High Financial Risk Research Articles

The Two-Sided Effect of Financial Globalization on Output Volatility

This paper provides evidence for a significant relation between international financial markets' integration and output volatility. In the framework of a threshold model, it is shown empirically that this relation depends on country's financial risk. Financial risk indicates a country's ability to pay its official, commercial and trade debts. In countries with low financial risk, financial openness decreases output volatility, while, in countries with high financial risk, financial openness increases output volatility. Extensive robustness checks confirm this result.

Exit Returns and Venture Capital Investment Opportunities

This study is the first to empirically construct exit returns - the return accruing to venture capitalists (VCs) from investments in portfolio companies - for a large sample of U.S. venture-backed companies. Exit returns are used (1) to document the size and trends in returns for specific investments that exit via an M&A or IPO during 1985-2008, and (2) to develop an Exit-to-Failure Ratio (EXF) to assess the strength of VCs’ investment opportunities in an industry. EXF measures the coverage exits provide to make up for failures that pose high reputational and financial risk to VCs. Outside of the Dotcom period, new investments initiated under higher EXF levels result in significantly higher future returns. Higher values of EXF also increase VCs’ risk appetite and their willingness to fund early stage companies. Our results show sharply diminished returns to VC investments over the sample period, which has resulted in a significant downward trend in VCs’ inclination to fund early stage companies. The finding raises concerns about the industry’s role in funding young, innovative companies if the trend persists.

Financial Statement Information and Evaluation of Newly Listed High-Technology Nano Caps

This study examines the usefulness of financial statement information in evaluating very small newly listed high-technology nano cap firms’ (i.e., market capitalization less than USD 50 million) by employing data from 36 countries during the high investor sentiment era of 1995-2000. I find that financial statement information is useful in screening nano caps from non-nano caps as well as explaining nano caps’ delisting risk and valuing them. The evidence based on these three approaches is consistent with the view that financial statements provide useful information to investors for evaluating high financial risk, hard-to-value firms irrespective of the institutional setting during a high investor sentiment period.

Studying the interdependence of contractual and operational flexibilities in the market of specialty chemicals

Abstract This paper focuses on the market of specialty chemicals and deals with the joint investigation and valuation of contractual and operational flexibilities from a manufacturers’ point of view. In this market, customized services related to research, development and manufacturing of chemicals, intermediates and active pharmaceutical ingredients are offered to a small number of customers. Traditionally, customers are granted a large degree of freedom with respect to demand quantity and time exposing the manufacturer to high uncertainty and financial risk. Using a model-based approach we quantify the effect of this contractual flexibility and relate it to the manufacturing flexibility concerning capacity allocation. Through the valuation of these flexibilities we provide first insights for the manufacturer on which customer requests to accept, how to set up the associated contracts with the customers and how to allocate capacity for a given portfolio of products.

Effective EOR Decision Strategies With Limited Data: Field Cases Demonstration

Summary Enhanced-oil-recovery (EOR) evaluations focused on asset acquisition or rejuvenation involve a combination of complex decisions using different data sources. EOR projects traditionally have been associated with high capital and operational expenditures (CAPEX and OPEX, respectively) as well as high financial risk, which tend to limit the number of EOR projects launched. We propose a workflow for EOR evaluations that accounts for different volumes and quality of information. This flexible workflow has been applied successfully to oil-property evaluations and EOR-feasibility studies in many oil reservoirs. The method associated with the workflow relies on traditional (e.g., look-up tables, x-y correlations) and more-advanced (data mining for analog-reservoir search and geology indicators) screening methods, emphasizing identification of analogs to support decision making. The screening phase is combined with analytical or simplified numerical simulations to estimate full-field performance with reservoir-data-driven segmentation procedures. This paper illustrates the EOR decision-making workflow by use of field case examples from Asia, Canada, Mexico, South America, and the United States. The assets evaluated include reservoir types ranging from oil sands to condensate reservoirs. Different stages of development and information availability are discussed. Results show the advantage of a flexible decision-making workflow that can be adapted to the volume and quality of information by formulating the correct decision problem and concentrating on projects and/or properties with the highest expected economic merit. An interesting aspect of this approach is the combination of geologic and engineering data, minimizing experts' bias and combining technical and financial figures of merit. The proposed method has proved useful to screen and evaluate projects/properties very rapidly, identifying when upside potential exists.

