of 10,000 hedge ratios still shows evidence supporting the superiority of the ex ante dynamic hedging strategy. The overall evidence from the perspective of a fund in a developing country indicates three interesting conclusions. First, for a static hedging strategy, the risk-adjusted return of a global portfolio decreases substantially with restrictions on short sales, over hedging, and reverse hedging. Second, dynamic hedging strategies, both ex post and ex ante, significantly improve portfolio performance. This suggests a high volatility in the currency value of a developing country. Third, currency hedging is more beneficial for global bond than global stock portfolios.
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References Black, F. (1990) Equilibrium exchange-rate hedging, Journal of Finance, 45(3), 899907. Black, F. (1995) Universal hedging: optimizing currency risk and reward in international equity portfolios, Financial Analysts Journal, 51(1), 161-167. De Roon, F. A., Nijman, T. E. and Werker, B. J. M. (2003) Currency hedging for international stock portfolios: the usefulness of mean-variance analysis, Journal of Banking & Finance, 27(2), 327-349. Eling, M. (2008) Does the measure matter in the mutual fund industry?, Financial Analysts Journal, 64(3), 54-66. Gibbons, M. R., Ross, S. A. and Shanken, J. (1989) A test of the efficiency of a given portfolio, Econometrica, 57(5), 1121-1152. Glen, J. and Jorion, P. (1993) Currency hedging for international portfolios, Journal of Finance, 48(5), 1865-1886. Herold, U. and Maurer, R. (2003) Bayesian asset allocation and US domestic bias, Financial Analysts Journal, 59(6), 54-65. Liu, S. H. (2007) Currency derivatives and exchange rate forecastability, Financial Analysts Journal, 63(4), 72-78. Paape, C. (2003) Currency overlay in performance evaluation, Financial Analysts Journal, 59(2), 55-68. van Inwegen, Hee, G., J. and Yip, K. (2003) Preference-based strategic currency hedging, Financial Analysts Journal, 59(5), 83-96. VanderLinden, D., Jiang, C. X. and Hu, M. (2002) Conditional hedging and portfolio performance, Financial Analysts Journal, 58(4), 72-82.
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Table 1. Summary Statistics: January 1993 to July 2005
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The table reports the average returns and associated standard deviations for a long position in a forward contract, and the excess returns and associated standard deviations for bonds and stocks. Fully hedged foreign assets consist of the underlying foreign assets plus a short position in a forward contract on associated foreign currencies. Returns are annualized percentages in NT$. Excess return is the return of an investment minus the one-month Taiwan risk free interest rate, derived from the Central Bank of China, Taiwan. Bonds Forward (long) Zero hedged Fully hedged Stocks Zero hedged Fully hedged
Panel A: Average excess return (% pa) United Kingdom United States Japan Taiwan 9.443 1.200 9.037 7.934 4.818 4.655 2.154 1.509 3.618 4.382 8.163 9.083 0.789 6.684 1.280 7.883 8.248
Panel B: Standard deviation of returns (% pa) United Kingdom United States Japan Taiwan 29.776 18.625 36.654 36.184 32.538 42.220 49.577 23.640 24.519 22.252 46.798 49.671 69.622 112.97 47.082 49.753 63.575
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Table 2. Performance of Static Hedging without Restrictions Panel A of the table reports means, standard deviations, and the Sharpe ratios of six optimal portfolios, which are determined by maximizing their Sharpe ratios. All hedging strategies are allowed for short selling, reverse hedging, and over hedging. Panel B reports the asset allocations and hedge ratios of the optimal hedged and unhedged portfolios. Panel C tests the hypothesis of no differences in the Sharpe ratio between an optimal hedged strategy and the three benchmark portfolios (i.e., unhedged, fully hedged, and partially hedged with a universal ratio of 0.6105). Returns are measured in NT$ in excess of the one-month Taiwan risk free interest rate, and are reported on a monthly basis in percentages. Positions for bonds and/or stocks add up to 100. Sample period covers January 1993 to June 2005. *** and ** denote significance at the 1% and 5% levels Bonds Stocks Bond and stocks Zero hedged 0.615 2.029 0.303 Optimal hedged 8.593 20.321 0.423
Zero Optimal Zero Optimal hedged hedged hedged hedged Panel A: Performance measures Mean (% pm) 0.546 3.567 0.888 3.782 Standard deviation (% pm) 2.354 9.402 4.344 8.792 Sharpe ratio 0.232 0.379 0.204 0.430 Panel B: Positions in percentages Bonds United Kingdom 66.73 1.49 United States 5.70 64.15 Japan 15.69 0.66 Taiwan 11.88 33.70 Stock United Kingdom 58.26 2.80 United States 65.37 80.71 Japan 26.21 1.01 Taiwan 2.58 23.10 Forward hedge ratios United Kingdom 102.57 211.77 United States 3.49 2.00 Japan 125.62 196.60 Panel C: Tests of performance improvement Optimal with forward versus (1) Unhedged optimal F-statistic (p-value) 4.074*** (0.008) 6.554*** (0.003) (2) Fully optimal F-statistic (p-value) 6.620*** (0.000) 7.880*** (0.000) (1) Universally optimal F-statistic (p-value) 6.421*** (0.000) 8.367*** (0.000)
43.22 4.27 15.63 11.92 0.50 25.49 8.13 7.10
55.40 172.88 74.22 31.01 55.00 172.67 74.64 69.22 1689.5 875.79 729.08
3.684** 7.705*** 6.149***
(0.014) (0.000) (0.000)
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Table 3. Performance of Static Hedging with Restrictions
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Panel A of the table reports means, standard deviations, and the Sharpe ratios of six optimal portfolios, which are determined by maximizing the Sharpe ratios. All hedging strategies are not allowed for short selling, reverse hedging, and over hedging. Panel B reports the asset allocations and hedge ratios of the optimal hedged and unhedged portfolios. The optimal weights for bonds and/or stocks are restricted to be positive, and the currency hedge ratios between zero and one. Panel C tests the hypothesis of no differences in the Sharpe ratio between an optimal hedged strategy and the randomly hedged portfolio. Returns are measured in NT$ in excess of the onemonth Taiwan risk free interest rate, and are reported on a monthly basis in percentages. Positions for bonds and/or stocks add up to 100. Sample period covers January 1993 to June 2005. Bonds Stocks Bond and stocks Zero hedged 0.569 1.917 0.297 Optimal hedged 0.547 1.833 0.299
Mean (% pm) Standard deviation (% pm) Sharpe ratio Bonds United Kingdom United States Japan Taiwan Stock United Kingdom United States Japan Taiwan Forward hedge ratios United Kingdom United States Japan Optimal with forward versus Random hedged optimal F-statistic (p-value)
Zero Optimal Zero Optimal hedged hedged hedged hedged Panel A: Performance measures 0.546 0.518 0.720 0.720 3.722 3.722 2.354 2.219 0.232 0.233 0.193 0.193 Panel B: Positions in percentages 66.73 5.70 15.69 11.88 60.41 14.84 13.94 10.81 44.09 54.46 0.00 1.45 44.09 54.46 0.00 1.45
42.19 6.91 11.28 11.79 0.00 21.17 0.00 6.66
39.80 12.83 10.10 10.30 0.00 21.14 0.00 5.83 0.000 0.521 0.000
0.000 0.000 1.000 0.000 0.000 0.000 Panel C: Tests of performance improvement
0.145
(0.933)
0.000
(0.999)
0.176
(0.913)
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Table 4. Performance of Ex Post Dynamic Hedging Strategy Panel A reports means, standard deviations, and the Sharpe ratios of four hedging strategies for bonds, stocks, and mixed bonds and stocks investments. Panel B tests the hypothesis of no differences in the Sharpe ratio between the ex post dynamic hedging portfolio and 10,000 randomly hedged portfolios. The ex post dynamic hedging portfolio uses data over the whole sample period (January 1993 to June 2005) to determine whether or not to hedge currency exposure for a particular month. All hedging strategies are not allowed for short selling, reverse hedging, and over hedging. Returns are measured in NT$ in excess of the one-month Taiwan risk free interest rate, and are reported on a monthly basis in percentages. Positions for bonds and/or stocks add up to 100. *** denotes significance at the 1% level. Bonds Zero Random Fully Dynamic hedged hedged hedged hedged Mean (% pm) Standard deviation (% pm) Sharpe ratio Optimal with forward versus Random hedge ratio Simulated p-value (0.000)*** (0.000)*** (0.000)*** 0.546 2.354 0.232 0.223 1.833 0.122 Zero hedged Stocks Random Fully Dynamic hedged hedged hedged Zero hedged 0.569 1.917 0.297 Bonds and stocks Random Fully Dynamic hedged hedged hedged 0.347 1.682 0.206 0.124 1.664 0.074 0.992 1.768 0.561
Panel A: Performance measures 1.030 0.720 0.519 0.319 1.185 0.103 1.546 2.000 3.722 3.675 3.774 3.688 0.515 0.193 0.141 0.084 0.321 0.066 Panel B: Tests of performance improvement
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Table 5. Performance of Ex Ante Dynamic Hedging Strategy Panel A reports means, standard deviations, and the Sharpe ratios of four hedging strategies for bonds, stocks, and mixed bonds and stocks investments. Panel B tests the hypothesis of no differences in the Sharpe ratio between the ex ante hedging strategy and 10,000 randomly hedged portfolios. The ex ante dynamic hedging portfolio can only use data over the past 60 months to determine whether or not to hedge currency exposure for the forthcoming month. The end of the 60-month window rolls over month by month from December 1997 to May 2005. The whole sample period covers January 1993 to June 2005, whereas the test period is between January 1998 and June 2005. Short selling, reverse hedging, and over hedging are not allowed. Returns are measured in NT$ in excess of the onemonth Taiwan risk free interest rate, and are reported on a monthly basis in percentages. Positions for bonds and/or stocks add up to 100. ** and * denote significance at the 5% and 10% levels Bonds Stocks Bonds and stocks
Zero Rando Fully Dynami Zero Rando Fully Dynami Zero Rando Fully Dynami c hedge m hedge c hedge m hedge c hedge m hedge d hedged d hedged d hedged d hedged d hedged d hedged Panel A: Performance measures 0.03 0.03 0.078 0.030 0.057 0.099 0.031 0.099 6 6 2.197 1.680 1.299 2.219 4.640 4.656 4.753 4.635 0.05 0.006 8
Mean (% pm) Standard deviation (% pm) Sharpe ratio Optimal with forward versus Random hedge ratio Simulated pvalue
0.085 0.059
2.352 2.407 2.499 2.441
0.035 0.018 0.02 0.026 0.021 0.007 0.00 0.021 0.036 0.024 0.02 0.003 8 8 3 Panel B: Tests of performance improvement
(0.079)
*
(0.034)
**
(0.047)
**
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Study on Investor Decision Making: Mediating Roles of Risk Propensity and Risk Perception
Hui-Lin Hsu, Ph.D Department of Finance Fortune Institute of Technology linda023@center.fotech.edu.tw
