The analysis of long-term bond excess returns is an important issue in portfolio management and risk dynamics. Under the classical expectation hypothesis, which assumes that long-term yield represents future short-term rate expectations, the excess return on a long-term maturity bond is constant over time. However, it is well known that this assumption does not hold empirically. In the U.S. and other international markets, the forward rate factor suggested by Cochrane and Piazzesi (2005) strongly predicts bond excess returns. Thus, the bond excess return is time-varying and the current yield curve contains information on bond risk premia. Given that the bond price reflects the market participants’ expectations regarding future economic states, it should be closely related to macroeconomic variables, such as inflation and real growth. There is a growing area of research called “macro-finance” that tries to explain the term structure of interest rates and bond risk premia with macroeconomic variables. In this paper, we empirically investigate the predictability of bond excess returns in the Korean market. We use information from the current yield curve, inflation shock, and real production shock. Specifically, we use the forward rate factor from Cochrane and Piazzesi (2005), the inflation cycle factor from Cieslak and Povala (2014) and the output gap factor from Cooper and Priestley (2009) as candidate variables to predict bond excess returns. First, we construct the three candidate factors: forward rate, inflation cycle and output gap. The forward rate factor is defined as the fitted value from the regression of the mean excess return on the forward rates. Under the Fisher hypothesis, a long-term yield can be decomposed into an expectation hypothesis term, a long-term inflation expectation term, and a cycle term. The inflation cycle factor summarizes information in the residuals from the regressions of the yields on the long-term inflation expectation. The output gap factor is generated by removing the time trend from the industrial production index. The empirical result shows that the forward rate factor strongly predicts the excess returns of all maturities, with an adjusted   higher than 50%. Consistent with the other markets’ results, the information in the yield curve is important in predicting bond excess returns. Compared to the forward rate factor, the inflation cycle and output gap factors, which are individual macroeconomic variables, have weak or no predictive ability. Although the cycle factor has comparable forecasting ability in relation to the forward rate factor, it does not have any additional predictive power when the forward rate factor is taken into account. Even worse, the output gap factor does not have any explanatory power alone. Overall, the results indicate that the macroeconomic variables in our analysis do not have information above the yield curve. We also conduct further analyses of the forward rate factor, which exhibits strong predictive power. The explanatory power of the forward rate factor is beyond the conventional yield curve factors (level, slope and curvature). It does not come from the multicollinearity of forward rates. In addition, the forward rate factor survives after controlling for the effect of international variables; specifically, the U.S. forward rate factor and the currency swap rate. As with the results from the international market data in Sekkel (2011), the explanatory power of the forward rate factor decreased after the financial crisis. Finally, the forward rate factor effectively explains the longer maturity bonds with maturities longer than five years. Focusing on the failure of the inflation cycle factor, which theoretically contains refined information about bond risk premia, we find that the long-term inflation expectation does not have explanatory power in addition to bond yields. Cieslak and Povala (2014) argue that the forward rate factor is a restricted version of the cycle factor, and they remove the long-term inflation term from the bond yields. In contrast, the inflation cycle factor becomes a noisier measure of bond risk premia in the Korean market and the predictive power of the forward rate factor is very strong in our sample period in the global market. The empirical results in this study imply the possibility that bond prices in the Korean market can be expressed as an affine model of yield curve factors, as in Cochrane and Piazzesi (2005). Although the macroeconomic factors do not seem to contain information about bond risk premia above the yield curve, we do not strongly reject the macro-finance models from our empirical results, as the macroeconomic factors in this paper are from a small subset of macroeconomic variables. We remain open to the possibility of more explanatory macroeconomic variables of bond risk premia.