Appointment of Political Top Executives and Subsequent Performance and Corporate Governance: Evidence from China's Listed SOEs

This paper investigates the replacement and appointment of top executives in a business highly involved by the government and their consequences on firm performance and corporate governance. It provides a dynamic setting to test the value of political connection as prior studies do not discern government interests and incorporate ambiguous institutions and self-selection problems by cross-section test. Using data of China's listed state-owned enterprises (SOEs), this paper finds that the state owner is more likely to replace top executives and appoint a politically-connected executive when SOEs encounter economic distress such as poor ROA, earnings loss, high financial risk, or political distress such as SEC regulation violation. It implies that the politically-connected executive may be considered helpful by the government in response to firm distress. Further, it is found that the political top executives improve firm performance following their appointments and reduce the frequency of executives' illegal actions, by initiating modification of internal governance structures and mitigating manager's discretion. And those firms do not have preferential access to resources or government assistances such as fiscal subsidies, tax benefits, or the credit market. All these findings support that political executives could serve as a disciplinary or monitoring mechanism in a political economy lack of external market for corporate control and legal protection for investors, instead of being only a form of bail-out. Their efficacy is based on their administrative power, regulatory expertise and accountability to the government interests. These results provide better understanding of government interests and their impact on corporate governance.

The Two-Sided Effect of Financial Globalization on Output Volatility

This paper provides evidence for a significant relation between international financial markets' integration and output volatility. In the framework of a threshold model, it is shown empirically that this relation depends on country's financial risk. Financial risk indicates a country's ability to pay its official, commercial and trade debts. In countries with low financial risk, financial openness decreases output volatility, while, in countries with high financial risk, financial openness increases output volatility. Extensive robustness checks confirm this result.

Smoothing Out Step Changes of LMP

The locational marginal pricing methodology may lead to a step change when system load grows, creating higher financial risk, especially for small and medium-sized market participants. A proposed continuous LMP method is a straightforward solution to eliminate these step changes when load grows.

The determinants of forward‐looking information in annual reports of UAE companies

PurposeThis paper aims to empirically explore the underlying factors that may affect the extent to which forward‐looking information is disclosed.Design/methodology/approachThis study uses a list of forward‐looking keywords to demonstrate the differences, if any, in the level of disclosure among firms and between sectors. The sample includes 46 companies listed in either the Dubai financial market or the Abu Dubai securities market. Statistical analysis is performed using a backward regression.FindingsDebt ratio and profitability are found to be significant; however, sector type, firm size, and auditor size are found to have insignificant association with the level of forward‐looking information disclosed in UAE annual reports.Practical implicationsA number of users, such as investors, lenders, and auditors, may find these results beneficial. These users may consider the results of this study when they are dealing with firms that have low profitability and high financial risk. Accordingly, they may wish to extend their investigations and verify such reporting practices. By doing this, the quality of information that is available to the public may be enhanced; and hence, users of annual reports may be better served.Originality/valueIt is important to note that the association between the extent of disclosure and the selected corporate attributes is still ambiguous. There are a very limited number of studies that have examined disclosure of forward‐looking information in developing countries and even fewer such studies may be found in the Middle Eastern countries. To the best of the one's knowledge, no study yet has examined the forward‐looking information disclosure issues in the UAE or Middle Eastern countries.

Modelling Transparency in Disclosure: The Case of Foreign Exchange Risk Management

Abstract: When managers choose not to disclose all the relevant information in their possession in their financial statements, there is an information gap between the managers and users and consequently a lack of transparency. We model the degree of transparency observed when disclosures of foreign exchange (FX) risk management in financial statements are compared to managerial information on FX risk management policy, as evidenced in questionnaire responses. In this comparative study of US and UK firms we find incomplete disclosure in both samples but with differing aspects. In the US case, the information gap is lower where the information has higher relevance or firms with higher financial risk (greater leverage) are signalling the extent of risk, but the gap is greater where firms are in competitive product markets. For the UK sample, the information gap is significantly lower where firms have higher financial risk or higher liquidity but the gap is greater where the shares are more closely held. We conclude that modelling and explaining this aspect of incomplete accounting disclosure in an international setting must be sufficiently flexible to accommodate national differences in managerial behaviour.

