Change In Equity Value Research Articles

Sustainability of Leverage Levels in Response to Shocks in Equity Prices: Islamic Finance as a Socially Responsible Investment

This study looks at how firms react to shocks in equity prices based on a classification which arises from social pressures rather than the financial objective of maximizing shareholders’ wealth. In order to meet the objective of the study, a sample of Malaysian firms from the period of 2003 to 2018 was utilized to evaluate the relationship between market and book debt ratios based on a social distinction. The study is based on the theoretical expectation that managers are inclined to adjust book debt ratios to converge with market debt values which arise from changes in equity values over time. We introduce a unique institutional setting into the relationship which is readily observable in the Malaysian capital market given the existence of Shari’ah and non-Shari’ah compliant company classifications on the stock exchange (Bursa Malaysia), as screened by the Securities Commission. The classification forms the basis for distinguishing Socially Responsible Investment options for investors. The findings reveal the existence of asymmetries in how both categories of firms adjust towards shocks in equity prices. The findings document that both compliant and non-compliant firms decrease book debt ratios in line with increases in firms’ equity values. Compliant firms, on the other hand, are more likely to increase book debt ratios during periods of decreases in equity values. Non-compliant firms do not significantly alter book debt ratios during periods of declining equity prices. The findings indicate that whilst firms tend to decrease debt levels in the presence of future growth potential, the response is asymmetric during periods of suppression of share prices. Thus, the screening of compliant versus non-compliant firms allows investors to distinguish sustainable firms in the long run, which further allows diversification when holding socially responsible investment portfolios. Our conclusions have wide reaching implications on a global scale for the development of sustainable capital markets.

External growth opportunities and a firm's financing policy

This study analyzes how external growth opportunities such as general demand growth impact a firm's financing policy. The model developed in this paper implies that a firm's optimal leverage ratio decreases with growth opportunities if the firm's manager is not highly risk-averse, but increases otherwise. The relation is driven by the respective changes in equity value. Our empirical tests show that equity value is greater and that financial leverage is lower for high-growth firms. This suggests that firms' managers are not highly risk-averse, on average. This paper provides an alternative explanation for the negative relation between leverage and growth opportunities.

Financial Reporting: An Enterprise Operations Perspective

ABSTRACTStudies related to the measurement of accounting numbers have tended to focus on accounting as it relates to: changes in equity values; equity valuation; estimation of the cost of equity capital; and prediction of equity earnings. I propose and justify a perspective for financial accounting research on measurement of accounting numbers that differs from the current generally applied perspective. I argue that important new insights will be gained if research efforts turn toward accounting measurement and valuation at the enterprise/operating/firm level.

Performance and determinants of the Merton structural model: Evidence from hedging coefficients

Abstract We empirically test the effectiveness of the Merton (1974) model in measuring the sensitivity of corporate bond returns to changes in equity value. We study the main variables that affect the performance of the model and relax the assumption of normally distributed rates of return. Results show that less than 6% of the bonds have a hedge ratio within 10% from the model predicted value. Volatility, time to maturity, size, distress, liquidity and information quality are found to be significant determinants of the efficacy of the model.

Corporate Bond Hedging and Fat Tailed Structural Model

The aim of this paper is to empirically test the effectiveness of the Merton [1974] model in measuring corporate bond returns sensitivity to changes in equity value. Compared to the standard framework the assumption of normally distributed rates of returns is relaxed in order to improve the measurement of the hedge ratios and allow for the use of firm specific elasticities. Despite this, results show that at most only 6.12% of the bonds have an hedge ratio ranging between [-10%; 10%] from the model predicted value.

Stock Market Event Studies and Competition Commission Inquiries

Event study analysis is a branch of econometrics which attempts to measure the effects of economic events on the value of firms by examining stock market data. Providing that share prices reflect the underlying economic values of assets, changes in equity values will properly capture expected changes in the economic profitability of the firm. This paper considers the effect on stock prices of announcements relevant to Competition Commission references, using established event study methodology.

Eyes on the prize: How did the fed respond to the stock market?

Since the stock market boom of the 1990s, many have suggested the Federal Open Market Committee (FOMC) has adopted an unannounced policy goal of supporting equity values. This paper offers a new approach to disentangle the relationship between changes in equity values and monetary policy. Specifically, the paper distinguishes the FOMC's reaction to forecasts of traditional goal variables, which may depend on equity prices, from the FOMC's independent reaction to changes in equity prices. By using actual forward-looking variables examined by the FOMC before each action (the “Greenbook” forecasts), the authors find little evidence to support the proposition that the FOMC responds to stock values, except as filtered through a forecast of accepted monetary policy goal variables.

How do firms adjust director compensation?

This paper examines outside director compensation for a sample of 237 Fortune 500 firms over the 1998–2004 period. We document a trend towards fixed-value equity compensation and away from cash only and fixed-number equity compensation. Adjustments to director compensation are consistent with firms targeting a market level of compensation, and firms that deviate from their market wage symmetrically adjust compensation back toward the market level. We also document the relation between changes in compensation and changes in equity values, and find that upward adjustments begin sooner than downward adjustments. When equity values rise, we find virtually no immediate offset to director compensation. However, when equity values fall, fixed-number equity compensation is adjusted in the same period (by awarding more shares or options) to offset the loss of income by almost one-third. Thus, the magnitude of adjustments towards the market wage level is symmetric, but the timing is not.