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Abstract The study examines the mediating roles of risk propensity and risk perception when investors make investments in financial products. This research utilizes a decision behavior model in which risk propensity and risk perception are placed between individual characteristics and risky decision-making behavior. This research surveyed investors in Taiwan using questionnaires and collected 302 valid samples. This mediating effect does not take place in investment experience and risk propensity. In addition, risk perception acts as a partial mediator when investors form expected returns based on risk propensity. Moreover, risk perception is a full mediator when investors construct their portfolios based on individual risk propensity. This study concludes that some individual characteristics, such as risk preference, are transmitted to investment decision behavior through the mediating effects of risk propensity and risk perception, affecting investors expected returns and construction of portfolios. Key WordsRisk propensity, Risk perception, Mediating effect, Decision-making I. Introduction This study examines whether investors utilize risk propensity and risk perception as the transmitting variables of mediators whereas individual characteristics influence the decisionmaking process, and examines whether mediating efforts exist using investment experience and risk preference as the fundamental risk decision model and risk propensity as the individual characteristic and mediating factor of decision-making behavior. This research surveys individual investors in Taiwan using questionnaires and tests the mediating effect. Investors previous investment experience, either successful or failures, along with individual psychological characteristics, affect investors investment behavior. Investors review their own previous investment experience, which become references for making decisions regardless of whether these experiences generated profits or losses. This behavior causes the alleged anchoring effect (Tversky and Kahneman, (1974)) during investors decision-making processes. Investors varying risk preferences may also affect investment behavior. Risk preference is a stable, individual characteristic that indicates attraction to or aversion to risks (Weber and Milliman (1997)), and is an innate characteristic. By using investors risk preference and previous investment experience as anchors and by applying behavioral finance as a foundation, this study discusses how investors characteristics influence return expectations and the construction of investment portfolios through mediating factors. The results of this research will help financial institutions and investment banks develop products and marketing strategies and, in the meantime, will assist investors in understanding how their own characteristics influence decision-making processes by using risk propensity and risk perception as mediating factors. II. Literature Review Sitkin and Pablo (1992) discover that the relationship between the antecedents of individual behavior and behavior is not direct; rather, it entails transmitting impact factors to decision making using risk propensity and risk perception as mediators. Their research results support the notion that risk propensity and risk perception present a mediating effect in the model for risk behavior, and theorize these opinions. Sitkin and Weingart (1995) utilize the risky decisionmaking behavior model of Sitkin and Pablo (1992) to conduct empirical research and find that risk propensity and risk perception indeed act as mediators in the decision-making model since they noticeably weaken the relationship between antecedents and decision-making behaviors. Byrne (2005) applies this behavioral decision-making model in the financial field to discuss how investors evaluate the risk of financial products. Her research findings determine investors risky 519
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opinions for specific financial products; however, the empirical analysis cannot test the mediating effect of risk propensity and risk perception. Chou, Huang and Hsu (2010) then apply this model to study investors attitude and behavior toward financial products by using investors in Taiwan as samples. However, they similarly did not verify the mediating effect. This research employs a risky decision-making behavior model to discuss investors investment decisionmaking behavior, to analyze the model, and to emphasize the mediating role of risk propensity and risk perception during investors risky decision-making processes. Investors risk preference and investment experience are personal characteristics that influence individual behaviors, and these two variables in the model are defined as the antecedents that influence investment behavior. Expected return and portfolio construction are investors final decision making and risky behavior. III. Methodology III.1. Research Design This research refers to previous theoretical literature to construct the analytical model, as shown in Figure 1. This analytical model is centered on risk propensity and risk perception, with investors risk preference and investment experience as prior exogenous variables, and investors expected return from financial products and portfolio construction decisions as their two final decision-related behaviors. This study examines whether risk propensity and risk perception play a transmitting role between individual characteristics and decision-making behaviors. If risk propensity and risk perception can be proved successfully to be mediators, then we can confirm that investors individual characteristics are transmitted to financial products expected returns through risk propensity and risk perception, and have an impact on the construction of portfolios. Mediators are the factors that theoretically influence observed phenomena. However, the existence of these factors cannot be detected or measured. Therefore, mediators can be defined as theoretical factors influencing dependent variables. Their impact on dependent variables must be derived from observing samples independent variables. Independent variables can be viewed as having a mediating effect if they can influence dependent variables through a mediator. Figure 2 shows a model for testing the mediating effect, of which a, b, and c represent the estimated coefficients of the mediation hypothesis model. There are two types of mediating effects: partial mediating effect and complete mediating effect. The testing process for mediating effect is shown in Figure 3. First, this testing process forecasts Y by using X: Y = 1 0 + 11 X , Where 10 is a constant and 11 is the regression coefficient. If 11 is significant, then testing continues to the following steps; otherwise, testing the mediating effect ceases. Then, X is used to forecast M: , Where 20 is the constant and 21 is the regression coefficient. The testing continues into the following steps if 21 is significant; otherwise, the test ceases. Finally, we use X and M simultaneously to forecast Y: Y = 30 + 31 X + 32 M , Where 30 is the constant, 31 is the regression coefficient of X, and 32 is the regression coefficient of M. If the test shows that 31 is an insignificant coefficient close to zero, then we determine that a complete mediating effect exists. If the test shows that 32 is a significant coefficient that is less than the 11 coefficient (using X to forecast Y), then we determine that a partial mediating effect exists. 520
M = 20 + 21 X
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III.2. Hypotheses Development Sitkin and Pablo (1992) hold that various exogenous variables do not directly affect risky decision making; rather, they transmit through the mediating functions of risk propensity and risk perception. Then, Stitkin and Weingart (1995) conclude that risk preference indirectly influences risky behavior together with decision-makers habits and previous consequences of taking risks. Previous research methods fail to properly illustrate the causal mechanism of transmitting risk preference to observed behavior; therefore, their studies conclude that risk preference indirectly influences risk behavior through risk propensity. In other words, the individual characteristics of investors are transmitted to investment decision-making behavior through a mediating mechanism and use risk propensity and risk perception as mediators. Risk propensity is the decisive role between an individuals actual characteristic and perception of the two factors during a decision-making process under uncertainty, and all individual characteristics of risks are presented in their risk propensity. Prior successful or failed experiences can affect investors risk propensity, and can further affect the extent of decision makers to either get involved with risks or stay away from risks. As the experience effect states (Thaler and Johnson, 1990), decision makers prefer holding previous successful investment position and abandoning previous failed position. Previous successful experience can affect investors risk propensity, either taking risks or avoiding risks, and then decision makers consider the high or low levels of risk. This is called risk perception and results in either risk-loving or risk-aversion behaviors. Therefore, this study refers to the conclusions of the previous literature and regards risk propensity as the mediator between individual characteristics and risk perception to establish hypotheses to measure whether risk propensity acts as the transmitting variable of mediators during the process in which investors individual characteristics influence decision-making behavior. Hypothesis 1: Investors risk propensity plays a mediating role between risk preference and risk perception. Hypothesis 2: Investors risk propensity plays a mediating role between investment experience and risk perception. Risk propensity is connected to risk perception through several methods, such as the kind of information that can be observed or noticed and the kind of information that can restrict an individuals attention and an individuals ability to react to risks. Therefore, risk propensity may not only directly affect decision-making behavior, but also indirectly affects risky decisionmaking behavior through the risk perception. The individual characteristics of investors form risk propensity, and whether risk propensity can affect the evaluation of expected returns through risk perception is one of the tests of this study to understand the process whereby investors set expected returns. Many previous studies demonstrate that the relationship between risk perception of individual investors and expected return is insignificant (Weber, Blais and Betz (2002); Byrne (2005)), and that individual investors cannot connect risks to returns when investing. This conclusion contradicts traditional financial opinions. Investors may purchase financial products, invest in shares, or make risky investment decisions instinctively. Although they understand the extent of the risks, they cannot build a relationship with returns. Therefore, this research examines whether risk perception can be the mediating variable between risk propensity and investment decision-making behavior, and develop the following hypotheses. Hypothesis 3: Investors risk perception plays a mediating role between risk propensity and achieving expected returns. Hypothesis 4: Investors risk perception plays a mediating role between risk propensity and constructing portfolios. 521
