Contributions published at Corporate Finance Theory (Michel Habib)

Issuer-paid credit ratings such as those from S&P or Moody's are supposed to be upward biased because conflicts of interest inherent in the issuer-paid business model induce the ratings to be too generous relative to the default risk of the issuer. The present master thesis discusses the market-based Bloomerg default risk model DRSK as a potential alternative to issuer-paid agency ratings. The main sample consists of 226 U.S. issuers which defaulted in the period from January 2003 to May 2016 and have multiple ratings by S&P and Bloomberg DRSK over that period. The applied ordered-probit analysis shows that S&P issuer level ratings are upward biased, especially when conflicts of interest are most pronounced as measured by outstanding debt which is a proxy for the issuer-paid rating agency's future business opportunities with the issuer. Additionally, Wilcoxon-Mann-Whitney tests indicate that Bloomberg DRSK ratings are timelier in predicting defaults compared to S&P ratings.

Since the Global Crisis, sovereign debt levels have exploded in many OECD countries. This column presents a new measure of government debt – maximum sustainable debt. This measure takes account of the fact that a shortfall in growth naturally increases the probability of default, while allowing for the possibility of rollover. Applications to recent data suggest that without sufficient institutional constraints, governments will generally borrow up to a level close to the maximum that can be sustained.

This bachelor thesis examines a relation between industrial diversification and firm value. Although there are a lot of scientific papers and articles on this subject, scholars still haven’t managed to reach unambiguous opinion about general effect of diversification. Some of researchers believe that diversification destroys value, while others state the opposite. Taking into account the results of the prior research, I predict that there is a negative linear relation between industrial diversification and firm value. Therefore, I set out in this paper to research this scientific question. In the empirical part of my research, I value the segments of four multisegment firms using two different valuation methods. After that, the obtained equity values of the segments are added together and compared to the market values of conglomerates in the sample. Thus, I’m able to define and quantify the diversification effect on firm value. I report unclear relation between diversification and value. My hypothesis is not supported by the data. Moreover, my finding is inconsistent with the previous studies on the subject. Nevertheless, if one of the firms is excluded from the sample, I find that related diversification always leads to value destruction, while unrelated diversification may have both the value-enhancing and value-reducing effect on firm value. In conclusion, my study contributes to the existing literature by providing new empirical evidence on the research topic. Moreover, I offer an alternative method for measuring segments’ values. My approach is more precise than the ones used in the prior studies and it also allows me to control for global diversification effect. However, it depends on a lot of assumptions and thus should be used with caution.

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Active fund managers implicitly promise to research profitable portfolio selection. But active management is an experience good subject to moral hazard. Investors cannot tell high from low quality up front and therefore fear manager shirking. We show how the parties mitigate the moral hazard by paying the manager a premium fee sufficiently high that the manager's one-time gain from shirking is less than the capitalized value of the premium stream he earns from maintaining his promise to provide high quality. Premium advisory fees act as a quality-assuring bond. Our model has a number of revealing extensions and comparative statics.

The association between disclosure quality and cost of equity capital is an important topic in accounting research. The main challenge lies in that both disclosure quality and cost of equity capital are subjective in nature and not easy to measure (Botosan, 1997; Luzi, 2002). Prior empirical research demonstrates both negative and positive relationship between the two variables, and implies that the results would heavily depend on the methodologies used to proxy for disclosure quality and cost of equity. Though there is a vast empirical literature on different measures of disclosure quality, little attention has been given to the disaggregation level of accounting data items in the financial reports (Chen et al., 2015). Adopting a similar disaggregation model as proposed in Chen et al (2015), I quantify the disclosure quality level by counting on the non-missing Compustat line items on balance sheets of firms’ annual reports. Disclosure quality index (DQ) constructed in this way covers almost all the accounting line items appeared on balance sheets of annual reports, mitigating researchers’ subjectivity which tends to put more weights on certain items or aspects of a firm. Moreover, this methodology is applicable for the overall Compustat industrial firms and can be easily replicated for later studies (Chen et al., 2015). For the dependent variable, I adopt an infinite horizon version of the residual income model and derive the implied cost of capital as a proxy for cost of capital. Before setting up the final regression model, I conduct several validation tests to further verify the model-generated proxies for disclosure quality and cost of capital, respectively. For a cross-sectional sample of all the non-financial U.S. firms in Compustat from fiscal year 1997 to 2011, this paper finds that increase in disclosure quality results in a decreased implied cost of equity capital. This significant negative relationship continues to hold and the model’s explanatory power increases after controlling for firm size, risk factors and book-to-market ratio.

