During the recent financial crisis, there was a dramatic spike in “idiosyncratic volatility”—the volatility of individual firm share prices after adjustment for movements in the market as a whole. The average firm’s increase was a remarkable five-fold as measured by variance. This dramatic spike is not peculiar to the most recent crisis. Rather, it has occurred with each major downturn in the economy since the 1920s, as our paper shows for the first time. These spikes present a puzzle in terms of existing economic theory. They also have important implications for several areas of corporate and securities law where the capacity of securities prices to reflect available information is particularly important. Examples include the presumption of reliance, loss causation and materiality in fraud-on-the-market suits, materiality in insider trading cases, and the corporate law regulation of defenses undertaken by targets of hostile takeover attempts. The continuing centrality of these issues is underscored by this week’s decision in Halliburton Co v. Erica P. John Fund, where the Supreme Court ruled that a defendant can defeat a fraud-on-the-market case class certification by showing that the alleged misstatement had no impact on price.
Posts Tagged ‘Market reaction’
Many financial markets have recently become subject to new regulations requiring transparency. In our recent NBER working paper, The Effects of Mandatory Transparency in Financial Market Design: Evidence from the Corporate Bond Market, we study how mandatory transparency affects trading in the corporate bond market. In July 2002, the Trade Reporting and Compliance Engine (TRACE) program began requiring the public dissemination of post-trade price and volume information for corporate bonds. Dissemination took place in four phases over a three-and-a-half year period, with actively traded, investment grade bonds becoming transparent before thinly traded, high-yield bonds.
Corporate scandals have large negative effects on the value of the firms that are discovered having committed fraud (Karpoff, Lee, and Martin, 2008; Dyck, Morse, and Zingales, 2013). Besides inflicting direct losses to shareholders, corporate fraud may also have indirect effects on households’ willingness to participate in the stock market, which may generate even larger losses by increasing the cost of capital for other firms. Evidence of the externalities generated by corporate fraud, however, is quite limited.
In our paper, Does Stock Liquidity Affect Incentives to Monitor? Evidence from Corporate Takeovers, forthcoming in the Review of Financial Studies, we examine the role of liquidity as a monitoring incentive and its effect on firm value by analyzing the market reaction to takeover announcements. The empirical evidence is consistent with the view that there is a tradeoff between monitoring via institutional intervention and liquidity for takeovers of private targets, but not for takeovers of public targets. This finding may be explained by the increased role of the disciplining effect of the threat of exit in connection to actions that on average destroy shareholder value, such as takeovers of public targets (Admati and Pfleiderer 2009).
In our paper, Merger Negotiations with Stock Market Feedback, forthcoming in the Journal of Finance, we investigate whether pre-bid target stock price runups increase bidder takeover costs—an issue of first-order importance for the efficiency of the takeover mechanism. We base our predictions on a simple model with rational market participants and synergistic takeovers. Takeover signals (rumors) received by the market cause market anticipation of deal synergies that drive stock price runups. The model delivers the equilibrium pricing relation between the runup and the subsequent offer price markup (the surprise effect of the bid announcement) that should exist in a sample of observed bids.
Recent events suggest that shareholders pay attention to matters involving the personal lives of CEOs and take this information into account when making investment decisions. In our paper, Separation Anxiety: The Impact of CEO Divorce on Shareholders, which was recently made publicly available on SSRN, we examine the impact that CEO divorce can have on a corporation.
There are at least three potential ways in which a CEO divorce might impact a corporation and its shareholders. The first is loss of control or influence. A CEO with a significant ownership stake in a company might be forced to sell or transfer a portion of this stake to satisfy the terms of a divorce settlement. This can reduce the influence that he or she has over the organization and impact decisions regarding corporate strategy, asset ownership, and board composition. Shareholder reaction to loss of control will vary, depending on the view that investors have of CEO performance and governance quality. If they view performance and governance quality favorably, they will react negatively to the news; if they view management as entrenched or a poor steward of assets, they will react positively. Shareholder reaction will also depend in part on what happens to divested shares, including whether they are transferred to the spouse, sold in a block to a third-party, or dispersed in the general market. Each of these can shape the future governance of a firm.
