Dear EFA Member,

As a current or recent EFA member, we are pleased to forward you the contents of the recently published second issue of Volume 26 of the Review of Finance – the EFA’s own journal – along with digests (short summaries) and abstracts.

ARTICLES

• Momentum, Reversals, and Investor Clientele (Editor's choice)
  by Andy C W Chui, Avanidhar Subrahmanyam, Sheridan Titman
• Sources of Value Creation in Private Equity Buyouts of Private Firms
  by Jonathan B Cohn, Edith S Hotchkiss, Erin M Towery
• Third-Party Credit Guarantees and the Cost of Debt: Evidence from Corporate Loans
  by Mehdi Beyhaghi
• The Costs and Benefits of Liquidity Regulations: Lessons from an Idle Monetary Policy Tool
  by Christopher J Curfman, John Kandrac
• The Distress Anomaly is Deeper than You Think: Evidence from Stocks and Bonds
  by Doron Avramov, Tarun Chordia, Gergana Jostova, Alexander Philipov
• Cancer and Portfolio Choice: Evidence from Norwegian Register Datas
  by Trond Døskeland, Jens Soerlie Kvaerner
• Correction to: The TIPS Liquidity Premium
  by Martin M Andreasen, Jens H E Christensen, Simon Riddell

• Momentum, Reversals, and Investor Clientele (Editor's choice)

A large and growing literature uncovers cross-sectional return predictability based on past price moves. There is extensive evidence for what is known as the momentum effect, which is the tendency of stocks that performed well in the previous six to 12 months to perform well in the next six to 12 months. At shorter intervals, researchers find reversals. Specifically, stocks which outperform over weekly or monthly intervals tend to underperform over similar durations going forward. Understanding why financial markets exhibit such simple forms of predictability is important.

We explore the role of investor clientele in generating momentum and short-term reversals by using the case of different share classes on the same firms as a natural experiment. Domestic retail investors have a greater presence in Chinese A shares, and foreign institutions are relatively more prevalent in B shares. These differences result from currency conversion restrictions and mandated investment quotas.

We find that only B shares exhibit momentum and earnings drift, and only A shares exhibit monthly reversals (see Figure). Further, institutional ownership strengthens momentum in B shares. These patterns accord with a setting where short-term reversals (which represent inventory risk premia) prevail in a market dominated by noise traders, and momentum prevails in markets where noise traders are less prevalent relative to informed investors who underreact to fundamental signals. Although we do not rule out the possibility that pricing of cash flow risks (e.g., real options) plays a role in generating momentum, such an explanation is not obvious.

For example, given that the domestic retail investors in A shares are likely more risk averse than foreign institutions and other relatively well-capitalized investors that prevail in B shares, we might expect an explanation based on cash flow risk pricing to generate more momentum in A shares. Instead, we find stronger momentum in the B market, particularly for those stocks held more by institutions. More generally, while stochastic discount factors (SDFs) across A and B markets should be different given market segmentation, what we show is that fluctuations in these SDFs are strongly related to investor clientele. Any neoclassical explanation of these fluctuations would not only need to accord with differing momentum and reversals across A and B shares, but also need to explain other evidence we find such as greater volatility in A shares, the lead from B returns to A returns but not vice versa, and stronger reversals after positive returns. Therefore, explanations of our results based on cash flow risk pricing appear to face daunting challenges.

In sum, our analysis suggests that differences in momentum and short-term reversals across markets are not likely to be due to differences in the fundamental risks of the firms in these markets, but rather due to differences in their investor clientele. Based on this analysis, we conjecture that if investor clienteles become more global, and more similar across markets, that differences in momentum and reversals across the different markets will tend to narrow.

Figure1: Cumulative monthly returns to short-term reversal and momentum strategies In Panel A, we plot the cumulative returns on three short-horizon return reversal portfolios: (1) A shares in the AB sample, LW(A|AB); (2) B shares in the AB sample, LW(B|AB); and (3) A shares in the Only A sample, LW(Only A). In Panel B, we plot the cumulative returns on three momentum portfolios: (1) A shares in the AB sample, WL(A|AB); (2) B shares in the AB sample, WL(B|AB); and (3) A shares in the Only A sample, WL(Only A). To the right of each plot we show the final dollar values of each of the three portfolios, given a $1 investment.

