nep-cfn New Economics Papers
on Corporate Finance
Issue of 2007‒01‒23
thirteen papers chosen by
Zelia Serrasqueiro
University of the Beira Interior

  1. Do U.S. Firms Have the Best Corporate Governance? A Cross-Country Examination of the Relation between Corporate Governance and Shareholder Wealth By Reena Aggarwal; Isil Erel; Rene M. Stulz; Rohan Williamson
  2. Eligibility of External Credit Assessment Institutions By Helena Suvova; Eva Kozelkova; David Zeman; Jaroslava Bauerova
  3. Why are Buyouts Levered: The Financial Structure of Private Equity Funds By Ulf Axelson; Per Stromberg; Michael S. Weisbach
  4. Stress Testing the Czech Banking System: Where Are We? Where Are We Going? By Martin Cihak; Jaroslav Hermanek
  5. The geography of asset holdings: Evidence from Sweden By Coeurdacier , Nicolas; Martin, Philippe
  6. Optimal Risk-Sharing and Deductables in Insurance By Aase, Knut K.
  7. Measuring Financial Asset Return and Volatility Spillovers, With Application to Global Equity Markets By Francis X. Diebold; Kamil Yilmaz
  8. The dynamics of bank spreads and financial structure By Reint Gropp; Christoffer Kok Sørensen; Jung-Duk Lichtenberger
  9. Pillar I treatment of concentrations in the banking book – a multifactor approach By Zoltán Varsányi
  10. Tunisian Financial System: a Growth Factor By Ben Fredj, Imene; Schalck, Christophe
  11. Spot and forward interest rates: Why practically homogeneous bonds of different maturities have different interest rates? By Govori, Fadil
  12. The term structure and risk structure of interest rates By Govori, Fadil
  13. A Critique on the Proposed Use of External Sovereign Credit Ratings in Basel II By Roman Kraeussl

  1. By: Reena Aggarwal; Isil Erel; Rene M. Stulz; Rohan Williamson
    Abstract: We compare the governance of foreign firms to the governance of similar U.S. firms. Using an index of firm governance attributes, we find that, on average, foreign firms have worse governance than matching U.S. firms. Roughly 8% of foreign firms have better governance than comparable U.S. firms. The majority of these firms are either in the U.K. or in Canada. When we define a firm's governance gap as the difference between the quality of its governance and the governance of a comparable U.S. firm, we find that the value of foreign firms increases with the governance gap. This result suggests that firms are rewarded by the markets for having better governance than their U.S. peers. It is therefore not the case that foreign firms are better off simply mimicking the governance of comparable U.S. firms. Among the individual governance attributes considered, we find that firms with board and audit committee independence are valued more. In contrast, other attributes, such as the separation of the chairman of the board and of the CEO functions, do not appear to be associated with higher shareholder wealth.
    JEL: G30 G32 G34 G38 K22
    Date: 2007–01
  2. By: Helena Suvova; Eva Kozelkova; David Zeman; Jaroslava Bauerova
    Abstract: The Basel Committee on Banking Supervision in 1999 issued a draft New Basel Capital Accord (Basel 2). Its principles are to be incorporated into the European legislation and into the Czech banking regulations. The Standardised Approach to calculating the capital requirement for credit risk is newly based on external credit assessments (ratings). Banking regulators and supervisors have to be prepared for the process of determining eligible credit assessment institutions (ECAIs) and will have to elaborate a formal recognition procedure. This paper investigates the approaches a supervisor may apply to ECAI recognition and elaborates on the criteria of recognition. First, the paper reviews the available rating agencies on the market (including their rating penetration on the Czech market), their best practices and the experience with the use of their ratings for regulatory purposes. Second, drawing on international experience and the proposed Basel 2 rules, we outline the fundamental supervisory approaches to recognition, including the legal aspects thereof, and analyse their pros and cons and the frontiers of supervisory decision making. Third, we outline the rules for recognition, including requirements or expectations (e.g. soft limits), documentation and typical interview questions with the potential candidates. We find the CNB's approach to be in compliance with CEBS Consultative Paper CP07 (issued for public consultation in June 2005).