An issue of considerable interest to accounting researchers is the association between shareholders and firms’ financial reporting quality (FRQ). In our paper, Blockholder Heterogeneity and Financial Reporting Quality, which was recently made publicly available on SSRN, we examine a specific type of shareholder, blockholders, because (1) they offer a sample of shareholders that are expected to have a significant impact on firms’ financial reporting decisions and (2) we are able to track individual blockholders and their association with FRQ. As discussed in more detail below, these two sample design features allow us to provide a test of the extent to which (large) shareholders influence FRQ. Blockholders also provide an interesting and economically important sample because of their large presence in U.S. capital markets in recent years.
In our paper, When Blockholders Leave Feet First: Do Ownership and Control Affect Firm Value?, which was recently made publicly available on SSRN, we investigate the effect of ownership and control on firm value, a longstanding question in finance, by employing the sudden death of large individual shareholders as a natural experiment. Our analysis focuses on stock price reactions to the deaths of individual blockholders who hold 5% or more in a U.S. listed firm. The main advantage of this approach is that sudden deaths are exogenous events that allow us to identify the impact of ownership and control on firm value. We analyze the value of inside and outside blockholders. Outside blockholders differ from insiders in that they are not actively involved in day-to-day management. We compare the magnitude of stock price reactions between inside and outside blockholders and note that any effect of ownership transition on firm value due to liquidity or anticipated takeover activity is likely to cancel out. The difference in the stock price reactions between inside and outside blockholders is therefore informative about the value of ownership and control.
Our study is the first to evaluate the effect of blockholders on firm value through the use of sudden deaths. In a related paper Slovin and Sushka (1993) analyze the event of death of blockholders. We draw a distinction between sudden and non-sudden deaths because entrenched blockholders are likely to hold onto their ownership until their deaths. Our concerns about entrenchment appears to be relevant as our findings show that stock price reactions are systematically more positive for non-sudden deaths than for sudden deaths. Using sudden death as opposed to non-sudden death is thus important for the interpretation of the effect of blockholders on firm value.
In Rollover Risk: Ideating a U.S. Debt Default, forthcoming in the Boston College Law Review, I systematically examine how a U.S. debt default might occur, how it could be avoided, its potential consequences if not avoided, and how those consequences could be mitigated. The impending debt-ceiling showdown between Congress and the President makes these questions especially topical. The Republican majority in Congress is conditioning any raise in the federal debt ceiling on spending cuts and reforms. Yet without raising the debt ceiling, the government may end up defaulting, perhaps as early as mid-October.
Even without that showdown, however, these questions are important. As the article explains, certain types of U.S. debt defaults, due to rollover risk, are actually quite realistic. This is the risk that the government will be temporarily unable to borrow sufficient funds to repay—sometimes termed, to refinance—its maturing debt.
Because rollover risk is such a concern, one might ask why governments, including the United States, routinely depend on borrowing new money to repay their maturing debt. The answer is cost: using short-term debt to fund long-term projects is attractive because, if managed to avoid a default, it tends to lower the cost of borrowing. The interest rate on short-term debt is usually lower than that on long-term debt because, other things being equal, it is easier to assess a borrower’s ability to repay in the short term than in the long term, and long-term debt carries greater interest-rate risk. But this cost-saving does not come free of charge: it increases the threat of default.
In our paper, Seasoned Equity Offerings, Corporate Governance, and Investments, forthcoming in the Review of Finance, we assess how the strength of governance affects investor confidence about management’s intended uses of the proceeds from SEOs. Our primary tests are conducted using difference-in-differences approaches using the staggered enactments of business combination statutes (BCS) as an exogenous shock weakening external pressure for good governance from the market for corporate control.
These tests are supplemented by two additional analyses, one relying on shareholder-value-reducing acquisitions as an ex post proxy for weak governance; the other relying on top management’s firm-related wealth sensitivity to shareholder value as a proxy for the strength of internal governance. These empirical analyses cover different sample periods spanning 1982 through 2006. Investor reaction to SEOs is positively and significantly related to the strength of governance regardless of which empirical strategy we use and which time period we examine.
The economic magnitudes of governance impacts are surprisingly large, explaining much of the negative stock price reactions to the announcement of SEOs. Absent secondary offerings, investors’ main concern with SEOs is whether management will use the proceeds productively or wastefully. Good governance enhances investor confidence, helping firms raise external equity at lower costs.