Adverse Selection Hypothesis Research Articles

Institutional Ownership and Stock Liquidity: Evidence From an Emerging Market

This research investigates whether institutional ownership contributes to enhancement of stock liquidity in emerging markets. The study examines data of listed companies on the Vietnamese stock market. Using a comprehensive data set for all stocks listed on Ho Chi Minh Stock Exchange (HOSE) and Hanoi Stock Exchange (HNX) from 2008 to 2017, the statistical findings consistently demonstrate that institutional ownership has a negative impact on stock liquidity. In other words, the empirical evidence supports the adverse selection hypothesis that the upward trend of institutional ownership could reduce stock liquidity because the institutional investors with superior and advantageous information could exacerbate informational asymmetry issues. By using a case study in Vietnam, this research makes an original contribution to the academic literature by examining the relationship between institutional investors and stock liquidity in emerging markets. In addition, this study offers policymakers, authorities, agencies, and managers some insightful recommendations and implications that will help to not only promote the active participations of professional institutions but also improve stock liquidity, fairness, and efficiency.

Non-Performing Loans of Commercial Banks in South Asian Countries: Adverse Selection and Moral Hazard Issues

In the South Asian region, a major cause of an increase in non-performing loans (NPL) is the bank’s adverse selection of borrowers. Using the GMM estimator, we empirically studied the bank-specific, industry specific and macroeconomic specific determinants of non-performing loans of banks in South Asian countries (Bangladesh, India, Nepal and Pakistan) from 1997 to 2012 and found that the adverse selection hypothesis of Stiglitz and Weiss (1981) was still effective. We found evidence for the bad luck, bad management, skimping and moral hazard hypotheses of Berger and DeYoung (1997) and their effect on the credit risk determination but we contributed to the literature by showing that ‘moral hazard type II’ (moral hazard between the bank management and the depositors) significantly affected the increase of non-performing loans. Bank size, industry concentration, inflation and GDP growth rate all significantly affected the sample countries’ non-performing loans. Empirical results showed a moderate degree of persistence of NPL and a late-hit of the global financial crisis in the region’s banking sector.

On Estimating the Determinants of Yearling Thoroughbred Prices

Using information for 3,562 thoroughbreds listed in Keeneland's 2011 September yearling sale, hedonic pricing models were estimated using both ordinary least squares regression and a Heckman selection model to test the adverse selection hypothesis that vertically integrated sellers whom breed and race are penalised with bid shading relative to sellers whom only breed, ceteris paribus. Though the null hypothesis of no adverse selection was not rejected in the standard regression model, when taking into account censoring due to sellers withdrawing listed yearlings prior to the auction the null hypothesis was rejected. However, the impact of adverse selection was greatly attenuated by bid shading associated with the reputation effect of sellers, both those whom are vertically integrated and those whom just breed horses, willing to accept final bids less than the stud fee further lessening the winner's curse in the auction. This seller type is new to the literature and as such is a key innovation of this research. The models controlled for other observable characteristics of the yearlings as well as those of the seller and the design of the auction.

Choices in Equity Finance: A Global Perspective

When companies raise equity finance they have to make two choices: the issuing method (cash versus rights) and, when they choose the rights issue method, whether rights should be traded or not. We study these choices using a sample of 15,751 rights issues and 22,016 cash offers announced during 1995-2011 in 127 countries. To explain these choices we consider three hypotheses: the adverse selection hypothesis, the control hypothesis and the financial distress hypothesis. The general conclusion is that none of these theories by themselves can fully explain what we observe.However, we clearly reject the most popular explanation in the literature, i.e. the adverse selection hypothesis, as both rights issues and cash offers are followed by long-term negative excess returns. When we examine the second choice, i.e. the choice to have tradable rights, we find that in the short run the market appreciates the fact that rights are not trading, but in the long run firms with non-tradable rights underperform.In fact, firms seem to restrict rights trading in order to raise financing when the prospect of restructuring is more doubtful and the need to force the hand of the existing shareholders is higher. This provides additional support for the hypothesis that many rights issues are made by firms in financial distress.

The Effect of Venture Capital Investment—Evidence from China's Small and Medium‐Sized Enterprises Board

In this paper, we use a matched sample to empirically test the effect of venture capital investment on the companies listed on the mall and edium‐ized nterprises oard in hina. We find that hinese venture capitalists neither add value to their invested firms in the initial public offering (IPO) process nor improve operating performance. Rather, compared with their non‐venture‐backed counterparts, venture‐backed firms are associated with a greater level of IPO underpricing and inferior operating performance both before and after IPO. Our findings in hina support neither the certification/monitoring hypothesis nor the grandstanding hypothesis, but partly support the adverse selection hypothesis.

