Firm-specific Risk Research Articles

Does Brownian Risk Matter in Debt or Equity Issuance and Repurchase Decision in Indian Non-Financial Companies?

External commercial borrowings (ECBs) of Indian non-financial firms have grown by 107 % in past few years. Looking at the high reliance of firms on external debt, this paper investigates the effect of foreign exchange, interest rate and firm specific risk on the debt issuance and retirement decision. It also investigates the factors affecting equity issuance and retirement decision of the firms. Foreign exchange risk and interest rate risk is estimated using stochastic volatility and GARCH (1,1) methods. Firm specific risk is calculated using Black-Scholes Merton model for company valuation. The results highlight that interest rate risk negatively affects the debt issuance and positively affects debt retirement decision of the firms. However, the foreign exchange risk does not affect debt issuance and retirement decision. Firm-specific risk negatively affects propensity of debt issuance of firms but plays no role in debt retirement. Foreign exchange risk, firm-specific risk, and profitability negatively affect propensity of issuance of debt to issuance of equity. This result supports the view that risky firms are more likely to finance their capital needs via new equity issues rather than by new debt issues to avoid the high-risk premium and to limit the likelihood of bankruptcy.

Locked-In: The Effect of CEOs' Capital Gains Taxes on Corporate Risk-Taking

ABSTRACTI study the effects of CEOs' unrealized capital gains tax liabilities (tax burdens) on corporate risk-taking. Recent work suggests that high tax burdens discourage CEOs from selling stock. I hypothesize that this causes the executives to become overexposed to firm-specific risk, thereby reducing their willingness to make risky corporate decisions. In a series of tests, I find that corporate risk-taking decreases as CEOs' personal tax burdens increase. Further, firms with CEOs who are more locked-in to their stock positions (i.e., CEOs with higher tax burdens) experience larger increases in risk-taking following federal and state tax cuts. When I investigate the mechanism behind this relation, I find that tax cuts trigger stock sales by the locked-in executives, allowing for improved diversification. Overall, my findings indicate that the personal tax burdens of CEOs affect the firm by reducing executives' preferences for risk at the corporate level.JEL Classifications: G32; H24; J33; M52.

Locked-In: The Effect of CEOs' Capital Gains Taxes on Corporate Risk-Taking

I study the effects of CEOs’ unrealized capital gains tax liabilities (tax burdens) on corporate risk-taking. Recent work suggests that high tax burdens discourage CEOs from selling stock. I hypothesize that this causes the executives to become overexposed to firm-specific risk, thereby reducing their willingness to make risky corporate decisions. In a series of tests, I find that corporate risk-taking decreases as CEOs’ personal tax burdens increase. Further, firms with CEOs who are more locked-in to their stock positions (i.e., CEOs with higher tax burdens) experience larger increases in risk-taking following federal and state tax cuts. When I investigate the mechanism behind this relation, I find that tax cuts trigger stock sales by the locked-in executives, allowing for improved diversification. Overall, my findings indicate that the personal tax burdens of CEOs affect the firm by reducing executives’ preferences for risk at the corporate level.

Bank rescues and bailout expectations: The erosion of market discipline during the financial crisis

We design a novel test for changes in market discipline based on the relation between firm-specific risk, credit spreads, and equity returns. We use our method to analyze the evolution of bailout expectations during the recent financial crisis. We find that bailout expectations peaked in reaction to government interventions following the failure of Lehman Brothers, and returned to pre-crisis levels following the initiation of the Dodd-Frank Act. We do not find such changes in market discipline for nonfinancial firms. Finally, market discipline is weaker for government-sponsored enterprises (GSEs) and systemically important banks (SIBs) than for investment banks.