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The Organisation for Economic Co-operation and Development (OECD) (1998) defines a tax haven as having the following characteristics: (a) no or only nominal taxes, (b) a lack of effective exchange of information, (c) a lack of transparency, and (d) no requirement that the activity be substantial. As these guarantee anonymity and little regulation in financial transactions, capital flows from tax havens are suspected to derive from dishonest motives and to have a negative impact on the local financial market. In Korea, there also has been a debate about local investors’ round-tripping through accounts in tax havens. Specifically, local investors set up paper companies in tax havens and camouflage themselves as foreign investors by trading local securities through these companies. The Korean media often refer to these investors as ‘blackhaired foreigners’. There is, however, little empirical evidence of the effect of capital flows from tax havens because relevant data are not available. This paper empirically investigates the impact of capital flows from tax havens on the Korean stock market using the 246 country codes provided by the Korea Exchange (KRX). The primary data source is the TAQ (trade and quote) dataset, which includes the full history of all trades made in the Korea Composite Stock Price Index (KOSPI) market between January 2006 and June 2008. Each trade record contains the price, quantity, time-stamp, investor class, and, most importantly, the country of origin of both buyers and sellers. First, I compute the dollar trading volume of both purchases and sales across nations and list all the foreign countries investing in the KOSPI market. The summary statistics indicate that investors from the U.K. constitute a quarter of the total trading activity of all foreign investors in Korea. U.S. investors account for roughly 14% of all trades from foreign countries. The Cayman Islands, which is a tax haven, is the third largest foreign country investing in Korean stocks, accounting for 9% of all foreign trading. I consider a country a tax haven if it was listed in the 1998 OECD report on tax havens. Finally, I define the following 5 jurisdictions as tax havens: the Cayman Islands, the Bermuda, the Bahamas, the British Virgin Islands, and the U.S. Virgin Islands. Trades from these tax havens amount to about 10% of the total trading volume of foreign investors in the KOSPI market. This suggests that trades from tax havens make up a substantial proportion of all foreign trading and that their impact on the KOSPI is likely to be significant. Next, I investigate whether foreign investors from tax havens pursue positive feedback trading strategies. These strategies are considered to have a destabilizing effect because their sales lead to falls in the stock prices and their purchases increasing in price. This may contribute to an increase in the volatility of stock returns. Such trading can also destabilize capital flows as investors rush into booming stocks and flee from falling ones. Empirical results show that tax haven investors buy more Korean stocks on days after a market rises and sell more on days after it falls. They also buy more of the stocks that outperformed the market the previous day. These results mean that foreign investors from tax havens are positive feedback traders. Finally, I examine whether foreign trades from tax havens have a significant impact on stock prices and increase the volatility of stock returns. In the first study, I select event days with large net purchases (sales) from tax haven investors, and compute abnormal returns for 11 days surrounding these events. The null hypothesis that tax haven investors do not have an effect on the Korean stock market can be rejected if significant abnormal returns follow large trades from tax havens in the same direction. The results show that both large purchases and sales from tax havens have a significant price movement within the event days and that the impacts are larger for purchases. In particular, the price impact of large purchase trades from tax havens persists one day after the event, and their cumulative abnormal returns are significantly positive for five days. These results mean that large trades by tax haven investors have a significant price impact on Korean stocks. In the second study, I use panel regression to examine the relation between stock volatility and trades from tax havens. The results show that stock volatility increases significantly as both net purchases and net sales from tax havens increase. Overall, the results in this paper allow the conclusion that capital flows from tax havens have significant effects on the Korean stock market. It is thus necessary for us to know who the tax haven investors are and what they do. However, tax havens remain domains of secrecy. This paper supports the recent efforts of the OECD and G20 to increase the transparency of capital flows from tax havens.