Hedging and Value in the U.S. Airline Industry

This article discusses the findings and practical import of the authors' study of the fuel hedging activity of 28 U.S. airlines during the period 1992‐2003. The aim of the study was to answer the following question: Does fuel hedging add value to the airlines and, if so, how? The airline industry provides a natural experiment for investigating the relation between hedging and value for a number of reasons: (1) the industry is by and large competitive and remarkably homogeneous; (2) airlines are exposed to a single, volatile input commodity—jet fuel—that represents a major economic expense for all competitors; and (3) fuel price increases cannot be easily passed through to customers because of competitive pressures in the industry.The results of the study show that jet fuel hedging is positively related to airline firm value. Those airlines that hedged their fuel costs had Tobin's Q ratios that were 5‐10% higher, on average, than those of airlines that did not hedge. What's more, the higher the proportion of future fuel requirements hedged, the larger the valuation premium. The authors' results also suggest that the main source of value added by hedging in the airline industry is its role in preserving the firm's ability to take advantage of investment opportunities that arise when fuel prices are high and airline operating cash fl ows and values are down. Consistent with this argument, the study finds that the value premium associated with hedging increases with the level of the firm's capital spending.The authors also report that the most active hedgers of fuel costs among the airlines are the larger firms with the least debt and highest credit ratings. This result is somewhat surprising, at least to the extent that smaller airlines are expected to have larger financial distress costs (as a percentage of firm value) and hence greater motive to hedge. One explanation is that the smaller airlines have lacked either sufficient resources or the strategic foresight to acquire a derivatives hedging capability. A second possibility—one that is consistent with the study's main findings—is that the largest airlines also have the highest costs of financial distress (even as a percentage of firm value) in the form of larger growth opportunities that could be lost as a result of high leverage and financial risk. In other words, only the largest airlines are typically able to buy distressed assets during periods of industry weakness; to the extent this is so, such firms may also have the most to gain from hedging.

The Financial Risks of Corporations in the Global Economy

We comprehensively examine the cross-sectional determinants of financial risk for a large sample of non-financial corporations in over 40 countries. The level of total firm risk depends on many firm-specific operating and financial characteristics. Consistent with theoretical models and some prior empirical evidence for U.S. firms, the level and type of assets, as well as profitability characteristics, are significant drivers of total risk. In contrast, most financial characteristics are less important, but surprisingly, dividend policy has the strongest effect on total risk of all factors we consider. We also decompose total risk into market risk and firm-specific risk. Contrary to some theoretical predictions, our results indicate that many similar factors determine each type of risk though not necessarily in equal proportions. However, some factors such as foreign operations and asset liquidity are only significant determinants of market risk. Interestingly, the effects of operating and financial characteristics on firm risk depend on the overall level of economic and financial risk in a firm’s home-country. For example, asset tangibility and the use of interest rate derivatives are only important in countries with high financial risk. Finally, we find that many determinants of total firm risk also have important effects on firm value in the way predicted by theory.

Commentary—Assessing the Impact of Managed Care Patient Protection Laws: Problems and Pitfalls

In their article ‘‘Impacts of Managed Care Patient Protection Laws on Health Services Utilization and Patient Satisfaction with Care,’’ Sloan, Rattliff, and Hall use data from three rounds (1996–1997, 1998–1999, and 2000–2001) of the Community Tracking Study (CTS) to assess the impact on health utilization and patient satisfaction of ‘‘patient protection’’ laws. Each of the three rounds of the CTS surveyed approximately 32,000 individuals about the care received by themselves and their families (a total of approximately 60,000 persons). Patient protection laws include those that address: the size and scope of provider networks, the range of covered benefits, the procedures essential to access covered benefits, and the financial incentives used by managed care plans to affect provider behavior. Specifically, they include gag-clause bans, direct-access to specialist laws, any-willing-provider laws, freedom-of-choice laws, mandated minimum length of stays for delivery laws, and laws limiting the size of physician withholds and bonuses. The basic purpose of these laws is to improve the care provided to enrollees of managed care plans. The proportion of American workers enrolled in managed care plans has risen from 4 percent in 1977 (Gabel 1999) to 93 percent in 2001 (Supreme Court to Rule on Patients’ Rights 2003), and all but three states have enacted a comprehensive set of patient protection laws (Sloan and Hall 2002). Thirty-five states enacted patient protection laws between 1997 and 1999. Proponents of these laws maintain that they help ensure that enrollees have a reasonable choice of providers at the time of service, do not face limits on services that may adversely affect their health, are not arbitrarily denied access to covered services, and are not treated by a physician who faces inordinately high financial risks for ordering necessary services. Opponents of these laws (who often refer to them as ‘‘anti-managed care’’ laws) maintain that they reduce the flexibility of plans in their dealings with physicians, prevent plans from limiting particular services in order to increase efficiency, preclude plans from implementing cost-effective utilization management techniques,