The impact of junior debt issuance on senior unsecured debt’s risk premiums

Numerous studies have examined the impact of security issuance upon the value of pre-existing debt and equity but the focus has largely been on changes in equity value. We examine changes in senior unsecured debt risk premiums that accompany new junior debt issues. Additionally, we test several hypotheses regarding the potential impacts of junior debt issues. Extant theory suggests senior debt value may be threatened under certain conditions by the issuance of junior debt. Our results indicate that when junior debt replaces bank debt, senior default risk premiums experience abnormal declines. The result is broadly consistent with the elevation of the senior unsecured debt by way of the elimination of a separate and more senior class of debt claimants. In contrast, we also find that larger junior bond issues are associated with abnormal increases in senior risk premiums, broadly consistent with issue size being correlated with negative information about firm cash flows. We find strong evidence of interaction effects. For example, replacement of bank debt results in greater changes in default risk premiums the larger the issue size. We also find lower credit ratings magnify other effects. For example, if the junior debt issued matures before the outstanding senior unsecured bond, senior risk premiums experience abnormal increases for lower rated debt.

Privatization and the Market for Corporate Control

The most important development in international corporate governance in the past 20 years has been the privatization of state-owned enterprises. There is evidence that privatization has resulted in improved firm performance but the source of this improvement is difficult to isolate. We argue that one of the most important results of privatization for corporate governance is the potential entry of those firms into the market for corporate control as targets and bidders, which can result in improved firm performance for numerous reasons. We document the magnitude and the wealth effects of the mergers of privatized firms, attempting to find every privatized firm that was either a target or a bidder in a merger. We find 52 privatized firms that subsequently become targets of takeovers and 90 privatized firms that became bidders in 341 mergers. In general, we find that privatized firms operate very much as non-privatized firms have in the market for corporate control. Target firms experience a 12 percent increase in equity value at the announcement of a merger. Bidding firms experience a positive but insignificant change in equity value at merger announcement. The results indicate that mergers result in net wealth creation for privatized firms and are indicative that one effect of privatization is wealth-creating mergers.

Embedded options and interest rate risk for insurance companies, banks and other financial institutions

We explore how embedded options in assets and liabilities of financial institutions impact interest rate risk, which is measured by equity value change with interest rate movements. We find that both asset and liability durations decline when embedded options are present where liability duration declines more substantially. This leads to a duration-mismatch and a negative change in equity value when interest rates rise, but a positive change for interest rate declines. In a more sophisticated model, an option adjusted duration-matching strategy eliminates interest rate risk caused by duration-mismatch, but the convexity-mismatch remains large due to large negative convexity of callable assets and large positive convexity of putable liabilities. The interest rate risk introduced by convexity mismatch is quite large in comparison to that of duration mismatch. The pattern of this impact is complex and strongest for roughly intermediate maturities. We propose and show that a simple convexity hedging strategy with putable assets and callable liabilities (or caps and floors combined with floating rate assets and liabilities) reduces the interest rate risk substantially.

Multinationality, CEO compensation, and corporate governance: some empirical evidence

Looks at previous research on the differences between multinational corporations (MNCs) and domestic corporations (DCs) and the theories underlying them, relating the ideas to optimal compensation packages for managers. Examines a sample of 724 MNCs and US domestic firms to compare the degree of alignment of their chief executive officer compensation packages and finds that average compensation changes for every $1,000 change in equity value are $33 for DCs and only $12 for MNCs. Analyses further to find out why and suggests that it is due to the higher‐valued investment opportunities of MNCs and differences in their corporate governance structures.