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The assets under management (AUM) of the Korean National Pension Fund (NPF), which started from 530 billion won in 1988, reached 426.9 trillion won by the end of 2013. This is the fourth largest pension fund in the world. Over 99% of the Korean NPF portfolio is comprised of finance sector holdings and the NPF’s performance thus depends on the management of financial sector investments. For many years, major investment vehicles in the NPF portfolio have been domestic bonds, domestic stocks, foreign bonds, and foreign stocks. Recently, alternative investments have become important parts of pension portfolio management. It is common to find alternative investment products such as real estate, infrastructure, private equity, commodities, and hedge funds in various sovereign pension portfolios. As alternative asset classes have little correlation with traditional investments, they help to diversify portfolio risk and also extend portfolios’ efficient frontier. In consequence, the proportion of alternative investments among global pension funds increased from approximately 7% in 2003 to 17% in 2012. The Korean NPF has followed this trend. The amount and proportion of alternative investments in the NPF portfolio steadily increased to reach 40 trillion won and to account for 9.4% of the total portfolio as of the end of 2013. However, few studies have been conducted on the management and performance of alternative investments in Korea. This study explores a way to construct the optimal alternative investment portfolio for the Korean NPF using both the Markowitz mean-variance and Black-Litterman models. With six asset classes, we use a proxy for the fund’s alternative investment portfolio to test which of the two optimization models is more appropriate for improving portfolio performance. We also construct an alternative investment portfolio with eight asset classes, adding commodity and hedge funds, which are currently excluded from the Korean NPF portfolio, to examine whether including these can enhance the portfolio’s efficiency. The main results of this study are as follows. First, we construct the optimal alternative investment portfolio with the Markowitz mean-variance model using the historical average returns of various alternative investment assets as proxy for the equilibrium expected returns. However, the model is extremely sensitive to changes in the input variables and often converges to the corner solution, which allocates unreasonably high weights to one or two assets. This reduces the advantages of portfolio diversification. Second, the Black-Litterman model has been devised to improve these limitations of the mean-variance model. It combines the equilibrium expected returns embedded in a market portfolio with managers’ views on its future asset performance. The model alleviates the extreme asset allocation problem. Thus, we suggest that the Black-Litterman model can be more appropriate so long as managers have marketforecasting capabilities. Finally, we confirm that including commodity and hedge funds in the Korean NPF alternative investment portfolio can improve its efficiency, as long as the fund has appropriate market-forecasting capabilities and imposes reasonable portfolio weights restrictions in asset classes. We consider the Black-Litterman model, which reflects managers’ views on future performance, in preference to the mean-variance model. We provide new insights into asset allocation methodology for the Korean NPF, which has mainly conducted asset allocation using a Markowitz-type mean-variance model. Some of the current alternative investment segment benchmarks used in the Korean NPF do not explain the variance and covariance of their asset classes, and we propose new benchmarks to replace them. Considering the growing prominence of the alternative investment portfolio in the Korean NPF, we suggest that continuous research effort should be made in this area to further improve the performance of the fund.

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According to the costly arbitrage model of Pontiff (2006), idiosyncratic risk increases holding costs that limit arbitrage. Since short sales are actively used for arbitrage, the costly arbitrage model should apply to short sales, which is the case according to the empirical findings of two recent studies: Au, Doukas, and Onayev (2009) on US markets, and Duan, Hu, and McLean (2010) on U. K. markets. Both studies offer evidence that idiosyncratic risk acts as a deterrent to short sales and affects returns subsequent to short sales. This study investigates whether a similar pattern exists in the Korean equity market using short sales data for stocks listed on the Korea Exchange from July 2004 to June 2011. Our study contributes to the literature in three important ways. First, it is the only study ever conducted outside the U.S. and U.K. markets on the relation between idiosyncratic risk and short sales. Second, different from Au et al. (2009) and Duan et al. (2010), we use short sale volume data rather than short interest data in our analysis. Using short sale trading volume is preferable to short interest volume because the former captures short sales activity more accurately than the latter, which often under- or over-estimates short sales activity. Third, we perform an investor-type analysis. Our data enable us to distinguish short sale volume by different investor types: individuals, domestic institutions, and foreigners. An investor-type analysis offers important insights into the effects of idiosyncratic risk on short sales activity. This is because different types of investors have different motives for short sales, an issue closely related to whether a certain type of investor engaging in short sales is more informed than other types. How idiosyncratic risk affects short sales made by different types of investors, and how it is related to the information content of short sales made by certain types of investors, are interesting questions. We measure short sales activity by short volume ratio (SVR), defined as the cumulative daily short volume of a stock in a month divided by the total trading volume of the stock in the same month. Following Ang, Hodrick, Xing, and Zhang (2006), we estimate the idiosyncratic risk of a stock in a given month from the Fama-French three-factor model. Our analysis is performed in two ways: a comparative analysis based on 20 groups formed by levels of idiosyncratic risk and SVR (5 by 4), and Fama-MacBeth regressions of (1) SVR on idiosyncratic volatility and (2) abnormal returns on SVR and idiosyncratic volatility. Both regressions use control variables that are believed to affect short sale volume or returns. Our findings can be summarized as follows. First, we find a negative relation between idiosyncratic risk and SVR, which is consistent with the recognition by investors of idiosyncratic risk as an arbitrage cost that limits short sales activity. Second, short sales made by domestic institutions show the strongest negative effect of idiosyncratic risk on SVR, followed by short sales made by foreigners. We do not find evidence of such a negative relation between idiosyncratic risk and short sales made by individuals. These patterns are consistent with different motives for short sales made by different types of investors. Institutions use short sales primarily for hedging and arbitrage. Hence, idiosyncratic risk is a significant binding factor. It binds short sales made by individuals less because they use short sales mainly for speculative purposes. Third, the greater the SVR, the lower the returns after short sales. This suggests that short sales predict future stock returns and that, on average, short sale traders are well informed. Fourth, the negative relation between SVR and future returns is stronger for firms with greater idiosyncratic risk. This finding is consistent with the model of Diamond and Verrecchia (1987), which states that costly short sales are used by informed traders. Finally, the effect of idiosyncratic risk on the relation between SVR and future returns is stronger for short sales made by foreign investors–a finding that suggests an informational advantage of foreigners over domestic institutions and individuals.