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IV. Analysis Results IV.1. Sample Collection and Data Description This study surveys investors in Taiwan using questionnaires, the survey period was April 2010, and the survey covered the three metropolitan areas. A total of 328 questionnaires were sent out and 302 valid samples were collected, and the valid collection ratio was approximately 97%. The sample data is showed as table I. The factor loadings of variables observed by this research are all beyond 0.5, which represents that the measurement index analyzed has good reliability. Squared multiple correlation (SMC) is also used as an index to measure a models internal structure. The SMC of 18 observed variables in this study are all beyond 0.5, which indicates that the measurement indices of this study are reliable (Bagozzi and Yi, (988)). The composite reliability (CR) values of each dimension of this study are all beyond 0.7, which complies with the standard of consistency and indicates that the dimensions of this study have good internal consistency (Hair et al. (1998)). The average variance extracted (AVE) of six lurking dimensions of this study is between 0.650.77, and AVE values are all greater than 0.5, which means that the lurking variables all present a convergent validity (Fornell and Larcker (1981)). As a summary, the individual item reliability and lurking variables composite reliability and AVE of this research all achieved an ideal standard, which means that all measurement items of this research are convergent at each corresponding dimension and present convergent validity. IV.2. Measurement of Mediating Effect Based on the testing process shown in Figure 2, this research conducts an examination of mediating effects to determine whether risk propensity and risk perception have a mediating effect. First, the study examines Hypothesis 1 by making risk preference an exogenous variable. Figure 4 shows the testing model of the mediating effect with each estimated coefficient listed in Table 2. From Table 2, we find that the coefficient c of risk perception estimated by risk preference, 0.19 (t=-3.45) is significant. Then continue to the next step, the regression test. By using risk preference to forecast the regression, the coefficient b of risk propensity is -0.23 (t 3.63), which is also significant. Furthermore, using risk preference and risk propensity simultaneously to forecast risk perception, we obtain coefficient c is -0.08, which is less than coefficient c and is not significant. These results indicate that a complete mediating effect exists in the model in Figure 3, and risk propensity is the mediator of risk preference and risk perception and represents a complete mediating effect. In relation to mediating structure, through risk propensity, the indirect impact of risk preference on risk perception is -0.1313, greater than the direct impact of risk preference on risk perception at 0.19. The test results confirm that, during the process of risk preference influencing the risk perception, risk propensity presents a mediating effect and the relationship between risk preference and risk perception is insignificant. As a result, this mediating effect is complete. Therefore, the test results support Hypothesis 1. To test the mediating effect of Hypothesis 2, this examination find that the regression coefficient of risk perception estimated by investment experience is 0.009 (t=0.055), which is insignificant at the 0.05 confidence level. Therefore, the result determines that risk propensity does not present a mediating effect on investment experiences influence on risk perception. From the above two test results, find that the role of mediating effect played by risk propensity only exists in the relationship in which risk preference influences risk perception, and the mediating effect of risk propensity does not exist in the relationship in which investment experience influences risk perception.
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The indirect impact effect is ab 0.552-0.234 0.129.
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To test Hypothesis 3 regarding the mediating role that risk perception plays between risk propensity and expected return, the testing model is shown in Figure 5 and the regression values are listed in Table 3. This test result finds that the regression coefficient of risk propensity in forecasting expected return is 0.12 (t=1.85), which is significant at the 90% confidence level. The regression coefficient of risk propensity in forecasting risk perception is -0.23 (t=3.63). The above two scenarios are both significant. Then to simultaneously examine the impact of risk perception and risk propensity on the estimation of expected returns, find that the coefficient for the lurking variable of risk perception for expected return is 0.01 (t=-0.13), which is insignificant. The coefficient of risk perception for expected return is 0.12 (t=1.82). Therefore, when a and c are significant, the risk perception plays a partial mediating role on risk propensity having an influence on the estimation of expected return. In testing Hypothesis 4 regarding the mediating role that risk perception plays between risk propensity and portfolio construction, the testing structure used is shown in Figure 6 and the regression test coefficients are listed in Table 4. The regression coefficient c of risk propensity influencing portfolio construction is 0.21 (t=3.29), and the regression coefficient a of risk propensity influencing risk perception is 0.23 (t=-3.63). The two are both significant at the 0.01 confidence level. Furthermore, when examining whether risk propensity and risk perception simultaneously influence portfolio decision-making behavior, the impact factor c of risk propensity having an influence on portfolio building behaviors is 0.16 (t=2.42), which is less than the value of c=0.21. Therefore, by using 1% as the significance level, we can determine that risk perception plays a complete mediating role between risk propensity and portfolio decisionmaking behavior. V. Conclusion and Discussion This research applies a risky decision-making model to conduct empirical research on financial markets in Taiwan. In this study, investor risk preference and investment experience are individual anchoring points, and then examine how individual characteristics influence individual expectations for financial products returns and the allocation of portfolios by using risk propensity and risk perception as mediators. The empirical research first examines the mediating role of risk propensity and finds that the risk preference of investors in Taiwan significantly influences their risk perception for financial products through risk propensity as a mediator. However, investors previous successful or failed investment experience cannot be transmitted through risk propensity to influence their risk perception for financial products. Therefore, risk propensity is not a mediator between investment experience and risk perception. Individual risk propensity is stable, but can be modified. Although prior literature argues that successful or failed investment experience can significantly influence risk propensity, our empirical research also finds that experience is not transmitted to risk perception for financial products through risk propensity. This empirical study was conducted in 2010 during the time global financial markets were going through the subprime crisis. That event caused a global weakening of investor confidence in financial products. Although past evidence shows that more successful investment experience explains a higher investor risk propensity, having gone through all the turmoil of the financial crisis, investors who were still successful may have invested in areas of relatively low risk within the financial market. Irrespective, investors making less profit or even a loss were more cautious and adopted a more careful approach and investment strategy and so risk propensity was lowered. As a result, due to changes in investors anchor values, investors with anchor values based on past experience also changed their risk propensity. 523
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When examining the mediating role of risk perception in the model, we find that investors risk can partially influence the expected return of financial products through risk perception. This result indicates that investors in Taiwan can connect risk to return partially through rational judgments. The high or low level of investors risk propensity can influence portfolio construction entirely through risk perception. Obviously, risk perception plays a mediating role and specifically presents investors risk propensity in investment decision-making behavior. Risk propensity represents the extent that individuals are conservative or seek risks, and their attitudes toward risk aversion or risk seeking can be transmitted entirely through risk perception and demonstrated especially and completely through investment decision-making behavior. References Bagozzi, R. P. and Yi, Y., 1988, On the evaluation of structural models, Journal of the Academy of Marketing Science 16, 7494. Fornell,C., and Larcker, D. F., 1981, Evaluating structural equation models with unobservable and measurement error, Journal of Marketing Research 8, 39-50. Hair, J. F., Anderson, R. E., Latham, R. L., and Black, W. C., 1998, Multivariate data analysis (5th ed.), Prentice Hall International: UK. Chou, S.R., Huang, G. L., and Hsu, H. L., 2010, Investor attitudes and behavior towards inherent risk and potential returns in financial products, International Research Journal of Finance and Economic (44), 16-30. Sitkin, S. B. and Pablo, A. L., 1992, Reconceptualizing the determinants of risk behavior, Academy of Management Review 17(1), 939. Sitkin, S. B. and Weingart, L. R., 1995, Determinants of risky decision-making behavior: A test of the mediating role of risk perceptions and propensity, Academy of Management Journal 38(6), 15731582. Tversky, A. and Kahneman, D., 1974, Judgment under uncertainty: Heuristics and biases, Science 185, 11241131. Weber, E. U. and Milliman R., 1997, Perceived risk attitudes: Relating risk perception to risky choice, Management Science 43, 122143.
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Variable Gender
Category Male Female Married Single 25 and under 26~35 36~45 46~55 56 and over
Number 118 184 188 114 19 96 118 60 9
% 39.1 60.9 62.3 37.7 6.3 31.8 39.1 19.9 3.0
Variable Income
Category
Number
Under US$1K 68 22.5 US$1K~US$2K 149 49.3 Marital US$2K~US$3.25K 60 19.9 Status US$3.25K~US$5K 16 5.3 Age More than US$5K 9 3.0 Education High school 40 13.2 Vocational school 98 32.5 University 130 43.0 Higher than 34 11.3 university Data source: The data was collected from 302 experienced investors in Taiwan through questionnaires.
Table II
Regression Test of Mediating Effect of H1

