Knowledge that Transforms

This paper empirically compares a variety of firm-value-based models of contingent claims. We formulate a general model which nests versions of the models introduced by Merton, 1974, Leland, 1994, Anderson and Sundaresan, 1996, and Mella-Barral and Perraudin (1997). We estimate these using aggregate time series data for the US corporate bond market, monthly, from August 1970 through December 1996. We find that models fit reasonably well, indicating that variations of leverage and asset volatility account for much of the time-series variations of observed corporate yields. The performance of the recently developed models which incorporate endogenous bankruptcy barriers is somewhat superior to the original Merton model. We find that the models produce default probabilties which are in line with the historical experience reported by Moodys.

This study investigates the relationship between market-based measures of risk and foreign currency contingent claims activity at US commercial banks. Specifically, four types of foreign currency contingent claims are examined: purchased foreign currency option contracts, foreign-exchange swaps, commitments to purchase foreign currency and forward contracts. Within the context of the Comptroller of the Currency's (OCC’s) Banking Circular 277, we differentiate between the risk exposure of dealer banks and non-dealer banks. Empirical results suggest that (i) the use of options tends to increase all market-based measures of bank risk, (ii) swaps are used primarily for risk-control purposes and (iii) the use of forward contracts and currency commitments contributes mildly, if at all, to any type of risk. There is some evidence that swaps activity at dealer banks increases unsystematic risk. Otherwise, dealer and non-dealer banks appear to similarly manage foreign currency risk.

We investigate the behavior of stock market indices across 33 countries around political election dates during the sample period 1974–1995. We find a positive abnormal return during the two-week period prior to the election week. The positive reaction of the stock market to elections is shown to be a function of a country’s degree of political, economic and press freedom, and a function of the election timing and the success of the incumbent in being re-elected. In particular, we find strong positive abnormal returns leading up to the elections (i) in less free countries won by the opposition, and (ii) called early and lost by the incumbent government. These results are consistent with the uncertain information hypothesis (UIH) of Brown et al. (Brown, K.C., Harlow, W.V., Tinic, S.M., 1988. Journal of Financial Economics 22, 355–385) and the model of election behavior of Harrington (Harrington, J.E., 1993. The American Economic Review 83, 27–42).

This paper draws regulatory lessons for emerging stock markets from an empirical study of the relationship between transactions costs and share price volatility in the London Stock Exchange. We concentrate our analysis on direct pecuniary costs of trading, namely transactions taxes (stamp duty) and brokerage charges, which derive directly from regulation. In a novel contribution to the transactions cost literature, we identify stock market performance with various measures of market volatility, and distinguish among market volatility, fundamental volatility and excess volatility; we also propose some simple ways of identifying the separate impact of transactions costs on these volatility measures. Our findings suggest that changes in transactions costs have a significant and dependable effect on share price volatility but the sign of this effect depends critically on the concept of volatility being measured. Among the important lessons for emerging stock markets is that transactions costs are an important factor in share market volatility and the regulatory regime therefore needs to take account of the impact of regulation on such costs. This is particularly important for those emerging stock markets that rely on stamp duty or other transactions taxes as a regulatory tool.

This paper investigates the influence the environmental conditions have on the cost-efficiency of French and Spanish banking industries. We propose a new methodology for cross-country comparisons of efficiency using a parametric approach. In particular, the specific environmental conditions of each country play an important role in the definition and specification of the common frontier of different countries. Our results suggest that, without environmental variables, the cost-efficiency scores of Spanish banks are quite low compared to those of the French banks. However, when environmental variables are included in the model, the differences between both banking industries are reduced substantially. Overall, our results demonstrate that environmental variables contribute significantly to the difference in efficiency scores between the two countries.

We investigate how banking market competition, informational opacity, and sensitivity to shocks have changed over the last three decades by examining the persistence of firm-level rents. We develop propagation mechanisms with testable implications to isolate the sources of persistence. Our analysis suggests that different processes underlie persistence at the high and low ends of the performance distribution. Our tests suggest that impediments to competition and informational opacity continue to be strong determinants of persistence; that the reduction in geographic regulatory restrictions had little effect on competitiveness; and that persistence remains sensitive to regional/macroeconomic shocks. The findings also suggest reasons for the recent record profitability of the industry.

This paper tests a model based on Wall's (Wall, L., 1989. Journal of Banking and Finance 13, 261–270) hypothesis of agency cost reduction using interest rate swaps. We find a significant positive relationship between the risk of the firm and the reduction of agency costs measured by the continuously compounded excess return (CAR) of the firm. Our findings are consistent with Wall’s hypothesis and other theories of swap transactions and in explaining the existence and growth of the swap market.

Economic theory tells us that market and credit risks are intrinsically related to each other and not separable. We describe the two main approaches to pricing credit risky instruments: the structural approach and the reduced form approach. It is argued that the standard approaches to credit risk management – CreditMetrics, CreditRisk+ and KMV – are of limited value when applied to portfolios of interest rate sensitive instruments and in measuring market and credit risk. Empirically returns on high yield bonds have a higher correlation with equity index returns and a lower correlation with Treasury bond index returns than do low yield bonds. Also, macro economic variables appear to influence the aggregate rate of business failures. The CreditMetrics, CreditRisk+ and KMV methodologies cannot reproduce these empirical observations given their constant interest rate assumption. However, we can incorporate these empirical observations into the reduced form of Jarrow and Turnbull (1995b). Drawing the analogy. Risk 5, 63–70 model. Here default probabilities are correlated due to their dependence on common economic factors. Default risk and recovery rate uncertainty may not be the sole determinants of the credit spread. We show how to incorporate a convenience yield as one of the determinants of the credit spread. For credit risk management, the time horizon is typically one year or longer. This has two important implications, since the standard approximations do not apply over a one year horizon. First, we must use pricing models for risk management. Some practitioners have taken a different approach than academics in the pricing of credit risky bonds. In the event of default, a bond holder is legally entitled to accrued interest plus principal. We discuss the implications of this fact for pricing. Second, it is necessary to keep track of two probability measures: the martingale probability for pricing and the natural probability for value-at-risk. We discuss the benefits of keeping track of these two measures.

We present evidence that managerial shareholdings are an important determinant of bank risk-taking. Managerial shareholdings are positively related to total and firm specific risk in the late 1980s when banking was relatively less regulated and when the industry was under considerable financial stress. However, following legislation in 1989 and 1991 designed to reduce risk-taking and also reflecting substantial improvements in bank franchise value, managerial shareholdings and total and firm specific risk became negatively related in the early 1990s. In contrast, systematic risk was unrelated to managerial ownership in both periods.

In an environment of asymmetric information, banks face information externalities due to their role as intermediaries of information. In particular, bank insiders will possess private information from monitoring loan customers. Accordingly, outsiders may interpret changes in a bank's financial policy as signals about the quality of its loan portfolio and to the extent that the assets (loans) of different banks are viewed as similar, they will interpret such signals as pertaining to non-announcing banks as well leading to contagion effects. We test for the presence of contagion effects in stock returns associated with announcements of dividend cuts by money-center banks. We find that dividend cuts induce negative abnormal returns in the stocks of non-announcing money-center banks and to a lesser extent in the stocks of large regional banks. The observed contagion effects appear consistent with informed rather than contagious panic behavior because these effects are systematically related to risks that are common to all affected banks.