    Keywords: Basel capital accord, Basel II, Credit rating, default, eligibility criteria, eligibility evaluation, external credit assessment institution (ECAI), export credit agency (ECA), mapping rating grades, market acceptance of ECAIs, rating agency, recognition process
    JEL: E65 G21 G18
    Date: 2005–12
  3. By: Ulf Axelson; Per Stromberg; Michael S. Weisbach
    Abstract: This paper presents a model of the financial structure of private equity firms. In the model, the general partner of the firm encounters a sequence of deals over time where the exact quality of each deal cannot be credibly communicated to investors. We show that the optimal financing arrangement is consistent with a number of characteristics of the private equity industry. First, the firm should be financed by a combination of fund capital raised before deals are encountered, and capital that is raised to finance a specific deal. Second, the fund investors' claim on fund cash flow is a combination of debt and levered equity, while the general partner receives a claim similar to the carry contracts received by real-world practitioners. Third, the fund will be set up in a manner similar to that observed in practice, with investments pooled within a fund, decision rights over investments held by the general partner, and limits set in partnership agreements on the size of particular investments. Fourth, the model suggests that incentives will lead to overinvestment in good states of the world and underinvestment in bad states, so that the natural industry cycles will be multiplied. Fifth, investments made in recessions will on average outperform investments made in booms.
    JEL: G31 G32
    Date: 2007–01
  4. By: Martin Cihak; Jaroslav Hermanek
    Abstract: This note summarizes the various outputs from the CNB research project Stress Testing for Banking Supervision. Previous research notes in this project presented the key stress testing concepts and discussed the design of stress tests in general terms. Since then, the project has generated outputs that were presented, for example, in the CNB's first Financial Stability Report. The note describes the current status of the project by presenting the latest stress test results and by comparing the methodology of these tests with those presented by other central banks. Finally, the note suggests further steps to improve the stress testing program at the CNB, such as strengthening credit risk modeling, including by engaging commercial banks in the exercise. The note is accompanied by an appendix presenting one of the project's outputs, namely a survey of stress testing practices in commercial banks.
    Keywords: Banking system, stress tests
    JEL: G21 G28 E44
    Date: 2005–02
  5. By: Coeurdacier , Nicolas (ESSEC Business School); Martin, Philippe (University of Paris 1 Pantheon Sorbonne Economie)
    Abstract: This paper analyzes the determinants of cross-border asset holdings on cross-country data and a Swedish data set. We focus our analysis on the effect of the euro not only for the determinants of bond holdings, but also of equity and banking assets. With the help of a simple theoretical model, we attempt to disentangle the different effects that the euro may have had on asset holdings for both euro zone countries and countries outside of the euro zone such as Sweden. We find evidence that the euro has implied 1) a unilateral financial liberalization which makes it cheaper for all countries to buy euro zone assets. For bonds and equity holdings, this would translate into a 14% and 17% decrease in transaction costs. Using Swedish data, we find that the effect is larger for flows than for stocks. 2) a preferential financial liberalization which on top of the previous effect has decreased transaction costs inside the euro zone by 17% and 10% for bonds and equity respectively. 3) a diversion effect due to the fact that lower transaction costs inside the euro zone have led euro countries to purchase less Swedish equity. Our empirical analysis also suggests that the elasticity of substitution between bonds inside the euro zone is higher than between bonds denominated in different currencies. We illustrate this effect for transaction costs generated by the difference in the legal system.
    Keywords: International Asset Trade; Gravity Equation; Euro
    JEL: F30 F36 F41 G11
    Date: 2007–01–01
  6. By: Aase, Knut K. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)
    Abstract: Risk-sharing in insurance is analyzed, with a view towards explaining the prevalence of deductibles. First we introduce, in a modern setting, the main concepts of the theory of risk-sharing in a group of agents. This theory we apply to the risk-sharing problem between an insurer and an insurance customer. We motivate the development through simple examples, illustrating some of the subtle points of this theory. In order to deduce deductibles endogenously, not explained in the neoclassical model, we separately introduce (i) the insurable asset as a decision variable, (ii) administrative costs, and (iii) moral hazard, and illustrate by examples.
    Keywords: Reinsurance Exchange; Equilibrium; Pareto Optimality; Representative Agent; Core Solution; Individual Rationality; Deductibles; Costs; Moral Hazard
    JEL: D50 G22
    Date: 2006–12–29
  7. By: Francis X. Diebold (University of Pennsylvania and NBER); Kamil Yilmaz (Koc University)
    Abstract: We provide a simple and intuitive measure of interdependence of asset returns and/or volatilities. In particular, we formulate and examine precise and separate measures of return spillovers and volatility spillovers. Our framework facilitates study of both non-crisis and crisis episodes, including trends and bursts in spillovers, and both turn out to be empirically important. In particular, in an analysis of sixteen global equity markets from the early 1990s to the present, we find striking evidence of divergent behavior in the dynamics of return spillovers vs. volatility spillovers: Return spillovers display a gently increasing trend but no bursts, whereas volatility spillovers display no trend but clear bursts.
