This paper aims to explore a common practice in which a bank designs an optimal double-layered debt contract through the means of controlling a lending rate and a deposit rate. For this study, I modify a monopolistic version of the Monti-Kelin model interpreted by Freixas and Rochet (2008). Positioned between depositors and borrowers, the bank takes into account the likelihood of a borrower exercising his or her limited liability in case of a negative income shock. On the other hand, the bank could also exercise its own limited liability against depositors if necessary. Thus, anticipating the consequences of dually limited liability, the bank specifies the conditions of loan and deposit contracts. In this regard, this paper contributes to the existing literature in that it explains endogenous determinations of credit ceiling and capital buffer of the two debt contracts a bank is involved in. It examines how the contracts can vary (asymmetrically) throughout a business cycle jointly with the deposit and the lending rates. A major result from the model is that a lending rate for a fully collateralized loan as well as a deposit rate for an unsecured loan may exhibit asymmetric and even adverse responses to the counter-cyclical policy rate adjustments. Furthermore, in the presence of capital regulation, it is deduced that the countercyclical interest rate policy may amplify the pro-cyclicality of bank lending.

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This study analyzes the factors which affect the underwriting contracts between firms and investment banks under two situations with different levels of information asymmetry, overnight block trades and new equity issues. This study focuses on the opportunistic behavior investment banks show while executing these contracts to analyze how the firm and investment bank affect the offer (sale) price. Previous studies conducted on opportunistic behavior of investment banks in possession of superior information on capital markets have focused mostly on its effects on pricing of initial or new equity issues, while not enough analysis has been conducted on investment banks’ opportunistic behavior and their respective effects on pricing which differ by type of underwriting contracts. Therefore, we have chosen to look into overnight block trades and new equity issues to differentiate the information asymmetry in which investment banks pursue their opportunistic behavior. In cases with high information asymmetry, that is overnight block trade, investment banks do not necessarily behave in line with sellers’ expectations. Rather, they are much more inclined to take advantage of the situation to maximize their share of the profits even by placing the sellers’ best interests at stake. When information asymmetry is low, that is the case with new equity issues, however, investment banks more readily act in line with the sellers’ expectations, regardless to the type of underwriting contract. In selection of investment banks, firms need to first decide whether to deal with one or multiple underwriting investment banks and whether they should sign a contract based on best efforts or firm commitment. From the perspective of investment banks, as part of their effort to maximize profits, they must also take into consideration their relationships with the sellers as well as the investors. In the case of overnight block trades, in which information asymmetry is high, investment banks show ample opportunistic behavior because it is relatively difficult for the firms to monitor investment banks’ activities. It is likely that investment banks, even when they receive a higher fee for additional risk taken in firm commitment contracts, will sell the shares at whichever price they can get from the market. In other words, the level of discount and underpricing is similar for each type of contract, which is against the anticipation of sellers who expect higher deal certainty and low discount level from firm commitment contracts than best efforts ones. However, from investment banks’ perspective, their main interest is to raise fees and reap the best economic benefits they can while lowering their underwriting risk, which inhibit them from putting in much effort to lower discount rates. Thus, for the best interest of the sellers, if the pricing is similar between the two types of contracts, it would prove to be more economic for them to pursue a best efforts contract. In the case of new equity issues with relatively low information asymmetry, investment banks are much more constrained from pursuing opportunistic behavior. Consequently, they prone to act less opportunistically by focusing more on meeting the expectations of the principal, regardless to whether the contract is best efforts or firm commitment. For example, for shareholder placement new equity issues, the majority of shareholders prefer firm commitment contracts as a way to maximize deal certainty and low pricing to minimize acquisition cost. For investment banks, a firm commitment contract is also a suitable as a way to secure their relationships with the sellers for future business opportunities while pursuing to lower pricing to minimize their underwriting risk. In such cases, the optimal alignment of interest between the principal and the investment bank takes place. Our findings from this study are as follows. Firstly, in the case of new equity issues, the level of discount and underpricing tends to increase for firm commitment contracts compared to that of best efforts contracts. This is due to the low level of information asymmetry in new equity issues, allowing investment banks to focus more on minimizing their underwriting risks rather than on showing opportunistic behavior to maximize profit. In the case of overnight block trades, however, the level of discount and underpricing is not dependent on the form of contract. This is due to the high level of information asymmetry involved in the course of overnight block trades, enticing investment banks to commit opportunistic behavior by executing transactions at any possible price even when it is against the interest of the sellers. Secondly, we find that in the case of overnight block trades, the level of discount tends to decrease as more investment banks are involved as bookrunners. This is due to the competition amongst investment banks in their common interest to maintain a positive business relationship with the sellers in the future. Thirdly, we find that in the case of overnight block trades, firms prefer firm commitment contracts with investment banks when the volatility of the firm’s stock price is high. On the other hand, in the case of new equity issues, firms prefer firm commitment contracts with investment banks when they have a stronger bargaining power over investment banks.