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Several studies have revealed that sustainable investments are gaining importance. However, it is questionable if people would buy/sell a company’s stocks primarily because such firm is more/less involved in sustainability. This thesis, through an empirical analysis, focused on the largest added and excluded corporations - according to their float adjusted market capitalization - from the Dow Jones Sustainability World Index between 2012 and 2014, as well as on all the index components added in 2015. Six hypotheses have been tested using the Market Model Method, focusing primarily on research of cumulative average abnormal returns resulting from the annual index announcement of included and excluded companies. The empirical analysis showed predominantly statistically insignificant results. In order to obtain more concrete answers from the findings and on sustainability awareness, the present work included some interviews with Sustainability Managers and Specialists. Consequently, several considerations have been elaborated on sustainability to show how the commitment of investors and companies to it could be augmented. Essentially, the role of regulation, together with education as well as engagement or active ownership, need to be intensified when relating to this developing topic.

United States dominates the list of top 500 global companies by market capitalization, which is considerably higher than the joint market capitalization of all the European companies. The same situation holds for R&D investment rates. This work presents the first known attempt to explain this phenomenon by focusing on R&D investments as a driver of company value. There is a body of literature demonstrating positive influence of inventive activities on value of a firm. Empirical studies show a high variation in R&D coefficients between countries, which are believed to be caused by their inherent characteristics, such as financial and legal systems and corporate governance mechanisms. Using a recent panel dataset of US and European publicly traded companies for the period 2010-2014 and controlling for unobserved firm and time specific effects, positive influence of R&D expenditures on a firm market value is demonstrated for European and US companies, while R&D expenditures in Switzerland show a negative effect. However, this influence is found to be higher for European companies than for US, implying that R&D efficiency does not explain the higher stock market capitalization of the United States. Concerning the magnitude of the coefficients, which are found to be lower than a unit, indicates that companies do not invest optimal amounts in R&D. The effects of company size and country’s legal origin are also examined in this work. The corresponding results are consistent with the main finding of this study. R&D investments by small (large) European companies are valued higher by the market than by small (large) US firms. Generally, R&D efficiency in generating value is proven to be greater for small companies than for large ones. Previous research shows evidence that companies in the countries with the common law legal system, such as the US, are valued higher than in the countries with the civil law legal system, such as Continental Europe. However, according to the quantitative results of this thesis, this effect does not hold for the R&D impact on the company market value. R&D expenditures are proven to have a lower impact on a firm’s value in companies from common law legal origin countries, where US companies represent the majority of the analyzed sample. The findings of this thesis are of practical interest to firms, investors and public policy makers, who should understand the role of R&D activities for their companies and countries to achieve better company performance and higher economic growth.

It is well-known that international stock portfolios greatly benefit from risk and return potentials in foreign markets, yet their constituents typically involve two risk factors: market risk and foreign exchange risk. We aim to uncouple these two immanent risks, but model them in parallel within a single model to foster a deeper understanding of the risk characteristics of international stock portfolios. To accommodate the empirical observation that almost all financial assets exhibit leptokurtosis, volatility clustering and mild asymmetry as well as joint extreme behaviour and possibly time-unstable dependence, we propose various extensions of the meta-elliptical t distribution of Fang, Fang and Kotz (2002), Fang, Fang and Kotz (2005) and Paolella and Polak (2015a). First, we allow for time variation by means of the copula parameters and second, we augment the structure of the copula function so that subgroups may assume different degrees of tail dependence. Furthermore, we propose a new calibration method of the conditional correlation models which greatly enhances the model performance, without causing any additional computational burden. The proposed models are then tested both in-sample and out-of-sample and indicate a superior fit when compared to the corresponding multivariate GARCH models. The model performance is then also illustrated in terms of practical applications, namely the predictive quality of Value-at-Risk forecasts, the conditional asset pricing of the portfolio constituents and one dynamic hedging exercise. In summary, the proposed models provide many new insights and the DCC model of Engle (2002) in conjunction with the copula parametrization yields the most appropriate distributional model, when compared to both static and regime switching alternatives.

This work considering a period spanning from January 2004 to November 2015, EUR/CHF spot exchange rates and different aggregate price indices aims at firstly calculating the PPP EUR/CHF equilibrium exchange rate and, secondly, at empirically testing the validity of the PPP. Having obtained a EUR/CHF fair value estimate of CHF 1.31 per euro, we were able to conclude that, at the time of writing, the Swiss franc remains 19% overvalued against the euro. On the other hand, by testing the coefficient restrictions imposed by the PPP theory and performing unit root tests, we were unable to find any evidence to support the PPP in either the short and long run, which led us to conclude that different factors, other than aggregate price indices are behind the behaviour of the EUR/CHF exchange rate. Besides these findings, we carried out further research in order to understand the reasons behind the current Swiss franc overvaluation. We found that the recent Swiss franc’s strength can be ascribed to both its safe-haven status and the changing preferences of Swiss investors. We documented that renewed tensions within the euro area over the course of 2015, especially over the summer, resulted in capital flowing into the Alpine country, suggesting that the Swiss franc has not yet lost its traditional safe-haven status. The macroeconomic fundamentals that validate the country’s safe-haven status are indeed structurally strong and set to remain unchanged in the near future. Furthermore, we observed that, confronted with high financial market volatility, domestic investors appear to remain risk-averse towards the rest of the world and to respond to the increasing global risk by being less inclined to invest in foreign assets. We believe that in the long run the expensive level of the Swiss franc, together with negative interest rates, will make the currency less attractive leading to a correction of its current significant overvaluation.