Regress Path Code c a b c Coefficient (t value -0.19(-3.45)*** 0.55(7.19)*** -0.23(-3.62)*** -0.08(-0.96) Test Result
Significant Significant Significant Insignificant
Use risk preference to forecast risk perception Use risk preference to forecast risk propensity Use risk propensity to forecast risk perception Use risk preference and risk propensity simultaneously to forecast risk perception ***represent p 0.01
Table III
Regression Test of Mediating Effect of H3

Regression Path code c a b c Coefficient (t value 0.12(1.85)*** -0.23(3.65)*** -0.01(-0.13) 0.12(1.82)*** Test Result Significant Significant Insignificant Significant
Use risk propensity to forecast expected return Use risk propensity to forecast risk perception Use risk perception to forecast Expected return Use risk propensity and risk perception simultaneously to forecast expected return ***p 0.01
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Code c a b c Coefficient (t value) 0.21 (3.29)*** -0.23 (-3.625)*** -0.28 (-4.376)*** 0.16 (2.42)** Regression Analysis Route Use risk propensity to forecast portfolio decision-making behavior Use risk propensity to forecast risk perception Use risk perception to forecast portfolio decision-making behavior Use risk perception and risk propensity simultaneously to forecast portfolio decision-making behavior **p 0.05, ***p 0.01
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Test Result Significant Significant Significant Significant
Figure 1
Model of the Mediator of Investment Decisions
Risk Preference Risk Investment Experience Propensity Risk Perception
Expected Return
Portfolio
Figure 2
Model of Testing Mediating Effect

