As a number of studies in macroeconomics attempt to explain the business cycle and asset pricing using firm dynamics, there is a growing interest in understanding how firms make financing decisions about the use of debt and equity in varying stages of the business cycle. Most of the studies, however, have overlooked the possibility that the cyclical behavior of equity issuance is different from that of debt issuance. They focus mainly on the procyclicality of debt financing or external financing in total. Similarly, little work has been done in corporate finance literature also on the cyclicality of firms’ financing behavior. The main concern there is to control macroeconomic factors in testing the traditional capital structure theories. Because the business cycle changes the amounts of debt and equity to be raised, which in turn influences the business cycle through corporate investments, it is meaningful to look into the cyclicality of debt and equity financings. Previous studies reveal conflicting views on the cyclicality of debt and equity financings. Using the NBER Business Cycle Data, Choe, Masulis, and Nanda (1993) find that the amount of equity raised is larger in expansion periods than in contraction periods, whereas the opposite is true for the amount of debt raised. However, because they only analyze a subset of external financing vehicles such as common stocks and corporate bonds, they fail to control the influences of large firms with relatively easy access to financial markets. Korajczyk and Levy (2003) document that the debt-equity ratio increases during recessions. But the use of the debt-equity ratio implicitly assumes that debt and equity financings are substitutes for each other, and thus rules out the possibility that they show the same cyclical behavior. Moreover, the macroeconomic variables used by Korajczyk and Levy (2003), such as equity market returns and term spreads, are not the typical measures of cyclicality in macroeconomics literature. While the two aforementioned studies argue that equity issuance is procyclical and debt issuance is countercyclical, Jermann and Quadrini (2012) claim that equity financing is countercyclical and debt financing is procyclical. They use the flow of funds data from the Federal Reserve Board. But their dataset does not include all of corporate debt and equity transactions, and thus it is strongly influenced by a small number of large firms and by the procyclicality of mergers (Baker and Wurgler, 2002). To overcome the limitations of the preceding studies, Covas and Den Haan (2011) divide firms into several groups by size and investigate the cyclicality of small firms’ financing behavior separately. They also construct a comprehensive time-series dataset of debt and equity issuances using the accounting data for individual firms in Compustat, instead of using the aggregate data that may cause a biased result due to the effect of large firms. Moreover, as with other studies in business cycle literature, they filter the real GDP or the value added by the Hodrick-Prescott (HP) method and use it as a measure for real activity. Unlike the results of the preceding studies, their finding is that both debt and equity financings are procyclical. Regarding this result, Jermann and Quadrini (2012) point out that the procyclicality of equity issuance is not robust because its statistical significance varies depending on how equity issuances are measured. In this study, we examine cyclical patterns of debt and equity financing in Korean firms. Contrary to the results of Covas and Den Haan (2011), we find that the equity issuance of Korean firms is countercyclical. In a macroeconomic-level analysis using the flow of funds data from the Bank of Korea, the use of debt is positively correlated with the HP-filtered GDP of the previous quarter, whereas the use of equity is negatively correlated. In a firm-level analysis using the accounting data of individual firms, we find the same result-that debt financing is procyclical and equity financing is countercyclical. In particular, the countercyclicality of equity issuance has become stronger after share repurchases were permitted in 1994. This result stands in contrast to the case of U.S. firms, in which both debt and equity financings are procyclical. To explain why equity financing is countercyclical in Korea, contrary to the U.S. case, we extend the panel regression model used in Covas and Den Haan (2011) and explore how debt and equity financings, investments, and asset growths in corporations respond to the cyclical movements of the economy. Following Covas and Den Haan (2011), we allow coefficients to vary with firm size. We also use cash flows and Tobin’s Q, respectively, as explanatory variables for current and future profitabilities. In addition, for the purpose of controlling collateral value, investment opportunity, non-interest tax-shields, and the effects of economic crises, respectively, we include tangible assets, intangible assets, depreciation, and time dummy variables for two economic crises. We find that the use of debt is procyclical for all firm groups and the use of equity is countercyclical for bigger firms. This result is consistent with that of the correlation analysis. While investments and asset growth are significantly procyclical for all firm groups, total assets vary more than investments as the business cycle changes. This implies that firms use financial assets as a buffer to insure against negative shocks during contractions. Interestingly, cyclical changes in debt are larger than those in total assets in Korea. This indicates that to finance the purchase of assets, Korean firms rely mostly on debt in boom periods, whereas they use equity only when it is difficult to raise debt in downturn periods. By contrast, U.S. firms utilize debt, equity, and retained earnings all the time to finance investment projects. The discrepancy between the two countries indicates that the cyclicality of corporations’ financing behavior is determined not only by the substitutability of debt and equity, but also by such dynamic factors as the availability of internal funds and the difficulty of accessing the debt market.