Firms’ investment decisions – explaining the role of uncertainty

PurposeThe purpose of this paper is twofold. First, based on the value optimization problem of the firm, the authors proposed a theoretical model for firms’ investment decisions, which incorporates the effects of both idiosyncratic (firm specific) and macroeconomic uncertainty/risk. Second, the authors empirically estimate the proposed model for Pakistan.Design/methodology/approachThe authors utilize an unbalanced firm-level panel data covering the period 1988-2013. To generate time-variant firm-specific uncertainty, the authors estimate the autoregressive model on firm sales for each firm included in the sample over the examined period. Firm-specific risk is also measured based on the square of the residuals of firms’ sales. Two measures of macroeconomic uncertainty are computed using the conditional variance obtained by estimating the ARCH model for consumer price index and industrial production index. Several alternative measures of both types of uncertainties are used to ensure the robustness of uncertainty effects. To mitigate the problem of endogeneity, the robust two-step system-generalized method of moments estimator is used to estimate the empirical model.FindingsThe results indicate that firms are likely to cut down their level of investment spending when either type of uncertainty increases. The results also reveal that the sensitivity of firms’ investment decisions to macroeconomic (aggregate) uncertainty is higher as compared to the firm-specific uncertainty. The authors show that these findings are robust to different uncertainty measures used in the analysis. The results related to firm characteristics suggest that the firm-specific variables namely the debt to assets ratio, the costs of debt to assets ratio, and the sales to assets ratio are also equally important in the determination of investment decisions of corporate manufacturing firms.Practical implicationsThe empirical findings of the paper are useful for firm managers, investors, and government authority. Specifically, the results help firm managers and investors to understand how firm-specific and macroeconomic uncertainty affects firms’ investment decisions. The finding that firms cut their investment spending in times of macroeconomic instability implies that declines in firms’ investment spending during the periods of macroeconomic turmoil may delay the process of recovery. Therefore, the policy makers should design such policies that encourage firms to invest more in economic crisis periods, which, in turn, would enhance the growth of the economy and help to overcome the problem of downturn/recession.Originality/valueThe authors first propose a theoretical model for firms’ investment decisions based on the value optimization problem of the firm by incorporating the role of both firm-specific and macroeconomic uncertainty. Next, unlike most of previous studies, they estimate the proposed model for non-financial firms operating in Pakistan. The authors predict that a higher exposure to both idiosyncratic and macroeconomic uncertainties leads to lower investment in Pakistani manufacturing firms. Further, the authors hypothesize that both types of uncertainties have differential effects on firms’ investment decisions.

The Local Market Perception of Firm Risks During Cross-Listing Events

To date, we know very little about how local market perceives the changes in risk structure for the firms listing in overseas market and specifically how relative firm-specific risks (ratio of firm-specific to total risks) vary by listing type and home market development. In this paper we examine the dynamic step-by-step transition of the local market perceptions of relative idiosyncratic risks around the cross-listing events. Using a sample of 606 ADR firms, we find that increases in cross-listed firms’ relative firm-specific risks on the local market around the listing date are only temporary and small for Level I ADRs. We observe the most variations in Level III ADRs. For exchange listed ADRs from emerging markets, we find that before the listing date, there is a significant decrease in relative firm specific risk in the year prior to listing which then increases during the cross-listing, but we do not find similar changes for developed market firms. For developed market firms we only observe significant increases in relative firm specific risks. We interpret these as evidences of negative relationship between firm opaqueness and relative firm specific risks (Jin and Myers, 2006, Journal of Financial Economics, 79, 257-292).

A conditional value-at-risk based methodology to intermediate-term planning of crude oil tanker fleet

Abstract Crude oil suppliers usually meet intercontinental demand through a fleet of ocean tankers, which not only have very high fixed and operating costs but also carry considerable financial risks because of the volatilities in oil demand and spot freight rate markets. Hence, most oil suppliers maintain an under-capacity fleet, and manage additional requirements through periodically adjusting a mix of various charter contracts and/or their purchase options. For this periodic fleet adjustment problem, we propose a conditional value-at-risk based methodology to hedge against extreme losses. More specifically we develop a mixed integer nonlinear programming model, where parameters are estimated via Monte-Carlo simulation, to minimize both the chartering costs and the associated financial risks. The proposed methodology was applied to a number of problem instances, generated using the marine transportation network of a major oil supplier, and it was observed that: full use of a mix of charter contracts and its purchase options significantly reduce spot charter market related risks, while substantially increase the firm or oil demand-specific risks—a key relationship driving optimal fleet decisions; and, firm-specific (tanker under-utilization) risks become increasingly irrelevant during higher oil demand periods, and that the market risks show sensitivity to the starting spot charter prices as well as the scale of delivery operations.