    Keywords: Asset Market, Asset Return, Stock Market, Emerging Market, Market Linkage, Financial Crisis, Herd Behavior, Contagion
    JEL: F30 G15 F36
    Date: 2007–01–03
  8. By: Reint Gropp (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany; Corresponding author.); Christoffer Kok Sørensen (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Jung-Duk Lichtenberger (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper investigates the dynamics of the pass-through between market interest rates and bank interest rates in the euro area as a function of cyclical and structural differences in the financial system. We find that overall the speed of adjustment for loans is significantly faster than for deposits, and that the pass-through is especially sluggish for demand deposits and savings deposits. Bank soundness, credit risk and interest rate risk are found to exert a significant influence on the speed of pass through. We also find evidence of faster (slower) pass-through for loans (deposits) if the change in monetary policy was up (down). Overall, we find that competition among banks and competition from financial markets result in a faster bank interest rate pass-through. Finally, we find some evidence that financial innovation speeds up the pass-through for those market segments that are most directly affected by these innovations. JEL Classification: E43, G21.
    Keywords: Monetary transmission, banks, retail rates, financial structure.
    Date: 2007–01
  9. By: Zoltán Varsányi (Magyar Nemzeti Bank)
    Abstract: The present regulation of concentration risk does not take into consideration recent, sophisticated methods in credit risk quantification; the new Basle Capital Accord has left the regulatory treatment unchanged. Recently, substantial work has begun within the EU on this issue with the formation of the Working Group on Large Exposures within CEBS. The present paper is concerned with the models available under Basle 2 for credit risk quantification: it is searching for tools that can be applied in a new regime in general and that are capable of replicating the riskiness of credit portfolios with risk concentrations - an area that the original Basel model does not cover. The main idea of the paper is to disassemble nongranular portfolios into homogenous parts whose loss can then be directly simulated - taking into consideration the correlation between the parts - without the need to simulate single exposures. This makes the calculation of portfoliowide loss very fast.
    Keywords: Basel regulation, multifactor model, NORTA, numerical integration.
    JEL: C15 G28
    Date: 2006
  10. By: Ben Fredj, Imene; Schalck, Christophe
    Abstract: The relationship between financial development and economic growth were the subject of many recent theorical and empirical works [Shepherd, Hasan and Klapper, 2004; Gylfason, 2004; Rioja and Valev, 2003; Driffill, 2004; Haas, 2002; Carlin and Mayer, 2000]. These authors generally focused their analysis of the link finance- growth on the mature financial systems. As the Tunisian economy knew a long period of financial repression before starting the phases of liberalization, it would be more judicious to start by McKinnon and Shaw’s theory of “financial deepening” (1973) to then determinate the impact of Tunisian financial system development on economic growth. Indeed, McKinnon and Shaw were the first authors to analyze positive effects of financial liberalization policy on economic performance of less developed countries. To check the relevance of this assumption in Tunisian’s context, we built a model inspired of the model of King and Levine (1993) who by measuring instruments of economic and financial development appears good indicators of Tunisian economy’s financiarisation. The results of the empirical study on Tunisia stemming from causality tests within B-VAR framework nuance McKinnon and Shaw’s theorical contribution. Reciprocal relationships are only finding between the ratio of investment on the GDP and the loans granted to private and public sectors. The economic role of State is highlighted, over the period of pre-reforms as well as during the recent time.