Mediator
Independent Variable X
Dependent Variable
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Mediating Effect Testing Begin
Use X to forecast Y, Is test coefficient significant? Yes
No
Use X to forecast M, Is test coefficient significant? Yes
No
Stop mediating effect analysis Use X to forecast Y and use M to forecast Y simultaneously, Is test coefficient significant? Not significant, the coefficient from X to Y is near zero. Significant complete Mediating effect
Is test coefficient significant?

Significant and less than the coefficient from X to Y, then partial mediating effect exists significantly
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International Research Journal of Applied Finance Vol III Issue 4 April, 2012 Figure 4 Testing Mediating Effect of H1
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a=0.55
Risk Propensity
b=-0.23
Risk Preference c = -0.19 c= -0.08
Risk Perception
Figure 5
Mediating Effect Test of H3

a= -0.23 Risk Perception b= -0.01
Risk Propensity c = 0.12 c= 0.12
Expected Return
Figure 6
Testing Mediating Effect of H4

a= -0.23 Risk Perception b= -0.28
Risk Propensity c = 0.21 c= 0.16
Portfolio
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Transmissions in International Cross-listings
Yong-chern Su Department of Finance National Taiwan University Taipei, Taiwan Yuan-jay Wu Department of Finance National Taiwan University Taipei, Taiwan Han-ching Huang* Department of Finance Chung Yuan Christian University Chung Li, Taiwan samprass@cycu.edu.tw
*Corresponding Author
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Abstract We investigate the cross-listing impact on the volatility of Taiwan stock market and the effect of information transmission by using GARCH (1,1) - MA (1) model. The price volatility of the stock market increased under the cross-listing impact. The GARCH models using the stock return rate of foreign stock market as proxy show that this proxy was positive correlated with the price volatility of TSMC. The GARCH models using the variability of the stock return rate of foreign stock market as proxy show that the relationship between those two variables of MXIC and ASETEST was inconclusive. Using the stock return rate of American or Taiwan stock market as proxy shows the same results as previous models of TSMC. Using the stock return rate of foreign stock market as proxy shows that the cross-listing impact has little effect on the information transmission of MXIC and ASETEST. Keywords: information transmission; cross-listing; ADR; GARCH JEL classification: G12, G14 I. Introduction The integration of international capital market makes it possible for firms to raise capital with the same cost of equity. Theoretically, firms face the same cost structure in international capital raising on condition that international capital markets are integrated. Previous studies in financial literature by Eun and Shim (1989) and Campbell and Hamao (1992) support capital market integration. However, due to the differences of geographic locations and regulations, firms might have some difficulties in access of international capital funds. International investment banks play an important role in encouraging international equity financing. International underwriting syndicates then introduce depository receipts. The U.S. market in the leading market in international capital markets in terms of market capitalization and trading volume. American deposit receipts become the most popular international equity financing instruments. Under the assumption of international capital market integration, firms have the same cost of equity in international equity financing. International cross listings have the same market value because they have the same discount rate and the same cash-flows. However, the integration of international capital market in under thorough examined in recent studies. Some literatures support the segmentation of international capital markets under different empirical results. Miller (1999) argues that indirect barriers, such as information availability, differences in accounting standards or liquidity risk are the dominant factor in segmenting markets. His argument seems to suggest information asymmetries between markets. Previous studies almost have an unambiguous result that international equity market is integrated in term of information transmission. Deposit Receipt is an equity issue and the regulations in issuing DR tend to encourage mitigation of information asymmetries across boarders. Level II and level III require full registrations and compliance of GAAP. Information transmissions between international markets seem not to be an issue at all. This study examines the information transmissions of international cross-listing deposit receipts. Information availability is assumed no to be an issue in cross-listing because of the regulations and integration of international capital market, especially in the internet world. Investors around the world can easily access databases provided by international investment banks without any indirect barriers. The remainder of this paper is organized as follows. Literature review is given in Section 1 while data and methodology are discussed in Section 2. Empirical results were exhibited in Section 3 and Section 4 is conclusion.
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II. Literature Review International cross-listing was introduced by J.P. Morgan in 1927. J.P. Morgan created Deposit Receipts for US investors to take part in London Stock Exchange. DR is one of the mechanisms of international cross-listings. The other alternative is ordinary listing with stock. DR issuers deposit their stock with custodial banks in listing countries in return of the negotiable securities to represent a certain right with stock. ADR and GDR represent American DR and Global DR, respectively. ADR is the most popular deposit receipt for international companies to list in NYSE, AMEX and NASDAQ. JP Morgan and Bank of New York are among the leading custodial banks in DR market. There were 1300 DRs listed in NYSE, AMEX and NASDAQ in Jan 1997 increased by 75% from 1995. The number of DR issues in 1996 was 162 with the total amount of 20 billion US dollars. Taiwan is one of the DR listing countries since 1992. There are 27 DR issuers in Taiwan and most of them are GDR listed in London and Luxembourg. Five issuers are in the ADR listings, such as Taiwan Semiconductor Company (TSMC), United Micro Company(UMC) and ASX listed in NYSE while MXIC and SPIL listed in NASDAQ. DR may be distributed by public offering or private placement. Custodial banks handle all of the paper work, such as dividends and voting right. Domowitz, Glen and Madhavan (1996) support DR market segmentation by Mexican market evidences. They explain market barriers with information linkage and order flow migration. Their argument is consistent with Alexander, Eun and Janakiramanan (1988), Mitto (1992) and Foerster and Karolyi (1993). Alexander et al(1998) argue that international cross-listings increase equilibrium price and hence decrease expected rate of return. Their sample of 34 Canadian ADRs listed in the States supported their argument. Mitto (1992) used CAPM and APT to examine the integration between Canadian and the US capital markets. He found the trend of integration between two markets. He also documented higher degree of integration in international companies in comparison of local companies. The Canadian sample in different time period of 1981 through 1990 investigated by Foerster and Karolyri(1993) also show a positive abnormal return and support market segmentation. The only exception is in utility industry, which indicates that industry may be a factor in explaining market integration. However, Lee (1991) couldnt find London and Tokyo cross listing US companies have a long term wealth change in 1962 through 1986. Market segmentation is not supported in his studies of 141 US international cross-listing companies. Information transmission is another important issue in international cross listing. Private information availability represents indirect barrier that explains market segmentation. For DR investors, the major concern is the private information in other countries or regions. Information asymmetric results in discount or premium between DR and its underlying stock. This paper tries to investigate the information transmission between DR and its underlying stock. Efficient information transmission implies market integration and insignificant information asymmetric. On the other hand, market segmentation is a better indicator on the conditional that information transmission is insignificant between DR and its underlying stock. Previous studies by Admati and Pfleiderer (1988), Freedman (1989) support that volatility is affected by private information. Under their framework, volatility is associated with volume increments, which is irrelevant with informed traders volume and liquidity trade volume. Volatility was explained by informed traders inside information which was provided by cross-listing companies.