CEO Risk-Taking and Socioemotional Wealth: The Behavioral Agency Model, Family Control, and CEO Option Wealth

We combine behavioral agency and family business literature to analyze the role of dominant firm principals in constraining the managerial agent’s (CEO’s) response to equity-based pay. Behavioral agency research has made progress in understanding CEO risk behavior in response to equity-based incentives and family firm risk behavior driven by concentrated socioemotional and financial firm-specific risk bearing. However, both literatures have evolved independently, which has limited our understanding of how the risk bearing of agent and principal influences the predictions of the behavioral agency model (BAM). We combine these literatures in order to enhance BAM’s predictive validity with regard to firm risk-taking as a function of both agent and principal risk preferences. Our findings suggest that family principals are more likely than nonfamily principals to constrain CEO risk behavior that is perceived as immoderate (excessively risk averse or excessively risk seeking). We also offer evidence that CEO ties to the family influence the CEO’s response to equity-based incentives. In doing so, we offer refinements to BAM’s formulation and advance our understanding of the unique nature of agency problems within family firms.

Priced Firm-Specific Risk and Accounting Information

There is a strand of CAPM based analytical research in accounting that uncovers a little known CAPM corollary, namely that the firm's cost of capital is a joint effect of its payoff risk and payoff mean. The CAPM equilibrium mechanism has the effect that the numerator (expected payoff) drives its own denominator (discount rate). My paper traces the origins of this finding to Fama and Lintner's original CAPM derivation. Although surprising, the role of the mean, and more generally the payoffs expression of CAPM, has deeply interesting and useful connotations for accounting firm-specific information. I expand on those implications and on how they provide an insightful footing for empirical accounting research.

Informed Options Trading and Stock Splits

After experiencing significant stock price run-ups, a firm becomes overweight in its shareholders’ portfolios, subjecting them to excessive firm-specific risk and creating portfolio rebalancing needs. If the firm cannot attract sufficient buying interests, selling pressure from rebalancing leads to undervaluation. The firm can resolve the undervaluation problem by splitting its shares to attract new investors to better facilitate shareholders’ portfolio rebalancing. Since undervaluation attracts informed trading and makes listed options more appealing, we analyze stock price behavior and relative trading of options over stock surrounding stock splits and find compelling evidence consistent with our portfolio-rebalancing hypothesis of stock splits.

Systemic Risk and Centrality Revisited: The Role of Interactions

We suggest that banks contribute extensively to systemic risk only if they are both “risky” and centrally placed in the financial network. To calculate systemic risk we apply the ∆CoVaR measure of Adrian and Brunnermeier (2016) and measure centrality using detailed US loan syndication data. In agreement with our conjecture our main finding is that centrality is an important determinant of systemic risk but primarily not by its direct effect. Rather, its main influence is to make other firm specific risk measures more important for highly connected banks. A bank’s contribution to systemic risk from a fixed level of Value-at-Risk is about four times higher for a bank with two standard deviations above average centrality compared to a bank with average network centrality. Neglecting this indirect moderation effect of centrality severely underestimates the importance of centrality for “risky” banks and overestimates the effect for “safer” banks.

How Do Investments in Human Resource Management Practices Affect Firm-Specific Risk in the Restaurant Industry?

Despite the importance of achieving a competitive advantage in human resources in the restaurant industry, restaurant firms often hesitate to make significant investments in human resource management (HRM) practices because of outcome uncertainty, operational issues, and limited financial resources, among other issues. Building upon the strategic human resource management (SHRM) literature, the current study attempts to better understand the HRM issues in the restaurant industry and investigate the effects of HRM practices on a firm’s risk. More specifically, we explore the separate effects of positive and negative HRM practices on firm-specific risk (i.e., unsystematic risk) in the restaurant industry. Our findings demonstrate that positive HRM practices have a nonsignificant relationship with firms’ unsystematic risk, but negative HRM practices have an inverted U-shaped relationship with unsystematic risk, supporting the stakeholder theory, theory of desensitization, and slack resource theory.