    Keywords: financial repression; financial deepening; economic development; finance and growth; B-VAR
    JEL: O16 E44 G21
    Date: 2004–07
  11. By: Govori, Fadil
    Abstract: The term structure of interest rates is a widely discussed topic in the economic literature. One of the main questions in these discussions is why practically homogeneous bonds of different maturities have different interest rates. The discussion of present value and interest rates assumes an abstract world of frictionless (or perfect) financial markets. In practice, markets are not frictionless, that is, there are no perfect financial markets. However, frictionless markets are a necessary starting point. Borrowers are faced with the choice to borrow short-term or long-term. Short-term borrowing runs the risk of refinancing at higher interest rates. Long-term borrowing runs the risk of locking-in a higher interest rate. In an unrestricted shortsale, the shortseller can use the proceeds from the sale. In practice, most shortsellers are not able to use the proceeds because of the possibility of a shortseller absconding with the funds. In addition, shortsellers usually have to post collateral to guarantee against default. Because of the time value of money, one euro received at a future date has a present value of less than one euro. The pattern of spot interest rates for different maturities is called the term structure of interest rates. One possible term structure pattern is for all spot interest rates to be the same; this is called a flat term structure. If the spot interest rates increase with maturity, the term structure is rising. Rising term structures are the most common pattern in practice; longer maturity interest rates are typically higher than short maturity interest rates. Spot interest rates decreasing with maturity are called a declining (or inverted) term structure. One of the most important concepts in finance is the concept of arbitrage, also called the law of one price. In frictionless markets, the same asset must have one price at a particular instant in time, no matter where it is traded. The arbitrage operations drive prices toward their equilibrium values. That is, purchase of one-period bond by the arbitrager drives its price up; sale of the two-period bond forces its price down. Arbitrage provides the fundamental link between the spot and forward markets. Arbitrage forces a precise relationship between forward and spot rates of interest. Forward transactions involve a contract signed in the present to do something in the future. The parties agree right now to exchange securities in the future at a price agreed upon right now. If securities are exchanged in the forward market, the buyer, called the long, contracts right now to purchase the bond at some future date, called the delivery date, at a specified price. Futures markets are very similar to forward markets.
    Keywords: Interest Rates; Spot Interest Rates; Forward Interest Rates; Term Structure of the Interest Rates; Maturity Structure of the Interest Rates
    JEL: G31 G11 G12 G10 G14 G13
    Date: 2007–01
  12. By: Govori, Fadil
    Abstract: The relationship that exists at a given point in time between the length of time to maturity and the yield on a security is known as the term structure of interest rates. Another important factor that also has significant bearing impact on both nominal and real interest rates of a financial instrument is its default risk, that is, the risk that the lender may not recover the original principal. Both nominal and real interest rates differ by maturity, or term. A schedule of spot interest rates by maturity is called the term structure of interest rates. The term structure can be rising, flat, declining, or humped. The yield curve: a set of points plotted corresponding to the yields existing on a given day on various maturities of a particular type of instrument. A yield curve shows the relationship between interest rates and maturity for coupon-bearing bonds. Historically, upward-sloping, or ascending, yield curves have been much more common than downward-sloping, or descending, patterns. Downward-sloping yield curves have occurred at the end of the expansion phase of business cycle. To answer what determines the shape of the yield curve, we must examine four different theories of the term structure of interest rates. All these theories seek to account for the shape of the yield curve at any point in time and for changes in its shape over time. Term structure theories include the segmented markets theory, the increasing liquidity premium theory, the preferred habitat theory, the money substitute theory, and the pure expectations theory. There are enormous numbers of securities on which the interest rates can and differ. The relationship among these interest rates is called the risk structure of interest rates. A default risk is a failure to meet the terms of a contractual agreement in full amount. In the case of a debt instrument such as a bond, default may refer to the borrower’s failure to make the full interest payment as agreed or to the failure to redeem the bond at face value at maturity. The spread between the interest rates on bonds with default risk and default-free bonds, is called the risk premium, and indicates how much additional interest bond buyer must earn in order to be willing to hold a risky bond. U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes or even print money to pay off its obligations. Bonds like these with no default risk are called default-free bonds. Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. For this reason there exist many investment advisory firms, that provide default risk information by rating the quality of corporate and municipal bonds in terms of the probability of default.
    Keywords: Interest Rates; Term Structure of Interest Rates; Risk Structure of Interest Rates; Yield to Maturity; Yield Curve; Term Structure Theories
    JEL: G0 G11 G24 G12 G32 G14 G13 G15
    Date: 2007–01
  13. By: Roman Kraeussl (Center for Financial Studies, Frankfurt am Main, Germany)
    Abstract: This paper deals with the proposed use of sovereign credit ratings in the “Basel Accord on Capital Adequacy” (Basel II) and considers its potential effect on emerging markets financing. It investigates in a first attempt the consequences of the planned revisions on the two central aspects of international bank credit flows: the impact on capital costs and the volatility of credit supply across the risk spectrum of borrowers. The empirical findings cast doubt on the usefulness of credit ratings in determining commercial banks’ capital adequacy ratios since the standardized approach to credit risk would lead to more divergence rather than convergence between investment-grade and speculative-grade borrowers. This conclusion is based on the lateness and cyclical determination of credit rating agencies’ sovereign risk assessments and the continuing incentives for short-term rather than long-term interbank lending ingrained in the proposed Basel II framework.
    Keywords: Sovereign Risk, Credit Ratings, Basel II
    JEL: E44 E47 G15

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