Demographic Development and Moral Hazard: Health Insurance with Medical Savings Accounts

In times of ever-rising health expenditures it is becoming more and more obvious that conventional models for funding health care are increasingly experiencing difficulties in meeting this challenge. The concept of Medical Savings Accounts (“MSAs”) represents an innovative and so far rarely analysed alternative for the funding of health care systems. In this concept an anticipated amount of money needed is saved up ex ante by each individual in a special account set aside to cover health care expenses. Since, however, health care expenses for certain kinds of treatment frequently exceed the financial capacity of the individual, Medical Savings Accounts are normally introduced in combination with health insurance covering defined services with higher financial risk. From a theoretical point of view the MSA concept helps to counteract the phenomenon of moral hazard in health insurance systems, at the same time coping with the future challenges posed by demographic development. This paper also examines experience gained so far in the implementation and use of Medical Savings Accounts in different countries. It draws a mixed but positive picture of the results. Therefore it could be feasible to integrate certain elements of this concept into health care systems of European countries.

Dear Editor: Specific Firm Risk Does Have A Place In A Firm Valuation

Page 94 Dear Editor: I would like to respond to a comment by John Kania (Letter to the Editor, December 2003) pertaining to Standard & Poor’s Corporate Value Consulting Risk Premium Report published by Roger Grabowski and myself. Our study, available at www.ibbotson.com, reports average rates of return for size-ranked portfolios of companies. As Dr. Kania reminds readers, we exclude certain companies from our size-ranked portfolios due to indicators of poor financial performance, such as a history of negative net income (companies that we loosely refer to as “losers”). According to Dr. Kania: [E]xcluding losers results in a serious selection bias. Investors do not share [Grabowski & King] advantage of being able to look backward, but must look forward, and are, therefore, impacted by winners as well as losers. Had their sample included losers, [Grabowski & King’s] likely would have found that... their small firm equity risk premium would decline considerably or even disappear. The exclusion of companies based on historical financial performance does not imply any unusual foresight on the part of hypothetical investors in our portfolios. In forming portfolios for a given year, we exclude companies on the basis of performance during previous years, not future years. For instance, to form portfolios for 1963, we take into account the average net income for the five fiscal years preceding 1963 (in our current methodology this means fiscal years ending on or before September 1962). We repeat this procedure for each year from 1963 through the latest available year. Investors commonly look at historical financial information before making investment decisions. Moreover, we report the average return realized by the “losers” (we call this the “High Financial Risk” portfolio in our report), and the historical return on this portfolio is greater than the returns realized by the smallest size-ranked portfolios by most measures of size. This is consistent with the idea that “losers” are risky and tend to earn a higher than average return.

The Determinants of Derivatives Use: Evidence from Non-Financial Firms in Taiwan

This paper examines the major determinants of a firm's derivatives use for companies listed in Taiwan Stock Exchange in the period from 1997 to 1999. The study finds that the proportion of derivatives use in Taiwan, ranging from 31% to 37%, is comparable to that of the US (35%), but less than that of New Zealand (53%). Firms' derivatives use in Taiwan asymmetrically focuses on currency/forwards derivatives. Industry breakdown illustrates that the electronic industry stands for the heavy user both in terms of number and amount. We show that the vital determinants of a firm's derivatives use are size, the ratio of long-term debt to total debt, the electronic industry dummy, and the export ratio. The fact that firms' derivatives use positively correlated with size and the long-term-debt-to-total-debt ratio implies the capability-willingness hypothesis: only large firms are affordable to engage in derivatives use due to the concern of economies of scale in establishing and maintaining expertise, and these firms demand more derivatives use when they face with high financial risk in debt structure.