Hot and cold IPO markets: The case of the Stock Exchange of Mauritius

The aim of this study is to assess the characteristics of the hot and cold IPO markets on the Stock Exchange of Mauritius (SEM). The results show that the hot issues exhibit, on average, a greater degree of underpricing than the cold issues, although the hot issue phenomenon is not a significant driving force in explaining this short-run underpricing. The results are consistent with the predictions of the changing risk composition hypothesis in suggesting that firms going public during hot markets are on average relatively more risky. The findings also support the time adverse selection hypothesis in that the firms’ quality dispersion is statistically different between hot and cold markets. Finally, the study concludes that firms which go public during hot markets do not underperform those going public in cold markets over the longer term.

Off-balance-sheet activity under adverse selection: The European experience

In the crisis that started in 2007, banks’ off-balance sheet activity has been blamed for flooding the market with low-quality assets and contributing to spreading risk throughout the economic system. Nevertheless, this view is hardly sustainable within the context of sophisticated markets. This paper puts forward an alternative interpretation of the off-balance sheet market, the so-called adverse selection hypothesis. According to this hypothesis, an adverse selection problem characterizes the relation between banks and their counterparties in off-balance sheet deals. Empirically, this implies that off-balance sheet activity is expected to be negatively related to failure risk, whereas it is expected to be positively related to the quality of the assets used for off-balance sheet operations. We test the adverse selection hypothesis for a sample of banks in the 27 member countries of the European Union during the pre-crisis period 1996–2006 and the crisis period 2007–2009. In addition, we check for possible differences between banks in the first 15 members of the European Union and those in the 12 new members.

Corporate Governance and Investor Confidence in Seasoned Equity Offerings

We investigate how governance affects investor confidence in seasoned equity offerings (SEOs) and the cost of raising external equity. Using a differences-in-differences approach with business combination statutes as an external shock, we find investors become worried about non-productive use of SEO proceeds when the law change weakens external pressure for good governance. We buttress this finding by identifying a channel through which governance causes heterogeneous investor reaction to SEO announcements--increases in capital expenditures following SEOs. Also consistent with the governance based explanation, market reaction is more negative when issuers have prior records of value-reducing acquisitions and weaker alignment of managerial incentives to shareholder value. The magnitudes of these impacts are surprisingly large, explaining most of negative market reactions to primary offerings. Secondary offerings are met with strong negative reactions due to signaling effects; however, our data show no evidence in support of the adverse selection hypothesis.

Ownership concentration, voluntary disclosures and information asymmetry in New Zealand

This paper investigates the impact of different classes of ownership concentration on information asymmetry conditional upon corporate voluntary disclosures in New Zealand. The current paper attempts to extend this stream of research by incorporating three mutually exclusive ownership structures and considering the interactive relationship between such ownership structures and corporate voluntary disclosures. Results reveal that ownership concentration in general is significantly positively associated with bid-ask spreads (proxy for information asymmetry) observed around annual report release dates. This finding supports the adverse selection hypothesis and importantly this effect is found to be most pronounced for financial institutions and management-controlled ownership categories. When voluntary disclosure is taken into account, the findings demonstrate that disclosures significantly attenuate information asymmetry risk associated with ownership concentration. This effect is particularly pronounced for firms with management-controlled ownership structures. The findings highlight the importance of corporate disclosures under concentrated ownership structures especially management-controlled ownership structures in reducing information asymmetry and enhancing market efficiency in New Zealand.

Analysis of Adverse Selection and Moral Hazard in the Health Insurance Market of Iran

This paper aims to estimate a demand model for health insurance and medical care in Iran, in the presence of heterogeneous and latent health status of individuals; moreover it tests the asymmetry of information in the health insurance market. Our data set have been taken from the Households’ expenditures survey (2006) of Iran. Parameters of the model are estimated by the Generalized Method of Moments (GMM) and the presence of asymmetric information (adverse selection and moral hazard) is tested by a non-parametric econometric method. The analytical model is specified under minimal assumptions on the selection process of different insurance categories and the statistical distribution of individual's latent health status. The findings confirm the presence of adverse selection hypothesis in personally purchased health insurance and moral hazard in all health insurance categories.