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This study empirically analyzes the relationship between corporate governance and cash holdings in Korea, a representative emerging market, using its data of listed firms with interests in contradictory recent research results concerning corporate governance and cash holdings. The variables used as proxies to represent types of corporate governance are very important. Unlike previous studies, this study uses the independence of boards as a proxy variable for corporate governance level because boards play a crucial role in monitoring management and simultaneously implementing decision-making processes. In addition, a principal decision-making process carried out by a board aims to protect investor profit and enhance firm value by efficiently allocating firm resources, and previous research has emphasized that independence is important to boards’ effective functioning. To measure board independence, we use the ratios of independent and non-independent outside directors used in previous studies, drawing on a very large amount of data gathered on the individual outside directors of Korean listed firms for the 2001-2010 period. Based on these data, the ratios of independent and non-independent directors are extracted after classifying two types of outside directors by setting up more stringent criteria, which include the educational and vocational backgrounds of individual outside directors as well as their legal qualifications. In this way, the study considers the importance of independent outside directors by empirically analyzing the effect of each ratio, and highlights that board independence originates with independent outside directors. More specifically, we provide empirical evidence in relation to the following three main questions. (1) Does the amount of cash holdings differ according to the degree of corporate governance (board independence) in Korean listed firms? (2) Are cash resources efficiently allocated according to the degree of corporate governance (board independence) in Korean listed firms? (3) Does the value of cash holdings differ and consequently affect firm value according to the degree of corporate governance (board independence) in Korean listed firms? The empirical results can be summarized as follows. First, when a board becomes more independent, the firm’s cash holdings decreases, while cash outflow increases. As the board’s independence grows, it is able to more efficiently control managers’ incentives to accumulate cash resources internally. Second, as board independence increases, high-growth opportunity firms may increase their investment options, while low-growth opportunity firms may increase their dividend options. Our analysis of the interaction between board independence and cash holdings in investments and dividends, according to growth opportunity, indicates that its effects on dividends were significant, but its effects on investments were not. In firms with high growth opportunity, as the ratio of non-independent outside directors increases, internally held cash is not spent on investments but on dividends, which confirms that the firms’ growth opportunities are not being used efficiently. In contrast, in firms with low growth opportunity, as the ratio of independent outside directors increases, managers are prohibited by the board from spending internally held cash, which instead is likely to be spent on dividends. Finally, firm value increases in firms with higher levels of board independence and more cash holdings. In other words, as board independence increases, investors value cash holdings more highly. This indicates that the value of cash holdings differs according to the type of corporate governance. Our findings confirm that the relationship between board independence and cash holdings in Korea, an emerging market, is different from that in the U.S., a well-developed market. More importantly, this study enables us to understand how good corporate governance enhances firm value. It shows that in firms with high board independence, the market estimates that the monitoring function of the board works effectively and that cash holdings are not exploited for managers’ private benefit; instead, they are allocated efficiently according to the firm’s characteristics, such as to growth opportunities. This market view is then reflected in the valuation of cash holdings, which in turn increases firm value.