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III. Sample and Empirical Methodology In this study, we collect individual daily stock returns from Yahoo financial and Taiwan Economic Journal (TEJ). Log return time series data was developed to eliminate nonstationarity. Two sample series in NYSE and NASDAQ and one TDR series were in our dataset. In order to examine information transmissions in international cross listings, we use a GARCH model to allow the time varying in returns with a MA component to capture the transitory shocks. A volatility spillover model was employed to examine the information transmissions caused by permanent shocks while a mean spillover model was used to investigate the transitory cash-flow effect. A. DR on stock volatility spillover
Rm ,t = m + m ,t m ,t 1
t 1 ~ N (0,ht )
2 ht = 0 + 1 m ,t 1 + 1 ht 1 + a At 1
where R m , t is the daily returns of a market in period t.
ht
is the conditional variance of returns
in period t. ht 1 is the conditional variance of returns in period t-1. At 1 is the daily returns from American market. B. DR on stock mean spillover
Ri ,t = i + i ,t i ,t 1 + a At 1
t 1 ~ N ( 0,ht )
ht = 0 + 1 i2,t 1 + 1 ht 1
where
R m , t is the daily returns of a market in period t. ht is the conditional variance of returns
in period t. ht 1 is the conditional variance of returns in period t-1. At 1 is the daily returns from American market. C. Stock on DR volatility spillover
Rm ,t = m + m ,t m ,t 1
t 1 ~ N ( 0,ht )
2 ht = 0 + 1 m ,t 1 + 1 ht 1 + t Tt 1
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International Research Journal of Applied Finance Vol III Issue 4 April, 2012 where
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in period t. ht 1 is the conditional variance of returns in period t-1. Tt 1 is t he daily r et urns fro m Taiwanese market . D. St ock on DR mean spillo ver
Ri ,t = i + i ,t i ,t 1 + t T
t 1 ~ N ( 0,ht )
ht = 0 + 1 i2,t 1 + 1 ht 1
where
in period t. ht 1 is the conditional variance of returns in period t-1. Tt 1 is t he daily r et urns fro m Taiwanese market . IV. Empirical Results We find strong mean spillover and volatility spillover between TSMC stock and DR. The empirical results were exhibited in Tables 1 and 2. The GARCH (1,1)-MA(1) model was converged with high likelihood values in both DR to stock and stock to DR. The significance of coefficients of conditional variances between two periods shows the GARCH effect in both series. Both of the coefficients of volatility spillovers show strong positive relations. It implies that the long term policy shock has a strong effect on both DR to stock and stock to DR. The US market has a unidirectional impact on Taiwan market has been examined in previous studies. However, in this study we document a strong policy effect of TSMC stock to its DR in NYSE. Information transmissions between Taiwan and NYSE with regard to company policy changes were efficient. The short term effect on return with regard to cash-flow between Taiwan and NYSE market is also significant in our findings. It implies that the short term fund flow between two markets in also efficient. The empirical findings support market integration between Taiwan and NYSE. Insert Table 1 about here Insert Table 2 about here We also find a strong volatility spillover between MXIC stock and DR. However, The mean spillover between MXIC DR and stock was insignificant. The empirical results were exhibited in Tables 3 and 4. The GARCH(1,1)-MA(1) model was converged with accepted likelihood values in both DR to stock and stock to DR. The significance of coefficients of conditional variances between two periods shows the GARCH effect in both series. Both of the coefficients of volatility spillovers show strong positive relations. It implies that the MXIC long term policy shock has a strong effect on both DR to stock and stock to DR. This study also confirmed that the US market has a unidirectional impact on Taiwan market. However, we document a strong policy effect of MXIC stock to its DR in NASDAQ. Information transmissions between Taiwan and NASDAQ with regard to company policy changes were efficient. However, the short term effect on return with regard to cash-flow between Taiwan and NASDAQ market is insignificant 533
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in our findings. The short term fund flow between two markets is inefficient. It implies that there is an arbitrage opportunity between two markets. Market segmentation between Taiwan and NASDAQ was supported. Insert Table 3 about here Insert Table 4 about here The picture was different in TDR case of ASTSF. A unidirectional volatility spillover was found in our study. It is not surprising that the US market has a strong significant spillover on Taiwan market. However, the other direction does not hold. The insignificant spillover from Taiwan to US market showed a similar pattern in international equity market. No market has spillover to the US market. The interesting difference between ADR and TDR could raise a question of the importance of indirect barriers, including accounting standards. However, mean spillovers between ASTSF DR and stock showed significant results in both direction between Taiwan and NASDAQ. The empirical results were exhibited in Tables 5 and 6. The GARCH (1,1)-MA(1) model was converged with high likelihood values in both DR to stock and stock to DR. The coefficient of volatility spillovers from the US to Taiwan showed a significant positive relation. It implies that the ASFSF long-term policy shock has a strong effect on Taiwan TDR However, the reverse direction does not hold. Long-term effect of TDR in Taiwan does not affect ASFSF stock in the US. This study also confirmed that the US market has a unidirectional impact on Taiwan market. Insert Table 5 about here Insert Table 6 about here The interesting results were found in short term cash-flow relation. Both mean spillovers in DR and stock were insignificant. The short term effect on return with regard to cash-flow between Taiwan and NASDAQ market is insignificant in our findings. The short-term fund flow between two markets is inefficient. It also suggests an arbitrage opportunity between two markets. Market segmentation between Taiwan and NASDAQ was supported in ASTSF result, which is consistent with that of MXIC. V. Conclusion We find strong mean spillover and volatility spillover between TSMC DR and stock. We document a strong policy effect of TSMC stock to its DR in NYSE. Information transmissions between Taiwan and NYSE with regard to company policy changes were efficient. The shortterm effect on return with regard to cash-flow between Taiwan and NYSE market is also significant in our findings. It implies that the short-term fund flow between two markets in also efficient. The empirical findings support market integration between Taiwan and NYSE. We also find a strong volatility spillover between MXIC DR and stock. However, The mean spillover between MXIC DR and stock was insignificant.. However, the short-term effect on return with regard to cash-flow between Taiwan and NASDAQ market is insignificant in our findings. The short-term fund flow between two markets is inefficient. It implies that there is an arbitrage opportunity between two markets. Market segmentation between Taiwan and NASDAQ was supported. However, TDR showed a different pattern with ADR. A unidirectional volatility spillover was found in our TDR case. It is not surprising that the US market has a strong significant spillover on Taiwan market. However, the other direction does not hold. The insignificant spillover from Taiwan to US market showed a similar pattern in international equity market. No market has spillover to the US market. The interesting difference between ADR and