International Insurance Cycles: Rational Expectations/Institutional Intervention

ABSTRACT This study further substantiates the presence of insurance underwriting cycles and analyzes their causes. A generalized least squares analysis of changes in premium levels is used to test the rational expectations/ institutional intervention hypothesis across countries as well as within each country. We also examine the relation between cycle length and the market/institutional features of each country. Finally, a logistic model is used to predict the presence of a cycle based on the market/ institutional features. The results suggest that the rational expectations/ institutional intervention hypothesis explains many aspects of the underwriting cycle, including cycle length. INTRODUCTION The cyclicality of underwriting profits for the property-liability insurance industry has been extensively researched.1 The industry results tend to follow a cycle consisting of alternating uniform periods of rising and then falling underwriting profits. The period in which the cycle "bottoms out" is typically characterized by withdrawal of insurers from some markets resulting in availability crises for some lines (Cummins, Harrington, and Klein, 1992a). Periods of rising underwriting profitability are characterized by increased entry of insurers and expanded coverage for many lines of business. Studies show that the underwriting cycle in the United States tends to follow a second-order autoregressive process with a total period (or cycle) averaging six years (Cummins and Outreville, 1987; Venezian, 1985; Doherty and Kang, 1988; and Smith and Gahin, 1983). But cycles are not limited to the United States; Cummins and Outreville (1987) observe underwriting cycles over long periods of time and in many countries. Explanations for the cycles follow two schools of thought. The first explanation is based on the premise that insurance markets operate irrationally (Venezian, 1985) and/or exhibit market imperfections (Gron, 1994; Winter, 1994), while the second emphasizes rationality with institutional intervention. The argument of irrational behavior suggests that insurance markets are destabilized by phenomena such as extrapolative forecasting and so-called "cash flow underwriting," which can result in prices considerably higher or lower than competitive levels due to erroneous estimates of losses or investment income. The Winter/Gron "capacity constraint" theory posits that cycles are caused by impediments to capital flows that result in alternating periods of excessive and inadequate capacity in the industry.2 According to this scenario, the underwriting cycle is most prominent in longtail lines (usually liability lines) because forecasting horizons are longer and anticipated investment income is more substantial for these lines.3 The other school of thought, which we call the rational expectations/ institutional intervention hypothesis, emphasizes insurance market rationality and considers whether underwriting cycles are caused by external events and market features not under the control of the insurer. Reactions to these phenomena make it appear that insurers behave irrationally. These external events include: (1) institutional, regulatory, and accounting characteristics (Cummins and Outreville, 1987; Witt and Miller, 1981; Outreville, 1990; and Tennyson, 1991); (2) exogenous shocks to surplus attributed to natural catastrophes, unexpected increases in claim costs, or shifts in loss distributions (Cummins and McDonald, 1992); (3) interest rate changes coupled with changes in equity values (Doherty and Garven, 1992; and Cummins and Danzon, 1997); and (4) uncertainties in the market environment (Berger and Cummins, 1992). Although the evidence is extensive regarding the existence of and causes for underwriting cycles in the United States, the examination of international underwriting cycles is limited to Cummins and Outreville (1987). The purpose of the present article is to explore further the presence of underwriting cycles in international property-liability insurance markets and to test the hypothesized explanations for these cycles. …

International transmission of monthly changes in equity values

Our purpose is to answer two questions pertinent to the international transmission of changes in equity values. First, do lead-lag relationships documented in short-horizon (daily) studies continue to hold in longer time (monthly) horizons? Second, does the lead-lag structure remain stable over time? The questions are answered by examining monthly equity returns for nine countries during the 1980s. We find evidence that is somewhat surprising—significant lead-lag relationships among some countries persist in monthly horizons, particularly during the first half of the 1980s. During the second half, the lead-lag relationships are substantially weaker. During the same period, we find that contemporaneous correlations across countries have largely increased, implying greater influence of worldwide factors in determining equity prices.

The Use of Changes in Equity Value as a Measure of the Information Content of Announcements of Changes in Financial Policy

Recent work uses the change in equity value surrounding an announcement of a change in financial policy as an explanatory variable in regressions that examine whether changes in financial policy convey information about firm performance. We explore the methodological and econometric issues of this approach and show that using the change in equity value as an explanatory variable can severely bias ordinary least squares estimates. We demonstrate the effect of this bias on standard statistical tests and conclude that the bias has a significant impact on the power of these tests. We propose an estimator to partially correct the biases.

The Use of Changes in Equity Value as a Measure of the Information Content of Announcements of Changes in Financial Policy

The Use of Changes in Equity Value as a Measure of the Information Content of Announcements of Changes in Financial Policy

Corporate Financial Policy, Information, and Market Expectations: An Empirical Investigation of Dividends

ABSTRACTThis paper documents a relationship between announcements of unexpected changes in financial policy and unexpected changes in performance of the firm. Using a new methodology that combines analysis of stock price movements and earnings forecast data, the authors provide evidence that analysts revise their earnings forecasts following the announcement of an unexpected dividend change by an amount positively related to the size of the unexpected dividend change. They also provide evidence that these revisions are positively related to the change in equity value surrounding the announcement. Further, they find that these revisions are consistent with rationality. Their results therefore provide direct evidence consistent with the hypothesis that unexpected dividend changes signal information about firm performance to market participants.

Corporate Financial Policy, Information, and Market Expectations: An Empirical Investigation of Dividends

This paper documents a relationship between announcements of unexpected changes in financial policy and unexpected changes in performance of the firm. Using a new methodology that combines analysis of stock price movements and earnings forecast data, the authors provide evidence that analysts revise their earnings forecasts following the announcement of an unexpected dividend change by an amount positively related to the size of the unexpected dividend change. They also provide evidence that these revisions are positively related to the change in equity value surrounding the announcement. Further, they find that these revisions are consistent with rationality. Their results therefore provide direct evidence consistent with the hypothesis that unexpected dividend changes signal information about firm performance to market participants.

The wealth effects of company initiated management changes

The essence of corporate control includes the hiring and firing of key managers. We examine changes in equity values when the Board of Directors appoints and dismisses top-level managers. The evidence suggests that management changes signal shifts in company policy and raise shareholder wealth, internal promotions confirm the soundness of investment by large companies in firm-specific human capital while external appointments do not, promotions occur more often than external appointments but decline in importance as firm size decreases, and dismissal is not a favored means to handle managerial underperformance but is associated with stock price increases when used.