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This paper reports an overall regime shift in asymmetric beta upon liberalization of the Korean stock market. There are various researches for effects of market liberalization. Especially, the global financial crisis in recent triggers great controversy over the capital market liberalization and global financial integration. And after many emerging countries, even developed countries go through unexpected capital flow, such controversy is deepening. It leads for us to consider the liberalization of the Korean stock market discreetly. Previous studies mainly concentrate the impact to the foreign-exchange market and real economy or the effectiveness of foreign investment. However, the structural change of capital market itself has been ignored. We attempt to organize specific arguments and previous discussions upon economic impact of the liberalization. We verify the long-term beta features using the longest data before and after Korean capital market liberalization. And we also attempt to identify the industrial characteristics of asymmetric beta. Hence, our study can be considered as associative study of capital market liberalization issue and asymmetric beta issue. The empirical results are summarized as follows. First, over the sample period, we consistently observe the existence ofasymmetric beta under the diverse categories of bull market (bear market). Our finding is consistent with previous studies such that the investors recognize the upside gain and down loss differently. Second, the sensitivity of beta under a bull market has increased after the liberalization. However, we find only weak evidences of beta expansion in bear market. These results denote that the typical paradigm that the sensitivity to down loss is higher is maintained, however, the investors are more conscious about the upside after the liberalization. In other words, the investors actively start to reflect the upside signal after the liberalization. Third, we find an intensified co-movement of Korean capital market and the foreign capital markets, Additionally, the conditional beta by the foreign market’s direction increases significantly. However, PND, the simplest criteria, shows the opposite results. It denotes that the investment strategy based on PND criteria may make an erroneous decision. Forth, the intensity of asymmetry beta varies in the cross-section of industrial sectors. Based on KSIC, we only observe asymmetric beta in ‘manufacturing’, ‘construction’, ‘financial and insurance business’, and ‘professional and scientific service’ sectors. Specially, in the majority of sectors, downward beta is higher than upside beta, however, the opposite result is derived in ‘financial and insurance business’ sector. It denotes that ‘financial and insurance business’ sector takes the leading role in increasing for the upside beta after the liberalization. Fifth, from the detailed analysis with industrial sub-sectors, we verify the significant differences among sub-sectors despite the significant upper-sectors. As a result, the capital market liberalization affects separate impacts and post changes by the industry sector. A practical implication suggests sector-based differentiation in portfolio management facing global market risks. We ask for careful attention to interpret our results. Korean capital market has experienced a considerable change by complex policies after the liberalization. Therefore, restricted interpretation such that our empirical findings are not derived only from the liberalization, but rather the liberalization becomes a turning point of the structural change and there is a possibility such that the discriminative impacts by industrial sectors after the liberalization is appropriate.

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The information asymmetry between managers and outside investors is a significant cost to firms. The related literature suggests that there is a negative relationship between information quality and cost of equity. The poor information quality represents imprecise information about firms’ future cash flows and is associated with higher information asymmetry, such that it increases the cost of equity capital. Bhattacharya et al. (2012) show that both accounting information quality and information asymmetry are related to the cost of equity. We measure firms’ accounting information quality based on the earnings accruals model in Francis et al. (2005), in which accounting information quality proxied by accruals quality is estimated based on the extended model of Dechow and Dichev (2002). The extended model posits an association between current period working capital accruals and operating cash flows in the prior, current and future periods, controlling for changes in revenues, property, plant and equipment as additional explanatory variables. Francis et al. (2005) show that working capital accruals reflect managerial estimates of cash flows, and the extent to which those accruals do not map into cash flows and, changes in revenues, property, plant and equipment is an inverse measure of accruals quality. They use an accruals measure that does not distinguish between intentionalearnings management and unintentional estimation errors from the model, as both measures imply poor accounting information quality. A cost to firms is measured by the implied cost of equity capital (ICOE) from an extension of the residual income valuation model (Ohlson, 1995). The ability to reliably estimate the cost of equity capital is an important issue for both academics and practitioners. In financial decision making, the ex-ante cost of equity capital is one of the most important factors, as it affects the value of a project or asset. However, as it is not easily observable in the market, we must estimate the ex-ante cost of equity capital. The literature suggests an approach (the residual income valuation model, or