Corporate financial policy and the value of cash under uncertainty

PurposeThe purpose of this paper is to provide evidence on how firm-specific and macroeconomic uncertainty affects shareholders’ valuation of a firm’s cash holdings. This extends previous work on this issue by highlighting the importance of the source of uncertainty. The findings indicate that increases in firm-specific risk generally increase the value of cash while increases in macroeconomic risk generally decrease the value of cash. These findings are robust to alternative definitions of the unexpected change in cash. The authors extend the analysis to financially constrained and unconstrained firms.Design/methodology/approachThe authors test the hypothesis that the marginal effect of cash holdings on excess stock returns is sensitive to uncertainty. To compute this marginal effect, the authors adopt and extend the approach of Faulkender and Wang (2006) to the authors’ more elaborate model.FindingsThe findings indicate that different sources of uncertainty affect the value of cash holdings differently. Findings indicate that increases in firm-specific risk generally increase the value of cash while increases in macroeconomic risk generally decrease the value of cash. These findings are robust to alternative definitions of the unexpected change in cash. The authors also extend the findings to financially constrained and unconstrained firms.Originality/valueThe findings indicate that the source of uncertainty firm-specific vs macroeconomic risk matters. The two sources of risk may have quite different effects on shareholders’ valuation of a firm’s cash holdings. Results from alternative sources of findings are new. These new findings are robust to alternative definitions of the unexpected change in cash.

Long-run adjustment of size, value, momentum and growth premium in equity returns: Evidence from South Asian emerging markets

ABSTRACTThis study scrutinizes the long-run adjustment of risk premiums in equity returns of the emerging stock markets of Pakistan, China and India, the three emerging South Asian economies, by keeping in view leading contributions of the Fama and French (1992) and Carhart (1997) models. Unlike the multifactor models based on macroeconomic factors, this study integrates firm-specific risk factors related to the market premium. The firm-specific growth factor, derived by Ho, Strange, and Piesse (2008), is incorporated as GML, which is based on assets to market value of the firm. The results from a sample of 1 198 companies, taken from three emerging markets for the period of 2001−2013, indicate that market risk premium is the leading factor affecting risk premium in Pakistan and India. Further results reveal that, although market momentum is high enough to overestimate betas in the short run, it congregates to stabilisation and correction in the long run. In contrast, Chinese markets appear to be predominantly reflective of risk factor explaining risk premium, and are relatively more stable and efficient, clearly representing their maturity. Smaller stocks deliver higher returns with higher volatility that is apparently consistent with the general notion of high risk associated with high returns. Growth stocks outperform value stocks in the economies of Pakistan, China and India. Moreover, these markets head towards illiquidity in pre-financial crises periods, but market recovery is observed in post-financial crises periods.

'Exchange Rate Risk' within the European Monetary Union? Analyzing the Exchange Rate Exposure of German Firms

In this paper we show that inflation differentials among the countries in the European Monetary Union (EMU) are an economically significant risk to German firms, which make up the largest economy in the EMU. This risk can be interpreted as real “exchange rate exposure” resulting from trade within the euro area. Actually, we find that this EMU exposure is nearly as high as the standard exchange rate exposure caused by trade with non-EMU countries. Moreover, our analysis shows that many of the conventional factors that drive firm-specific exchange rate risk, such as size, debt ratio, asset turnover and foreign business activity, also determine EMU exposure in an economically meaningful way. However, EMU exposure challenges firms’ risk management, particularly as it cannot be reduced by standard financial hedging instruments such as currency derivatives.

Earnings Yield as a Predictor of Return on Assets, Return on Equity, Economic Value Added and the Equity Multiplier