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This paper analyzes brief episodes of high-intensity quotes turnover and revision-"bursts" in quotes-in the U.S. equity market. Such events occur very frequently, around 400 times a day for actively traded stocks. We find significant price impact associated to this market-maker initiated event, about five times higher than during non-burst periods. Bursts in quotes are concurrent with short-lived structural break in the informational relationship between market makers and market takers. During bursts, market makers no longer passively impound information from order flow into quotes-a departure from traditional market microstructure paradigm. Rather, market makers significantly impact prices during bursts in quotes. Further analysis shows that there is asymmetry in adverse selection between the bid and ask sides of the limit order book and only a sub-population of market makers enjoy an informational advantage during bursts. Our results call attention to the need for a new microstructure perspective in understanding modern high-frequency limit order book markets.

We investigate the impact of high-frequency trading (HFT) on market quality and investor welfare using a general limit order book model. We find that while the presence of HFT always improves market quality under symmetric information, under asymmetric information this is the case only if competition between high-frequency traders is sufficiently strong. While HFT does not negatively impact investor welfare, it reduces the welfare of slow speculators. The flexibility of the model allows investigating the effect of the main recent regulatory initiatives designed to curb HFT on market quality and investor welfare. We consider time-in-force rules, cancellation fees, transaction taxes, rebate fee structures, and speed bumps. While some of these regulations lead to improvements in a number of market quality measures, this generally does not translate into higher welfare for long-term investors. Rather, the main effect of such regulations is to generate wealth transfers from high-frequency traders to slow speculators. These regulations therefore appear inadequate to enhance investor welfare in the presence of HFTs. Of the different measures, transaction taxes are the least harmful; while they reduce welfare roughly by the amount of the tax, they do not significantly worsen market quality. The common practice by exchanges of granting rebates to limit orders is detrimental to market quality and investor welfare, causing both higher effective spreads and longer execution times.

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This master thesis deals with the liquidity of syndicated loans. Both risk and reward characteristics with regards to liquidity are analyzed. There are three main results. First one is that the liquidity premium exists in the loan markets and that investors are being compensated for holding less liquid loans by receiving higher credit spreads. Variables that are priced into the credit spreads are provided toghether with the impact they have in pricing. The second main result is that it is possible to predict loan liquidity given the data at origination and the list of characteristics impacting the liquidity is provided. The third main result was obtained by calculating the liquidity adjusted Value at Risk in order to analyze the risk associated with holding less liquid loans. As it is shown, the liquidity component presents the larger part of the total Value at Risk and consequently should not be ignored when the risk/reward profile of a loan is analyzed.

Transfer pricing is, today, a priority matter to the OECD and tax administrators across the globe but as well a big business to accounting and consulting companies. Its use can radically alter the tax burden of multinational enterprises and is, as a consequence, more than just documents requirements. Recently, Apple, Google, Starbucks, Adobe, Microsoft and other multinationals enterprises have made headlines because of tax avoidance. These companies are using legal complex tax planning schemes in order to minimize their global tax burden, and a key element of these schemes involves transfer pricing. Each one of these tax avoidance disputes often end up in income adjustments of millions to upward billions of euros. Across this Thesis, first we examined the origins of transfer pricing and the current techniques tax administrators have in order to value them. It has been showed that as a consequence of changes in the global production process – among other reasons – it is increasingly complex to align transfer pricing to value creation. We identified three direct impacts of profit shifting through the use of transfer pricing: 1) MNEs have a tax competitive advantage against SMEs, 2) jurisdictions might enter into harmful tax competition to attract / maintain profit reporting inside their borders and 3) the tax system’s integrity and its performance will be hurt. Additionally, the research shows that developing countries’ economies are very dependent on MNEs and, at the same time, have little power of control on transfer prices and other tax avoidance schemes. As a consequence we have found that transfer mispricing greatly impacts the overpricing level of goods being exported by developing economies across the globe. The fiscal loss caused by profit shifting from developing countries is – according to different organizations – between $70 and $180 billion annually. We also covered several empirical studies aiming to numerically prove the existence of relationships related to transfer pricing. We have examined three clear relations: 1) MNEs will manipulate their intra-group transfer prices in response to change in corporate tax rates, 2) MNEs will change the location of their intangibles holding in accordance with level of corporate taxes (inverse relationship) and 3) MNEs will adjust their reported profits to the level of corporate tax rates among their sub- entities jurisdictions. We then considered current and alternative solutions to counter the abusive use of transfer pricing. We examine the Actions 12 and 13 of the OECD’s Action Plan. It aims to increase transparency in tax planning schemes and transfer pricing documents by creating mandatory disclosure rules. Additionally, we consider the implementation of Formulary Apportionment / Unitary Taxation with a focus on the new European Commission’s project, the Common Consolidated Corporate Tax Base.

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