RIM) that calculates the internal rate of return by equating the stock prices with the present value of all future cash flows to common shareholders based on contemporaneous earnings forecasts. Gebhardt et al. (2001) estimate the rate of return (ICOE) that the market implicitly uses to discount a firm’s expected future cash flows. They find that the ICOE based on the RIM is a reliable proxy for the ex-ante cost of equity capital. Lee and Masulis (2009) measure a firm’s information asymmetry by its accounting information quality based on the extended earnings accruals model of Dechow and Dichev (2002). Lee and Masulis (2009) investigate whether poor accounting information quality raises uncertainty about a firm’s financial condition among outside investors, resulting in higher flotation costs in seasoned equity offerings. They find a significant and negative relationship between accounting information quality and flotation costs, and thus claim that their measures of accounting information quality are credible proxies for the information asymmetry. In this paper, we investigate the association between accounting information quality and the implied cost of equity capital. Specifically, we examine whether high- quality accounting information proxied by quality of accruals can alleviate information asymmetry among participants in the market, effectively reducing the cost of firms’ equity capital. To test our main hypothesis, we use a sample period from 2003 to 2007 and our alignment of accounting information quality and the implied cost of equity variables is based on the fiscal years used to measure the quality of accruals. Our sample includes only non-financial companies listed on the Korea Exchange. The final sample comprises 474 firm years. Our results reveal a statistically significant and negative relationship between accounting information quality (measured by accruals quality), as estimated by Francis et al. (2005), and the implied cost of equity capital, estimated from the residual income valuation model (Gebhardt et al., 2001), which is consistent with the literature. This finding implies that high-quality accounting information about firms’ future cash flows reduces information asymmetry between insiders and outside investors, thus lowering the cost of equity capital. However, the common proxies for information asymmetry, such as corporate governance indices and analysts’ earnings forecast errors, are not related to the implied costs of equity. We also find a significantly negative association between accounting information quality and the cost of equity capital estimated from Easton’s (2004) model. In conclusion, the results of our analysis suggest that higher- quality accounting information is a more effective way of reducing the cost of equity capital than good corporate governance and low volatility of earnings forecasts.

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The world economy has experienced several historical events in which liquidity dry-ups were accompanied by real economic recessions, including the Asian crisis in the late 1990s and the global financial crisis in the late 2000s. Since then, financial market liquidity has been extensively studied and several recent empirical studies have documented evidence of time variation in liquidity and its relation to the macroeconomy (Fujimoto, 2004; Lu and Glascock, 2010; Næs, Skjeltorp, and Ødegaard, 2011). While there is a consensus about the close link between financial market liquidity and the real economy, previous studies provide conflicting views on the lead-lag relation, or causality between them. In this study, we use Korean stock market data to provide new empirical evidence that financial market liquidity has leading information on the real economy. To this end, we examine the time-series relation between stock market liquidity and the real economy using the daily data of stocks listed on the Korean Stock Exchange and quarterly macroeconomic variables over the 1987 to 2013 period. Specifically, we construct two aggregate liquidity measures at a quarterly frequency following Amihud (2002, Illiquidity and stock returns: cross-section and time-series effects, Journal of Financial Markets 5, 31-56) and Pastor and Stambaugh (2003, Liquidity risk and expected stock returns, Journal of Political Economy 111, 642-685), and we also use real GDP, real consumption, real investment and unemployment rate as proxies for the state of the real economy. Our empirical findings are as follows. First, we find that stock market liquidity varies before a change in real economy, and that liquidity has significantforecasting power for future real economic growth. The estimation results of our predictive models indicate that improved stock market liquidity predicts real economic growth, whereas deteriorating stock market liquidity predicts a slowdown in the real economy. The predictability of stock market liquidity is highly significant even after controlling for various financial market variables known to be important predictors of the real economy, such as monetary liquidity, interest rate, dividend yield, market excess returns and market volatility. This implies that stock market liquidity contains leading information not contained in other asset price predictors for future economic conditions. Second, from Granger causality tests, we find evidence that stock market liquidity causes changes in the real economy, whereas the real economic variables do not have significant forecasting power for future stock market liquidity. This result provides new evidence for conflicting views about the lead-lag relation between liquidity and the macroeconomy in the literature, and further highlights the critical role of stock market liquidity as a predictor of the real economy. Third, we analyze the effects of firm characteristics on the predictability of liquidity, and find that the liquidity of stocks with low market