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TDR could raise a question of the importance of indirect barriers, including accounting standards. The interesting results were also found in short term cash-flow relation. Both mean spillovers in DR and stock were insignificant. The short-term effect on return with regard to cash-flow between Taiwan and NASDAQ market is insignificant in our findings. The short-term fund flow between two markets is inefficient. It also suggests an arbitrage opportunity between two markets. Market segmentation between Taiwan and NASDAQ was supported in ASTSF result, which is consistent with that of MXIC. References Admati, A. R., and P. Pfleiderer, 1988, A theory of intraday trading pattern: Volume and price variability, Review of Financial Studies, 3-40. Alexander, Gordon J., Cheol S. Eun and S. Janakiramanan, 1988, International listings and stock returns: Some empirical evidence, Journal of Financial and Quantitative Analysis 23, 135-151. Campbell, John Y. and Yasushi Hamao, 1992, Predictable stock returns in the United States and Japan: A study of long-term capital market integration, Journal of Finance 47, 4369. Domowitz, Ian, Jack Glen, and Ananth Madhavan, 1998, International cross-listing and order flow migration: Evidence from an emerging market, Journal of Finance 53, 2001- 2027. Eun, Cheo S., and Sangdal Shi, 1989, International transmissions of stock market movements, Journal of Financial and Quantitative Analysis 24, 241-256. Foerster, Stephen R., and G. Andrew Karolyi, 1993, International listings of stocks: The case of Canada and the U.S., Journal of International Business Studies 24, 763-784. Freedman, R., 1989, A theory of the impact of international cross-listings, Working PaperStanford University. Miller, Darius P., 1999, The market reaction to international cross-listings: Evidence from depositary receipt, Journal of Financial Economics 51, 103-123. Mittoo, Usha, 1992, Additional evidence on integration in the Canadian stock market, Journal of Finance 47, 2035-2054.
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Table 1 Volatility spillovers between TSMC DR and stock coefficients America Taiwan Taiwan America 0.781776E-03 -0.207481E-02 (0.797) (-1.413) 0.771514E-04 0.350322E-03 0 (2.143*) (3.422**) 0.677217 0.441439 1 (9.041**) (4.526**) -0.537030E-01 -0.238151E-01 (-1.205) (-0.568) 0.140518 -0.238151E-01 1 (3.141**) (-0.568) 0.398220E-01 0.582176 a , t (2.862**) (4.629**) Log L 1544.2860 1265.4778 AIC 1267.68 1572.20 Not e: *, ** den ot e 5% si gni fi c ant l e vel , 1% si gni fi c ant l e vel . Table 2 Mean spillover between TSMC DR and stock coefficients America Taiwan Taiwan America 0.771868E-03 0.131507E-03 (0.787) (0.179) 0.790329E-04 0.937296E-04 0 (2.180*) (4.674**) 0.677561 0.358347 1 (8.991**) (7.258**) -0.545875E-01 0.252098E-01 (-1.225) (0.736) 0.142014 0.746692E-01 1 (3.158**) (2.586**) 0.379168E-01 0.382983 a ,t (2.952**) (7.003**) a. Log L 1543.9853 2042.6758 AIC 3568.19 3075.80 Not e: *, ** den ot e 5% si gni fi c ant l e vel , 1% si gni fi c ant l e vel .
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Table 3 Volatility spillover between MXIC DR and stock Coefficients America Taiwan Taiwan America 0.126783E-03 0.238394E-02 (0.172) (-2.891**) 0.957778E-04 0.284736E-03 0 (4.656**) (8.842**) 0.353276 0.150207E-05 1 (7.131**) (0.000) 0.246482E-01 0.391555E-01 (0.722) (1.230) 0.754666E-01 0.138973 1 (2.571**) (5.589**) 0.385645 0.977119 a , t (7.024**) (9.913**) Log L 2042.6829 1924.8021 Not e: *, ** den ot e 5% si gni fi c ant l e vel , 1% si gni fi c ant l e vel . Table 4 Mean spillover between MXIC DR and stock Coefficients America Taiwan Taiwan America 0.263483E-02 0.133891 (1.244) (1.138) 0.210516E-04 1.32596 0 (5.179**) (1.745) 0.947482 0.783016 1 (2.022*) (8.216**) 0.300477E-01 -0.764385E-01 (0.658) (-2.194*) 0.525145E-01 0.935150E-01 1 (5.705**) (2.514*) -0.676673E-04 -10.9583 a ,t (-0.546) (-0.429) Log L 1484.5301 -2423.4569 AIC 2207.86 4851.67 Not e: *, ** den ot e 5% si gni fi c ant l e vel , 1% si gni fi c ant l e vel .
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Table 5 Volatility spillover between ASTSF DR and stock Coefficients America Taiwan Taiwan America -0.247013E-02 -0.239864E-02 (-2.445*) (-1.986*) 0.382737E-03 0.253799E-03 0 (8.003**) (4.845**) 0.734836E-03 0.597735 1 (0.035) (10.769**) 0.466211E-01 0.150013E-01 (2.129*) (0.321) 0.979935 0.273091 1 (7.110**) (6.229**) 0.360370 0.184216E-02 a , t (11.756**) (0.515) Log L 1179.2989 1180.8166 AIC 2657.73 2237.85 Not e: *, ** den ot e 5% si gni fi c ant l e vel , 1% si gni fi c ant l e vel . Table 6 Mean spillover between ASTSF DR and stock Coefficients America Taiwan Taiwan America -0.258661E-02 0.128333E-04 (-2.154*) (0.013) 0.251585E-03 0.616676E-03 0 (4.900**) (15.000**) 0.599353 0.140144E-02 1 (10.891**) (0.089) 0.168142E-01 -0.590319E-01 (0.359) (-2.536*) 0.275032 0.988124 1 (6.243**) (3.600**) 0.119280 -0.199523 a ,t (1.303) (-0.817) MLE 1183.1057 1171.1649 Not e: *, ** den ot e 5% si gni fi c ant l e vel , 1% si gni fi c ant l e vel .
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International Research Journal of Applied Finance Vol III Issue 4 April, 2012 Editorial Board Editor-In-Chief Prof. Y Rama Krishna, MBA, PhD Associate Editor Prof. Vinay Datar, Seattle University, USA Senior Sub-Editor Dr. Moustafa Abu El Fadl, Rhode Island College, USA
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Members Dr. Yu Hsing, Southeastern Louisiana University, USA Prof. Richard J. Cebula, Jacksonville University, USA Prof. Nur Adiana Hiau Abdullah,Universiti Utara Malaysia Dr. Mohammad Talha, King Fahd University of Petroleum & Minerals, Saudi Arabia Dr. Sorin A Tuluca, Fairleigh Dickinson University, USA Dr. Nozar Hashemzadeh, Radford University, USA Dr. Dar-Hsin Chen, National Taipei University, Taiwan Dr. Hayette Gatfaoui, Rouen Business School, France Dr. Emmanuel Fragnire, University of Bath, Switzerland Dr. Shwu - Jane Shieh, National Cheng-Chi University, Taiwan Dr. Raymond Li, The Hong Kong Polytechnic University, Hong Kong Prof. Yang-Taek Lim, Hanyang University, Korea Dr. Anson Wong, The Hong Kong Polytechnic University, Hong Kong Dr. Shaio Yan Huang, National Chung Cheng University, Taiwan Mr. Giuseppe Catenazzo, HEC-University of Geneva, Switzerland Prof. J P Singh, Indian Institute of Technology (R), India Dr. Jorge A. Chan-Lau, International Monetary Fund, Washington DC Prof. Carlos Machado-Santos, UTAD University, Portugal Dr. Osama D. Sweidan,University of Sharjah, UAE Dr. David Wang, Chung Yuan Christian University, Taiwan Prof. David McMillan, University of St Andrews, Scotland UK Dr. Abdullah Sallehhuddin, Multimedia University, Malaysia Dr. Burak Darici, Balikesir University, Turkey Dr. Mohamed Saidane, University of 7 November at Carthage, Tunisia Dr. Anthony DiPrimio, Holy Family University, USA Advisors Dr. Michail Pazarskis, Technological Educational Institute of Serres, Greece Dr. Huseyin Aktas, Celal Bayar University, Turkey Dr. Panayiotis Tahinakis, University of Macedonia, Greece Dr. Ahmet Faruk Aysan, Bogazici University, Turkey Dr. Leire San Jose, Universidad del Pas Vasco, Spain Dr. Arqam Al-Rabbaie, The Hashemite University, Jordan Dr. Suleyman Degirmen, Mersin University, Turkey 539
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Prof. Dr. Ali Argun Karacabey, Ankara University, Dr. Moawia Alghalith,UWI, St Augustine, West Indies Dr. Michael P. Hanias, School of Technological Applications, Greece Dr. Mohd Tahir Ismail, Universiti Sains Malayasia, Malayasia Dr. Hai-Chin YU, Chung Yuan University, Taiwan Prof. Jos Rigoberto Parada Daza, Universidad de Concepcin, Chile Dr. Ma Carmen Lozano, Universidad Politcnica de Cartagena, Spain Dr. Federico Fuentes, Universidad Politcnica de Cartagena, Spain Dr. Aristeidis Samitas, University of Aegean, Greece Dr. Mostafa Kamal Hassan, University of Sharjah, College of Business, UAE Prof. Muhammad Abdus Salam, State Bank of Pakistan, Pakistan
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Exchange Interest Inflation Production M2 Stock Valid (listwise)