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By using country-level data on the foreign affiliates of U.S. global banks in 20 developed and 60 emerging economies from 2006 to 2013, we present consistent evidence that liquidity shocks triggered by a global financial crisis are transmitted to affiliate locations that are important for the parent bank funding sources within the banking group. We find that the funding location of global banks is driven by affiliates’ dependence on local deposit funding, by host country-specific characteristics (financial liberalization), and by foreign affiliate-specific characteristics (liquidity constraints). As a result of foreign affiliates’ support to their parent banks, funding location may suffer internal capital outflows during a financial crisis. We conclude that internal capital outflows are confined to local funding affiliates with sufficient liquidity operating in fully liberalized financial systems. These results indicate that contrary to the findings of Cetorelli and Goldberg (2012), foreign affiliates financed by local deposits rather than a parent bank’s resources were not necessarily a significant source of internal capital outflows from the host country during the global financial crisis. Hence, the benefits of local funding can be achieved without its cost if either high liquidity constraints or low financial liberalization is in place.

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This study investigates the capital market reactions to announcements of seasoned equity offerings (SEOs), earnings management activities during the year before an SEO, and the decline in post-SEO stock performance. Although previous studies focus on the type of SEO and earnings management behavior, we classify SEO firms into two subsamples, those in which the largest shareholders increase their shareholding ratio and those in which they decrease their shareholding ratio, to examine management incentives that protect the wealth of existing shareholders. The announcement of an SEO in which the largest shareholders participate is good news for the market. We first seek to examine whether the response of the capital market to an SEO in which the largest shareholder’s shareholding ratio increases is more positive than its response to an SEO in which the largest shareholder’s shareholding ratio decreases. Because the cash flow of an SEO is dependent on the stock price, the management has an incentive to temporarily raise the stock price to maximize the existing shareholders’ wealth in SEO cases where the largest shareholder’s shareholding ratio decreases. Therefore, our second hypothesis is that there is greater earnings management, involving increased reported earnings, in the year before an SEO in which the largest shareholder’s shareholding ratio increases than an SEO in which it decreases. The decline in post-SEO stock performance in cases where the largest shareholder’s shareholding ratio decreases is more severe than in cases where it increases, because post-SEO performance is driven by accrual reversal. Therefore, our third hypothesis is that there is higher post-SEO stock performance in cases where the largest shareholder’s shareholding ratio increases than in cases where it decreases. The empirical results of this study are as follows. First, the cumulative abnormal returns (CAR) around the announcement date of SEOs in which the largest shareholders’ shareholding ratio increases is higher than the CAR around those in which the ratio decreases. This provides support for our first hypothesis that the capital market responds more positively to SEOs in which the largest shareholder’s shareholding ratio increases than to SEOs in which the ratio decreases. Second, the relationship between discretionary accruals during the year before an SEO and the change in the largest shareholder’s shareholding ratio is negative. This is consistent with our second hypothesis that there is more earnings management to increase reported earnings during the year before SEOs in which the largest shareholder’s shareholding ratio decreases than SEOs in which the ratio increases. Third, the relationship between the three-month buy and hold abnormal returns of SEOs and the change in the largest shareholders’ shareholding ratio is positive. This partially supports our third hypothesis that there is higher post-SEO stock performance in cases where the largest shareholder’s shareholding ratio increases than in cases where the ratio decreases. Overall, our findings show that the greater the change in the largest shareholder’s shareholding ratio, the more positive the capital market reaction to the SEO announcement, the less the earnings management, and the higher the post-SEO stock performance. The results can be explained as the incentive of management to protect the wealth of existing shareholders. We make several contributions to the literature. First, we investigate SEOs by classifying SEO firms into two subsamples, those in which the largest shareholders increase their shareholding ratio and those in which they decrease their ratio, to examine management incentives to protect the wealth of existing shareholders. Our study differs from others in the literature, which focus on the type of SEO and earnings management behavior or market responses to SEOs. Classifying firms by the change in the largest shareholder’s shareholding ratio is a more feasible way to examine management incentives to protect the wealth of existing shareholders than classifying them by the type of SEO, because the type of SEO is associated with the participation of existing shareholders. For example, in the case of a general cash offer, the largest shareholder can either participate in an SEO or not, or stand by the rights offer because there are no mandatory regulations. The largest shareholders can increase their shareholding ratio through third party allocation in cases where the third party is the largest shareholder. Our results showing that the largest shareholder’s shareholding ratio increases through SEOs in the Korean capital market explains why the positive market response to the announcement of SEOs in Korea is different from the negative market response in other countries.