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Previous studies on risk management, particularly on the relationship between hedging activity and firm value, have used derivatives tradings as a proxy variable for hedging. Yet, the results from theses tudies have shown some inconsistency, weakening the argument that such type of activity as a form of risk management can actually boost firm value. To the best of our knowledge, Zou (2010) is the first paper of such kind that examines the impact of hedging activity on firm value; in particular, it analyses a property-liability insurance as a firm’s hedging activity in light of risk management. Using a unique set of property-liability insurance data from China, Zou (2010) examines whether propertyliability insurance can enhance firm value. Zou is one of very few in this line of research thus far. Such lack of research on the effect of hedging, especially using property-liability insurance, on firm value can be best explained by the limitation of data availability on firms’insurance in the U.S. and Europe. In China, on the other hand, for the past decade, one of the interesting developments in the global economy is the liberalization of China’s insurance market. Despite much change in the industry, many Chinese insurance companies still do not take fully into account the level of risk exposure in setting insurance prices (Zou, Adams, and Buckle, 2003). In other words, insurance premiums paid by firms in China don’t reflect the level of hedged risk. Evidently, this calls for more compilation of different sets of data from global firms to further reinforce the hedging effect of insurance on firm value. Therefore, this paper applies Zou (2010)’s model to a sample of Korea’s publicly listed non-financial firms. Unlike the case in China, Korean insurance companies determine the insurance prices mainly based on the firms’ level of risk exposure, there by fully reflecting the level of hedged risk of each firm they insure. It is reasonable to expect that, therefore, using a sample of property-liability insurance from Korea will provide accurate and reliable results in examining the hedging effect on firm value. In measuring the effects of hedging activity on firm value, this study uses Pooled OLS, Fama and MacBeth (1973) cross-sectional regression, and fixed effects panel regression. In all three regression models, Tobin’s Q as a proxy variable for firm value has a positive and statistically significant relationship with the level of property-liability insurance use. This result indicates that firms with more insurance use for hedging activity have higher firm value. This study also adopts the instrumental variable approach to address the endogeneity of insurance purchase. This result is consistent with the findings of three previous estimation methods. Based on the pooled OLS result, the average hedging premium is estimated at about 2.68%. This average hedging premium is much higher than the one reported in Zou (2010), which is about 1.47%. This study also runs regression models, considering the lag effects since the insurance use in current year as well as in previous year can affect firm value. As expected, firm value in current year has a positive and statistically significant relationship with the level of insurance use in previous year. This paper also tests whether financially constrained firms have a higher average hedging premium. Several studies (e.g., Froot, Scharfstein, and Stein, 1993; Smith and Stulz, 1985; Stulz, 1996; Ross, 1997; Leland, 1998) have argued that as firms reduce the variability of future cash flow through their risk management strategy, they can overcome their financial constraints and consequently enhance their firm value. Assuming the validity of these arguments, we can expect that financially constrained firms have higher value premiums associated with hedging than financially unconstrained ones do. In our paper, as a proxy variable for internal financial constraints, we use a dividend dummy variable (e.g., 1=if a firm pays dividends less than median firm does; 0=otherwise) and a firm size dummy variable (e.g., 1=if a firm size is less than median one; 0 =otherwise) for external financial constraints. We then run regression models with these dummy variables. As expected, we find that financially restricted firms have a higher value premium associated with hedging than financially unrestricted ones. Therefore, our finding contributes to the risk management literature in providing clear-cut direct evidence that hedging activity via property-liability insurance can enhance firm value. In addition, this study tests whether firms with large investment expenditures have higher average hedging premium than ones with small investment expenditures. According to several studies (e.g., Froot, Scharfstein, and Stein, 1993; Stulz, 1996; Ross, 1997), firms can reduce their taxes and overcome an under investment problem through the hedging activities. In this paper, we use a capital expenditure dummy (e.g., 1=if a firm’s capital expenditures are more than median firm does; 0=otherwise) as a proxyvariable for firms with large capital expenditures and a R&D and advertising spending dummy variable(e.g.,1=if a firm’s R&D and advertising spending are more than median firm does; 0=otherwise) for firms with large R&D and advertising spending and then run regression models with these dummy variables. According to the results, a firm with large expenditures has a higher value premium associated with hedging than one with small expenditures. Our paper contributes to research in risk management by providing richer empirical evidence and practical application of risk management theories. This paper ultimately aims to narrow the gap in findings between theoretical and empirical researches.