This study identifies earnings yield as a measure of financial performance that is based on a firm’s ability to sell profitable goods. It excludes the irrationality that can confound market-based measures of financial performance by emphasizing a firm’s ability to earn profits as the indicator of superior performance. For the full sample, the differential effects of earnings yield on return on assets, return on equity, stock returns, economic value added and the equity multiplier are determined for firms of different size and volatility. The analysis is conducted both across industries and within the oil and gas, computer software, biotechnology and retail industries. For the full sample of NASDAQ stocks from 2010-2014, earnings yield significantly explained return on assets, return on equity, stock returns, economic value added and the equity multiplier beyond book value and book to market. The influence of earnings yield on return on assets was predictable with linear relationships and autocorrelated residuals, while that for small firms was unpredictable with nonlinear relationships between earnings yield and all outcomes with heteroscedastic residuals. In the oil and gas industry, small producers with low market risk and high firm-specific risk, i.e. drillers in new locations with existing technology, found that earnings yield was related to all outcome measures, while large, high-market risk firms, or drillers using the new shale rock techniques strove for operational efficiency through higher return on assets and return on equity. Market risk demarcates small biotechnology firms with those with low market risk demonstrating the explanation of return on assets by earnings yield, while earnings yield is significantly related to economic value added for high market risk firms. In large biotechnology firms, earnings yield was significantly related to all outcomes. Similar results were obtained for the computer software industry. Retail is in retrenchment with small retailers selling traditional product lines emphasizing return on assets or being operationally efficient for survival, while large retailers borrow against large-scale investments in assets, as shown by the significant explanation of the equity multiplier by earnings yield. It may be concluded that earnings yield measures multiple dimensions of financial performance for firms of different size and volatility levels in multiple industries. For small firms, the ability of earnings yield to measure the productivity of capital through economic value added is noteworthy. For large firms, earnings yield is particularly effective in predicting operational efficiency or return on assets.

Managerial Theory of Firm: Towards a Synthesis of Finance and Strategic Management

Modern strategic management explains competitive position of a company through manager’s efforts in searching and constructing firm-specific resources and capabilities. Corporate finance claims that an investor forms a diversified portfolio taking into account systematic risk only (no link to management) whereas firm-specific risk is completely ignored. We have arrived to a paradox, which affirms that company’s value does not depend on manager’s efforts. In essence everything depends on industry (industry beta is a recommended proxy for systematic risk). The survey is devoted to recent progress in solving the paradox. The breakdown is based on consideration of shocks in idiosyncratic cash flows, which leads to a new systematic risk model being grounded on managers’ actions. These shocks are related to exercising of growth options, which are the major tool for adaptation to uncertainty of external environment recommended by strategic management.

Sufficiency Economy Philosophy and Firm Risks

Using data from Thailand, we designed and created our Sufficiency Economy Philosophy score (SEP score) that measures the extent to which a firm is aligned with Sufficiency Economy Philosophy. We find that our SEP score has a negative relationship with firm-specific risk measured by the standard deviation of residuals from the market model. However we find no relationship between SEP score with neither market risk nor other measures of firms’ performance. The findings support the notion that alignment with Sufficiency Economy Philosophy could reduce risk without sacrificing performance, it leads to sustainability, and that Sufficiency Economy Philosophy practices are well aligned with shareholders’ interests.

Capital structure adjustments: Do macroeconomic and business risks matter?

We show that risk plays an important role in estimating the adjustment of the firm’s capital structure. We find that the adjustment process is asymmetric and depends on the type of risk, its magnitude, the firm’s current leverage, and its financial status. We also show that firms with financial surpluses and above-target leverage adjust their leverage more rapidly when firm-specific risk is low and when macroeconomic risk is high. Firms with financial deficits and below-target leverage adjust their capital structure more quickly when both types of risks are low. Our investigation suggests that models without risk factors yield biased results.

Firm-specific risk, managerial certainty and optimism

Purpose– The purpose of this paper is to focus on investor reactions to unanticipated changes in income, and whether those reactions can be mitigated by managerial discussion. The authors investigate how top-management team certainty and optimism during post-earnings announcement conference calls can serve as corrective actions and add back firm value in times of unexpected changes in firm-specific risk.Design/methodology/approach– The research question is tested empirically in the context of large, publicly traded, US firms’ quarterly earnings announcements, and their subsequent post-earnings announcement conference calls. The authors use the advanced content analysis software DICTION to measure the levels of managerial certainty and optimism displayed during post-earnings announcement conference calls, and event-study methodology to measure investors’ reactions.Findings– Results indicate that earnings surprises are negatively associated with firm value, but that this relationship is mitigated positively by displays of managerial certainty and optimism during post-earnings announcement conference calls.Originality/value– This work uses an innovative research design to study top-management team rhetoric in post-earnings announcement conference calls, and how specific discussions mitigate investors’ negative reactions to increases in firm-specific risk. The study highlights the importance of top-management team certainty and optimism for value creation in times of change in firm-specific risk, and the importance of rhetoric as a tool for corrective action.