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We examine how competitive threat in a product market, as an external environmental factor of the firm, influences corporate risk-taking behavior. Product market competition as a control mechanism is an issue of growing importance in the academic field of corporate finance (Giroud and Mueller, 2011; Kim and Lu, 2011). Firms in competitive industries have high investment and bankruptcy risks and low marginal profits, and thus need to lower their production costs to gain a competitive edge. Moreover, to decrease the cost of capital and signal the firm’s reputation to the market, firms should reveal their inside information and alleviate information asymmetry. Competitive threat is also an important factor in agency theory, as it is related to managerial compensation (Karuna, 2007) and to management’s pursuit of private benefits of control. In sum, competitive threat influences managerial decisions in various ways. Therefore, we investigate the relationship between competitive threat and firms’ risk-taking behavior to better understand its role as an external control device. The relationship between product market competition and corporate risk-taking behavior is not yet theoretically defined; therefore, empirical evidence from this study will provide significant academic and practical implications. One strand of the literature argues that managers should be reluctant to pursue risk in a competitive environment, due to the high risk of bankruptcy (Griffith, 2001) and high turnover sensitivity based on performance. Managers are expected to build conservative investment portfolios to lower the cost of capital. A similar argument is that competitive threat mitigates the risk-pursuing behavior of management based on the overinvestment incentive (Alchian, 1950; Stigler, 1958). The other strand of the literature argues that firms in competitive industries pursue more risks to acquire market power and a competitive edge. Under strong competition, managers are endowed with greater discretion to make managerial decisions quickly (Hubbard and Palia, 1995; Christie, Joye, and Watts, 2003), and hence can take risks to make large profits. In addition, in a competitive environment with lower profits, managers might pursue higher risks to increase their monetary compensation (Hernalin, 1992; Raith, 2003), or pursue private benefits by overinvesting in risky projects. We empirically investigate which of these two competing theories is supported in the Korean economy. This is the first study to empirically examine the effect of product market competition on corporate risk-taking behavior in the Korean economy. External factors that influence risk-taking behavior are not actively discussed in the academic field, thus we aim to fill this academic gap. Moreover, we extend recent studies that analyze the effect of product market competition by investigating its effect on firms’ risk-taking behavior. Under the agency theory, we test the disciplinary effect of competition in the Korean product market and explain how it disciplines managers or agency problems based on the risk-taking behavior of controlling shareholders. We use firms listed on the Korean Stock Exchange and run regressions while controlling for various firm characteristics and environmental factors. Measuring the level of product market competition, we use the Herfindahl-Hirschman index, which is commonly used in the field of corporate finance and industrial organization. To estimate corporate risk-taking behavior, we follow previous studies in using the standard deviation of the profit or net income over the past five years, standardized by total assets. Empirically, we find that competitive threat has a significantly negative effect on corporate risk-taking behavior. This means that managers burdened by high investment risks and bankruptcy costs in more competitive product markets do not want to form risky investment portfolios. It also implies that competitive threat can be considered as an external control device in the agency framework. The result is robust to control of the potential endogeneity problem, and to the use of alternative proxies for the level of product market competition and corporate risk-taking behavior. Furthermore, we find similar results when we perform an industry-level analysis. Our result is more strongly observed in firms with a low market share and those that do not belong to business groups. Meanwhile, examining the effect of the interaction between corporate governance and product market competition on corporate risk-taking behavior, we find that firms with good corporate governance are less likely to pursue risk. However, the negative effect of corporate governance on corporate risk-taking behavior exists only in less competitive product markets. We interpret this result as indicating that there is a substitution effect between internal corporate governance and competitive threat in product markets in determining corporate risk-taking behavior.