capitalization and low payout ratio contains more significant information about future economic conditions than that of large and high-payout-ratio firms. Given that small and low -payout-ratio stocks are more likely to be affected by a recessionary shock in the real economy than large and high-payout ratio stocks, investors may trade those stocks according to the prediction of future economic conditions, resulting in the market liquidity of those stocks being highly informative. The result implies that the predictability of stock market liquidity comes from investors’ trading activities based on rational expectations of future economic states. Finally, our results are robust for choice of liquidity measures and real economic indicators, and the out- of-sample predictability is also statistically significant. We also document that stock market liquidity can significantly forecast up to two-year-ahead economic conditions. Moreover, the predictability of liquidity is not much affected when the specific periods of the Asian crisis and the global financial crisis are excluded from the sample. Overall, our findings are consistent with flight-to-quality, the phenomenon wherein investors suddenly shift their portfolios from risky assets to safe ones during economic downturns, creating a negative shock in the liquidity of risky assets. This implies that stock market liquidity contains valuable information about future economic states not contained in other asset price variables, and highlights the role of liquidity in financial markets as a predictor of the real economy. Our study contributes to the literature on the time variation of liquidity in emerging markets by taking a closer look at the Korean economy. Although numerous studies have examined the effects of financial market liquidity on asset pricing and the macroeconomy, most of them have focused on major developed markets, including the U.S. stock market. Given that several emerging economies including Korea have suffered from a lack of liquidity during financial crises, they are suitable for investigating the relation between liquidity and economic states. In particular, empirical research on liquidity in the Korean stock market has been mainly confined to market microstructure issues. Our findings provide a new direction for future research on financial market liquidity in Korea.

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Institutional investors have increased their presence in financial markets (Gompers and Metrick, 2011), securing positions as dominant players by becoming actively involved in firms’ operations. Active institutions influence the board of directors and management, thus bringing about changes in corporate policies, influencing governance, and affecting the quality of financial reporting and corporate disclosure. While some studies have found that institutional investors actively monitor firms’ management and mitigate managerial agency problems (e.g., Kaplan and Minton 1994; Chung, Firth, and Kim 2002), other studies have argued that institutional investors seeking to maximize personal benefits influence firm management, prompting managerial opportunism such as earnings management (e.g., Agrawal and Knoeber, 1996; Black, 1998; Parrino, Siasand, and Starks, 2003). Recent papers have focused on the investment horizons of institutional investors, such that long-term institutional ownership improves corporate governance (Lee and Chung, 2012), exhibits less tax avoidance (Khurana and Moser, 2013), and increases investment (Derrien, Kecskés, and Thesmar, 2012). Firms with large portions of transient institutions are more likely to reduce research and development expenditures (Bushee, 1988) and get lower premiums at acquisitions (Gasperet al., 2005). In Korea, domestic institutional investors exhibit short-term trading behavior and fail to contribute to the increase in earnings quality (Cheon, 2003). Likewise, Kwon (2007) classified institutional investors into four types: financial institutions, security companies, insurance companies, and foreign investors. He found that foreign investors and insurance companies improved earnings quality, whereas other local institutional investors tended to focus on short-term profits and did not contribute to the increase in earnings quality. Research has indicated that short-term investors have less incentive to engage in improving a firm’s long-term performance, but use their informational advantage to enjoy the personal benefits of short-term stock trading (Park and Song, 2014). Thus, the monitoring role played by institutional investors is closely related to their investment behavior. In this paper, we study the effect of the investment horizons of institutional investors on the effectiveness of internal control systems over financial reporting. Specifically, we examine how the investment horizons of institutional investors effect the disclosure of material weaknesses in internal control over financial reporting under Section 404 of the Sarbanes-Oxley ACT of 2002. We measure institutional investors’ portfolio turnover using churn rate, as introduced by Gasper et al. (2005), which measures how frequently an institution buys and sells its stocks. Our measure of a firm’s investment horizon is the weighted average of the total portfolio churn rates of its institutional investors. We find that institutional investor ownership decreases both the frequency and the number of material weaknesses under the SOX 404. However, this positive relationship is weakened as institutional investors’ investment horizon for each firm is short-term. These findings suggest that institutional investors’ influence over the effectiveness of internal control is closely dependent on their investment horizons. Our results contribute to the literature that the role of institutional investors in enhancing internal control systems is closely related to institutions’ investment horizons.