Panel A: Short-term reversals

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• Sources of Value Creation in Private Equity Buyouts of Private Firms

Despite the prevalence of private equity (PE) buyouts of private firms, little is known about how these transactions create value. We provide evidence that PE acquirers disproportionately target private firms with weak operating profitability and those that have growth potential but are highly levered and dependent on external financing. Target firms grow rapidly post-buyout, especially those undertaking add-on acquisitions, and profitability increases for both profitable and unprofitable targets. Our evidence suggests that PE acquirers create value by relaxing financing constraints for firms with strong investment opportunities and improving the performance of weak firms, while financial engineering plays a limited rol.

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• Third-Party Credit Guarantees and the Cost of Debt: Evidence from Corporate Loans

A recent stream of literature highlights the importance of the assets that firms own in their financing decisions. These studies argue that a negative shock to the value of a firm’s assets can have long-term consequences for the firm, as the firm will experience difficulty pledging collateral and therefore is not able to obtain credit or obtain credit at an increased cost. The issue is compounded when the firm relies on its assets, not only for financing purposes but also to cover future payments to hedging counterparties.

My research is motivated by the anecdotal evidence that suggests many borrowing firms, especially smaller and growing borrowers, do not have sufficient high-quality assets to pledge as collateral, or are not willing to pledge collateral to have more flexibility to sell or redeploy assets for other purposes. In this study, I focus on third-party credit guarantee, an arrangement used by many corporate borrowers instead of or in addition to pledging their own assets as collateral. In the presence of a third-party credit guarantee, a lender is protected from adverse idiosyncratic shocks to a borrower's assets.

I use the data collected by the Federal Reserve under Y14Q schedules containing details of all USD commercial and industrial loans with $1 million or more in commitment that are issued by large bank holding companies in the United States. My first finding is that third-party credit guarantees are frequently used in U.S. bank lending: Over 46% of corporate loans (equivalent to over 40% of all bank exposures in USD through corporate loans) are fully or partially guaranteed by a legal entity separate from the borrowing firm.

Using an empirical strategy that accounts for time-varying firm and lender effects, I find that the existence of a third-party credit guarantee is negatively related to loan risk, loan rate, and loan delinquency. Moreover, I find that third-party credit guarantees alleviate the effect of collateral constraints in credit market. Firms (particularly smaller firms) that experience a negative shock to their asset values are less likely to use collateral and more likely to use credit guarantees in new borrowings. The prevalence of credit guarantees challenges the extent to which the “collateral” channel of bank lending explains a firm’s financing and investments.

Further, I find that, consistent with the notion that different types of guarantors have different credit risks, a government agency-guarantee provides the highest discount on cost of debt for a borrower reducing it to a rate of return close to the risk-free rate. A corporate guarantee generates a discount that is equivalent to about 9% of the cost of debt for an average borrowing firm. I find that personal credit guarantees (those provided by a shareholder or a manager) are less effective in reducing the cost of debt for a corporate borrower.

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• The Costs and Benefits of Liquidity Regulations: Lessons from an Idle Monetary Policy Tool

Liquidity regulations implemented after the global financial crisis had a transformative effect on the financial system. The rapid implementation of such regulations occurred despite the relatively limited empirical evidence on the effects of liquidity requirements on banks. The simultaneous introduction of other bank regulations after the financial crisis frustrate attempts to measure the effects of more recent liquidity requirements.

In this paper, we examine the possible costs and benefits of mandated bank liquidity buffers by exploring the effects of a reserve requirement, which is de facto liquidity requirement that was in place in the United States in the years before the financial crisis. Although reserve requirements were not altered following the de-emphasis on monetary aggregates to pursue monetary policy objectives, the required reserve schedule increases sharply beyond an exogenous asset threshold.

The kink in the reserve requirement schedule allows us to draw causal inference using a regression kink design. We find that a higher liquid asset requirement led banks to substitute out of the most illiquid types of loans and into cash and other assets with higher liquidity value. Banks passed on only some of the cost of the liquidity requirement to depositors, causing bank profits to fall.

Finally, we document a microprudential benefit of liquidity requirements by demonstrating that banks with higher cash requirements prior to the financial crisis had a lower probability of failure. The beneficial effects of liquidity requirements on bank survival apparently stem from both a reduction in risky commercial loan intensity and a lower likelihood that banks with higher liquidity requirements will be forced to sell distressed securities amid fire sales. Our results offer a unique perspective on the causal effects of liquidity regulations and yield several general lessons for policymakers regarding the costs and benefits of such regulations.