Becoming an Entrepreneur for a Trial Period: The Pre-Incubation Experience

In most member states of the European Union a major failing of the innovation system is that inventions generated at universities and other higher education institutes are too rarely commercialized by the creation of new, innovative firms. One reason for this can be found in the accumulation of obstacles that prevent academic researchers with a technology-based business idea from setting up their own company. Such obstacles include a lack of knowledge in business management and negotiation skills, the unknown market potential of products and services, high financial risks and the widespread fear of failure. In this article a new and innovative support scheme is described, based on the concept of ‘pre-incubation’ and set up by the Institute for Innovation Transfer at the University of Bielefeld. The core of the concept is a university-associated facility, the pre-incubator, which is a new device for managing the spin-off process. The innovative feature of the pre-incubator is a specific management, legal and insurance structure that allows academic researchers to test the feasibility of their business ideas before they take the risk of setting up a company. The legal entity of the pre-incubator forms an umbrella under which potential entrepreneurs, guided and controlled by the management staff, can test their products on the market, thus gaining valuable business experience. This experience, in addition to continuous training and coaching, is expected to increase the sustainability of the future company. In addition the article outlines how the concept of pre-incubation is currently implemented at the Universidad Politecnica de Valencia in Spain and the Ecole Polytechnique in France within the framework of the EC-funded innovation project USINE (University Start-up of International Entrepreneurs). An analysis from the University of Strathclyde in Scotland, which monitors the transfer process of the pre-incubation scheme within the project, concludes the article by identifying the features of the pre-incubator that set it apart from other tried and tested mechanisms. The adaptability of the model to different national contexts is also discussed, as are the benefits and costs to stakeholders and the ways in which they can measure ‘success’.

Rethinking Pension Liabilities and Asset Allocation

The objective of a defined-benefit pension fund9s asset allocation policy should be to fully fund accrued pension liabilities at the lowest cost to the plan sponsor, subject to sensible risk. A major risk plan sponsors face is that higher contributions will be required should the asset portfolio not be constructed properly. Specifically, the plan sponsor in establishing its asset allocation strategy should take into account both the present value of liabilities (cash flows) and the volatile behavior of the value of the liabilities due to changes in interest rates. While fluctuations in the present value of assets versus liabilities (funding ratios) represent high financial risk for all plan sponsors, most plan sponsors fail to recognize this risk because it is seriously attenuated by actuarial and accounting smoothing of financial statements. Instead, due to the way pension contributions are calculated, and earnings reported, plan sponsors focus on the return on asset assumption rather than assets versus liabilities. The authors look at the performance of defined-benefit corporate pension plans in 2000 and 2001, and consider the implications of this performance for future corporate earnings. They then address issues associated with measuring pension liabilities and offer solutions to deal with this measurement problem.

The relation between audit pricing and audit contract type: a public sector analysis

Our study used North Carolina local government data to examine the extent to which audit contract type is capable of explaining the variation in audit fees, after controlling for variables found to be significant correlates in prior audit economics studies (e.g., Z. Palmrose, The Account. Rev. 64 (3) (1989) 494). We used a LOGIT regression model to identify factors associated with the probability of negotiating a particular contract type, either fixed fee or cost-reimbursement. We found evidence that audit fees are, on average, lower for fixed fee contracts than for cost-reimbursement contracts. Also, the probability of negotiating a fixed fee contract increased for governmental units with higher financial risk when they engaged an independent auditor with more knowledge about the public sector.

Comparative Performance of Chinese Commercial Banks: Analysis, Findings and Policy Implications

This paper investigates the financial performance of Chinesebanks by using financial ratio analysis. The analysis shows that the lowprofitability of state-owned commercial banks results from their higherratio for non-interest expenses and lower interest margin thanjoint-equity banks. The much lower profit margin in state-owned banksdraws down their levels of ROE and ROA, even with the offsetting effectsof more efficient utilization of their assets and higher financialleverage. Although data limitations prevent us from studying the riskprofiles of the banks in detail, it is clear that these Chinese banksgenerated lower returns with higher financial risks than their Westerncounterparts. The paper concludes with a discussion of major issuesaffecting Chinese bank performance. Significant difficulties encounteredin assessing bank performance are also identified anddiscussed.