Mean Statistic .000244 .020373 .006798 .005445 .078487 .026147

Std. Error .0035764 .0233799 .0008487 .0059628 .0765630 .0125165

Std. Deviation Statistic .0390143 .2550441 .0092585 .0650466 .8352038 .1365387

Variance Statistic .002 .065 .000 .004 .698 .019

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Jakarta Index -.2109 -.0618 -.0435 -.0246 .0261 1.0000

Notes: *, ** signifies a significant relationship

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Interest Rate 0.1211 (0.1451) [0.8341)

Table 6: Coefficient of error correction terms

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An Examination of the Markets Anticipation of Directors and Officers Liability Insurance

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COVERAGE =100% (-10,-1) (-1,1) 3,181 2,781 -7.99*** -6.06***

(2,10) -5,414 5.46 -4.52

(2,10) 113,628** -0.95 -11.62

-18,597 12,230 -0.14 1.66 -106.35 0.58

-17.10* 40.47*** -57.16 0.23

-33.88*** 16.69* -187.64 -254.56 0.23 .98 0.33 .000

16.00 -104.22 -0.045 .86

-50.30*** -2.98 -36.97 0.33 63.27 0.21

LAG_ACCRUALS -623.76 0.29

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Determinants of bank failures? Evidence from US failed banks

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111.53 28.47 140.00 111.53 79.66 20.34 29.66 59.33

70.00 70.00 140.00 70.00 50.00 50.00

COVERAGE =100% (-10,-1) (-1,1) 3,181 2,781 -7.99* -6.06*

3.684 7.705* 6.149***