Figure 1

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• The Distress Anomaly is Deeper than You Think: Evidence from Stocks and Bonds

This paper provides new evidence on the distress anomaly based on a comprehensive sample of stocks and corporate bonds. The distress anomaly represents a puzzling cross-sectional effect because high credit risk securities realize abnormally low returns even when they are markedly riskier than low credit risk securities. This challenges the basic risk-return paradigm in finance. The literature has proposed several rationales to resolve the distress anomaly, including transfer of wealth from bondholders to equity holders, time-varying beta, lottery type preferences, institutional trading, and limits to arbitrage. These rationales have been tested using only stocks. Our paper emphasizes the important role of corporate bonds in dissecting the distress anomaly.

First, we show that the distress anomaly extends to corporate bonds, which provides out-of-sample reinforcement of the puzzle. In addition, corporate bonds lead to new implications for existing rationales because their payoff structure, liquidity, and investor base are different from those of stocks. We show that existing rationales for the distress anomaly are inconsistent with the return patterns of corporate bonds. We argue that the most coherent rationale for the distress anomaly is underreaction to financial distress, even by the most sophisticated investors who dominate fixed income markets.

In addition, the distress anomaly implies real distortions in the real economy because corporate decisions are undertaken based on incorrect asset prices. We provide suggestive evidence that real distortions are economically significant and moreover they are severely understated if measured only based on equity mispricing. In particular, real distortions due to both equity and bond mispricing are significantly larger than those based only on equity mispricing. Examples of real distortions include excess investments, excess debt financing, and excess equity issuance.

We conclude that the distress anomaly is an unresolved puzzle, deeper than previously thought. In addition, the puzzle is associated with potentially severe implications for the real economy.

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• Cancer and Portfolio Choice: Evidence from Norwegian Register Data

We examine the effect of a health shock on personal investment decisions. The health shock is a cancer diagnosis. The identifying assumption that allows for a causal interpretation is that the exact timing of the diagnosis is as “good as random”; conditional on being diagnosed with cancer over the next few years. Consequently, we can recover the effect of a cancer diagnosis on investment decisions from the difference in outcomes between households affected today and households affected a few years later.

The figure illustrates the first central finding of our paper. The y-axis shows the likelihood that a household participates in the stock market, and the x-axis shows the years around the diagnosis. Averaged across all households and cancer types, a cancer diagnosis reduces the stock market participation rate by about 1.7 percentage points. The parallel trends in the outcomes provide evidence that the results are not driven by trends or realizations of confounders over the event window.

The novelty of the paper is not only that it establishes that adverse health shocks have a causal impact on risk-taking but also the reasons why they do so. Specifically, we investigate the interplay between life expectancy and income in determining financial choices after a change in health status. This analysis starts by comparing the estimated effect of cancer on the likelihood of participating in the stock market with the estimated years lost, which is specific to the cancer type and stage. We find that the probability of exiting the stock market is highly correlated with the expected loss in life expectancy.

Furthermore, in doing a similar exercise for the loss in household income, we find that the higher the income loss, the larger is the effect. Taken together, the two channels, reduction in life expectancy and income loss, account for about 40 to 90 percent of the estimated effects of cancer on personal investment decisions. In a nutshell, our results reveal that certain health shocks, for example, specific cancer types, which lead to revisions in survival expectations and significant drops in income, are the main drivers of the correlation between health status and risk-taking we see in the data.

Figure 1

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• Correction to: The TIPS Liquidity Premium

We introduce an arbitrage-free term structure model of nominal and real yields that accounts for liquidity risk in Treasury inflation-protected securities (TIPS). The novel feature of our model is to identify liquidity risk from individual TIPS prices by accounting for the tendency that TIPS, like most fixed-income securities, go into buy-and-hold investors’ portfolios as time passes. We find a sizable and countercyclical TIPS liquidity premium, which helps our model to match TIPS prices. Accounting for liquidity risk also improves the model’s ability to forecast inflation and match surveys of inflation expectations.

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NOTE: This and previous issues of Review of Finance [ISSN 1572-3097 | EISSN 1573-692X] are freely available to current EFA members as a benefit of annual membership.  For information on how to submit a manuscript to Review of Finance, please visit the RF Editorial Office website revfin.org.  Follow us on LinkedIn.