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Since the seminal work of Irving Fisher, the question of how stocks covary with inflation has been extensively examined because inflation risk erodes purchasing power and threatens invetor’s long-term objectives (Ang et al., 2012). Most studies found that nominal stock market returns and inflation are negatively correlated. However, there are some evidence that some non-cyclical industries tend to covary positively with inflation, even though the inflation beta is not significant. In addition, the previous literature has focused on the hedging ability of aggregate stock market indices. Recently, Ang et al. (2012) found that some stocks have the ability to be good inflation hedges, suggesting that an investor seeking to hedge inflation risk would optimally hold this firm-level constructed portfolio rather than a market-weighted index. Therefore, if equity funds construct their portfolios based on individual stocks whose returns covary strongly with inflation, those funds have the potential to provide a better inflation hedge for investors, especially who want to avoid inflation risk. Based on this conjecture, this paper examines the inflation hedging ability of Korean equity funds during the January 2001 to May 2013 period. To measure the inflation hedging ability of individual equity funds, we compute fund-level inflation betas following Bekaert and Wang (2010), by regressing individual fund returns on inflation. This allows us to conduct an ex-post analysis of which funds provided the strongest realized covariation between fund returns and inflation. As Jiang, Yao, and Yu (2007) noted, evidence of timing ability can result simply from “luck.” For instance, even if no funds have timing ability, when there are a large number of them, some will have significant timing measures based on t-statistics, due to random chance (Jiang et al., 2007)and the sampling variation. To consider this problem and identify whether the inflation hedging ability is genuine, we use the cross-sectional luck distribution, estimated using the bootstrap approach, to distinguish between skill and luck (due to sampling variation), as proposed by Kosowski et al. (2006). The advantage of the cross- sectional bootstrap approach is that it allows researchers to obtain a distribution of the inflation betas for all funds; specifically, it does not consider the luck distribution of a particular fund but, rather, considers that of all funds, which allows us to draw a statistical inference of funds in the extreme tails of the cross-sectional distribution (i.e., extreme positive inflation betas). When using the realized and expected inflation, we find that while some Korean equity funds have inflation hedging ability, it is due more to fund managers’ luck (or sampling variation) than skill. Some previous studies have shown that inflation betas are time-varying. To consider this finding, we divide our sample period into two sub-periods ranging from January 2001 to December 2005 and from January 2006 to May 2013, respectively. This sub-period analysis shows that slightly more funds have returns that covary significantly and positively, in the second sub-period than in the first period. However, the significantly positive inflation betas in both periods are due to luck, consistent with those of the whole- period analysis. The bootstrap procedure used by Kosowski et al. (2006) assumed that the residuals from the regression analysis were independently and identically distributed for funds. However, it is possible that the residuals have serial dependence over time or cross-sectional correlations across funds. To evaluate their effect on the bootstrap results for inflation hedging skill, we adopt the sieve and stationary bootstrap approaches. The empirical results for these two approaches do not differ from those of the previous results. Lee and Jeon (2012) found that most Korean equity funds tend to invest in large and growth stocks relative to the KOSPI 200 index, implying that their inflation hedging ability may influence our results. To examine this effect, we divide our sample funds into their investment styles: large/small and value/growth using the Fama-French three-factor model. The results for their investment styles are consistent with those of whole sample funds. Finally, examining the persistence of Korean equity funds’ inflation hedging ability reveals no persistence, indicating that it is difficult for fund investors to construct portfolios of equity funds that are good inflation hedges. Overall, our results indicate that the good inflation hedging abilities of some Korean equity funds are merely the result of luck (or due to sampling variation) rather than fund managers’ skills.

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