Off-Balance Sheet Activity Under Adverse Selection: The European Experience

The share of off-balance sheet activity (OBSa) in the future of banking business has been questioned by the use of low-quality assets in this activity. Nevertheless, this paper puts forward the adverse selection hypothesis, which counter argues that more stable banks engage in OBSa to a larger extent, and that banks use high-quality assets to engage in OBSa. For this hypothesis: (1) the OBSa-risk relation is not necessarily homogenous across the different risk measures that define a bank’s risk position; and (2) banks' counterparties in OBSa are the risk averse, less informed side of an adverse selection problem. As a result, on the one hand, the on-balance sheet assets used by banks to engage in OBSa are the most valuable for risk-averse counterparties; i.e., the safest and most liquid assets. However, on the other hand, investors value more highly off-balance sheet items issued by banks that signal a safe general risk position. We test the adverse selection hypothesis for a sample of banks in the 27 countries of the EU during the period 1996-2005, and check for possible differences between banks in the 15 former State members of the EU and those in the 12 new joiners.

Competition and Adverse Selection in the Small-Dollar Loan Market: Overdraft versus Payday Credit

We find that competition from payday lenders leads depository institutions to raise overdraft fees and reduce the availability of “free” checking accounts. We attribute this rise in prices partly to adverse selection created by banks’ practice of charging a flat fee regardless of the overdraft amount―pricing that favors depositors prone to large overdrafts. Payday credit is priced per dollar borrowed, so when that option is available, depositors prone to small overdrafts switch. That selection works against banks; large overdrafts cost more to supply and, if depositors default, banks lose more, so prices rise. Consistent with this adverse selection hypothesis, we document that the average dollar amount per returned check at banks and other depository institutions increases when depositors have access to payday credit. Our findings illuminate competition and pricing frictions in the large, yet largely unstudied, small-dollar loan market.

The Determinants of Corporate Debt Ownership Structure: Evidence from Market-based and Bank-based Economies

This paper offers a comparative analysis of the determinants of the corporate debt ownership structure in a bank-oriented economy (Germany) and market-oriented economy (the UK). Using GMM estimators, we control for the problems of endogeneity, heteroscedasticity, normality, simultaneity and measurement errors that are common in firm-level panel data. The results show that the firms in both countries adjust their debt ownership structure towards their target levels - British firms being the swiftest. The findings confirm the validity of the liquidation and renegotiation hypothesis and the flotation cost hypothesis in both countries. However, the moral hazard and adverse selection hypothesis receives strong support in the UK but not in Germany. Moreover, the role of control factors (market related variables) in determining the choice of the lender is country dependent. Therefore, the debt ownership structure of a firm is influenced by both the firm-specific factors and the financial systems and corporate governance traditions in which the firm operates.

The Consequences for a Monopolistic Insurance Firm of Evaluating Risk Better than Customers: The Adverse Selection Hypothesis Reversed

This article models a situation in which a monopolistic insurer evaluates risk better than its customers. The resulting equilibrium allocations are compared to the consequences of the standard adverse selection hypothesis. On the positive side, they exhibit the property that low-risk people are better covered than higher-risk people. On the normative side, the article shows that there are two reasons for avoiding excessive risk classification: one is the classical destruction of insurance possibilities, and the other comes from the distrustful atmosphere generated by new asymmetric information.

Information asymmetry, monitoring, and the placement structure of corporate debt

We empirically examine the impact of flotation costs, agency conflicts, regulation, and information asymmetries on a firm's mix between public and private debt. Results indicate that firms with larger issue sizes exploit the scale economies in flotation costs of public debt. Firms with higher contracting costs due to moral hazard have higher proportions of private debt. There is only limited support for the adverse selection hypothesis. We find little evidence that firms with favorable private information about future profitability choose more private debt. However, those firms with favorable information about future profitability that also operate under greater information asymmetry rely more on private debt.

The underpricing of initial public offerings: A theoretical and empirical reconsideration of the adverse selection hypothesis

In this paper we generalize Rock's theory regarding the underpricing of IPOs. In Rock's model, informed investors have a firm-specific informational advantage pertaining to a firm's cash flow. We derive the new results that the level of beta and the size of the market risk premium positively affect underpricing. These implications extend the adverse selection theory and further distinguish this theory from the current state of signalling theories of underpricing. The results put the “hot and cold” issue markets phenomenon in a theoretical context. Empirical results are consistent with the theoretical propositions and provide support for Rock's theory of underpricing.