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Structured derivatives markets, including equity linked securities (ELS), derivatives linked securities, structured notes and credit linked notes have grown dramatically since the mid-2000s in Korea, but little attention has been paid to how much these securities contribute to the improvement of investors’ performance from a portfolio perspective. This study fills the gap by examining the optimal portfolio choice of investors who are allowed to invest not only in stocks and bonds, but also in ELS (especially auto-callable ELS). As ELS are generally regarded as alternative assets to enhance portfolio performance, their economic benefits should be considered from a portfolio perspective rather than on a stand-alone basis. In addition, even though the majority of ELS in Korea include an auto-callable feature, there is little study for this specific type of product. This study is the first step in understanding the investment benefits of ELS. In our analysis, we first estimate the return distributions of the KOSPI200 index, a risk-free asset, and a typical auto-callable security linked to the KOSPI200 index. Taking the complexity of the payoff structure into consideration, it is very difficult to theoretically determine the return distributions of the auto-callable ELS. Unlike stocks and bonds, even from an empirical point of view, any standard statistical method to derive the empirical distributions from the observed historical returns cannot be applied to the auto-callable ELS as we do not have a large enough sample (i.e., independent or non-overlapping return data) to obtain a reliable estimate. For example, even if we assume that all of the auto-callable ELS issued during the past 10 years were exercised early on the first possible exercise date, the maximum number of independent returns we can observe is only about 20, and thus we cannot estimate the return distributions in a valid manner. To reconcile this problem, we estimate the GJR-GARCH (1,1) model from the observed returns of the KOSPI200 index from 2003 through 2015, and then derive the empirical return distributions of the ELS via Monte Carlo simulations using the estimated GARCH model. Second, we use three portfolio selection models to derive investors’ optimal portfolio choice given access to the ELS market: (1) the conventional expected utility theory, (2) the prospect theory of Kahneman and Tversky (1979), and (3) the safety first theory of Telser (1956), which is the cornerstone of the behavioral portfolio theory with mental accounts proposed by Das, Markowitz, Scheid, and Statman (2010). Our main empirical findings are as follows. First, auto-callable ELS are shown to be unnecessary for the construction of the optimal portfolio for all investors trying to maximize their expected utility, regardless of their degree of risk aversion. Second, the auto-callable ELS do not improve performance for the majority of loss-averse investors. That is, the auto-callable ELS are regarded as a redundant asset according to both expected utility theory and prospect theory. Third, we find that auto-callable ELS are valuable assets that play a key role in improving the portfolio performance of the majority of investors who make investment decisions based on the safety first theory. This suggests that auto-callable ELS can be a very effective investment tool for investors who try to maximize the expected returns of a portfolio with a restricted probability of failing to reach a pre-specified threshold return. The difference in our empirical results depending on the portfolio selection models arises fundamentally from the structural characteristics of the auto-callable ELS. Their risk and return profile indicates that losses occur infrequently, but when they do, the expected losses can be considerably large. Similarly, although gains occur frequently, they tend to be very marginal. These characteristics of auto-callable ELS are very similar to those of selling deep out-of-the-money (OTM) put options. In this sense, for investors assumed by safety first theory, who measure risk by the frequency rather than the amount of expected losses, auto-callable ELS can be effective in enhancing the investment opportunity set. However, for investors with expected utility theory or prospect theory preferences, the relative advantages of auto-callable ELS over common stocks and bonds are weakened as the portfolio risk is generally recognized and measured by the expected losses rather than the frequency of losses. Finally, our robustness test results indicate that the findings remain valid when we consider other types of auto-callable ELS, issuing costs, and the effect of the global financial crisis.

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This paper analyzes the information value of a credit watchlist in the Korean credit rating market. Credit rating agencies issue credit watches to indicate the direction of ratings changes within a short time horizon of three months on average. Credit watches are marked as either up, down, or uncertain. A watch is usually triggered by discrete corporate events such as mergers, acquisitions, restructuring, and announcements of plans expected to affect credit quality, or by trends in the issuer’s operations or financial weaknesses such as financial performance, liquidity and leverage, and accounting fraud. The watchlist either improves the information-certification role of credit ratings (delivering information), or allows rating agencies to influence the risky choices of issuing firms by threatening them with imminent rating downgrades and subsequent investor reactions (implicit contract). This study tests these two different explanatory lines to determine the information value of the credit watchlist. This study also identifies the features of firms with rating changes that are preceded by credit watches, and the factors affecting the agreement between a credit watch and subsequent rating changes. In addition, it examines whether the market reaction to rating changes depends on whether it is preceded by a negative credit watch. It is observed that there is a greater proportion of credit watches marked as “down” in Korea than in the US, and that the credit watchlist has been operated quite conservatively. Using the Nice’s credit rating and watchlist data from 2000 to 2014, the results support the delivery of information argument more than the implicit contract argument. Most of the variables that represent delivery of information, such as size, fixed assets, and BBB rating, are statistically significant, whereas the only significant variable associated with an implicit contract is cash ratio. However, the watchlist by provisional evaluation and simultaneous announcement with rating change presents a role of the implicit contract as well as the delivering information A negative watchlist followed by a downgrade is more likely to occur with larger issuers, greater rating changes, and lower credit ratings. Moreover, the extent to which the direction of credit watches coincides with the direction of subsequent rating changes is greater when there is a shorter duration between the watchlist and the rating change, periodical evaluation, and lower credit ratings. In terms of market reactions to downgrades, the negative watch-proceeded downgrades rather than the direct downgrades exhibit greater negative cumulative abnormal returns, which deepen in investment grade, provisional evaluation, and simultaneous announcement of watchlist and rating change. Meanwhile, the issuing firm’s cumulative abnormal return is statistically significantly negative when a negative watchlist is issued, but insignificantly positive when a positive watchlist is issued. Therefore, the information value of the credit watchlist can be summarized as follows. First, the watchlist in the Korean credit rating market generally fulfills the delivery of information rather than the implicit contract role. Analysis of the characteristics of firms that are issued with a negative watchlist indicates that the proxies measuring the delivery of information, such as size, fixed assets, and BBB of credit rating, are statistically significant. The role of the implicit contract is also partly observed in that the downgrades are actually executed in less than seventy percent of the issued negative watchlist cases. Furthermore, the credit watches by provisional evaluation and simultaneous announcement with rating change are also observed to present the implicit contract role. Second, the watchlist provides more information about issuers with investment credit ratings than speculative credit ratings. There is a greater deterioration in negative cumulative abnormal returns for investment than for speculative grades when a negative credit watch is issued. This phenomenon also appears when the downgrade is subsequent to a negative credit watch. The watchlist is less likely to be issued to speculative or default credit ratings. Third, the watchlist together with rating changes magnifies a negative market reaction in Korea, which is inconsistent with the results for the US market due to the unique timing of announcements, as the watchlist tends to be issued simultaneously with rating changes. This study makes three contributions to the literature. First, it is the first study to document the watchlist in the Korean credit rating market. Most studies have examined market reactions with respect to rating changes. The findings will be useful for academics and practitioners. Second, the study comprehensively investigates the role of the watchlist in Korea and discloses the genuine economic function of the delivery of information. Finally, the paper suggests policy implications for encouraging more issuance of speculative grades, separation from grade changes, and periodic evaluations.

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