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The effects of corporate diversification on firm value have been extensively investigated in the field of finance. The conventional wisdom is that a diversification discount results from inefficient internal capital allocation. This paper suggests that it does not necessarily hold in a signaling game model in which the types of the firm can have a significant impact on the bankruptcy risk. Under information asymmetry, single firms invest only in projects with high net present values (NPVs) or fall into bankruptcy. By contrast, diversified firms with efficient internal capital markets invest in a broader set of projects with positive NPV. Consequently, this indicates that the average values of surviving single firms can be higher than that of a diversified firm. This study contributes to the literature in three ways. First, we show that under viable conditions, a diversification discount can occur even with efficient internal capital. Second, our study suggests a theoretical basis which takes into account survivor bias in gaining a better understanding of a diversification discount. Third, this study provides a means through which both diversification discount and premium can be explained within one framework.

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Investment banks (IBs) are often viewed as key players in the capital markets because of their pivotal roles in securities businesses as underwriters. Mainly, they are most useful as producers of information or creators of information market place, often resorting to resolve the asymmetric information problems that exist in the market. Indeed, IBs’ role as the providers of information to the market participants is vital for active financial markets especially for IPOs and renegotiation of corporate loan payments in times of distress. In such situations, investment banks can create added value by producing information for themselves or by designing and running a market place within which information are being produced and traded. As such, the Korean government has made a major regulatory reform so as to introduce investment banking businesses. Despite the favorable regulatory environment, Korea has witnessed thus far very little success with this endeavor as only few domestic IBs can be found in the domestic market. In general, financial companies in the Korean capital market play limited roles in stock brokerage. Other complex financial services related to securities underwriting or M&A deals are mostly performed by foreign investment banks. This paper, therefore, examines to gain better understanding what obstacles exist in Korea’s capital market for securities companies to properly function as full-fledged investment banks. In particular, the paper explains theoretically that it is difficult for an investment bank, which is affiliated with non-financial firms, to produce accurate information about its non-financial affiliates or their rivals, and thus it cannot build up easily its reputation as an IB. This potential conflict of interest often gets in the way for investment banks in Korea to secure their positions in the financial market as proper IBs, or reliable information sources. The game theoretic model used in this paper is based on Bolton et al. (2012), and Chemmanur and Fulghieri (1994). The model is developed in the context of an investment bank underwriting a stock issue and there are three main participants: issuers, investment banks, and investors. Issuers approach the equity market to raise capital for their projects and market their equity either directly to potential investors or through investment banks (or underwriters). Investment banks are producers of information about the issuers. But they produce noisy evaluations of issuers’ projects, which they report to investors when marketing equity in return for a fee from the issuer. Then, investors determine the market value of the equity based on the information provided by the IBs. In this paradigm, investors believe ex-ante that the project is good with the 50% probability. This lack of certainty creates room for the investment banks to perform their role using their expertise to accurately assess whether the project in hand is actually worth the investment. Investment banks obtain fees only from those firms whose equity they market. The fees charged by the investment banks are assumed to be a fraction k of the value added by their services for the issuer firms. This value added can be determined by assessing the difference between the value of equity when the investment bank is involved and the value when it is not when the issuer approaches the equity market directly without the help of an underwriter. After reviewing the report, the issuer has the choice whether to accept or refuse the investment bank’s proposed evaluation report. When the issuer firm turns down the investment bank’s report, it does not pay fees and the report is not disclosed. Once the investment bank’s evaluation report is announced or it is known that the report has been turned down, the issuer sets a uniform price for the investment. Investors, after taking into account the evaluation report and the price, finally decide whether and how much they intend to invest. Investors are divided into two types: sophisticated and naive. Sophisticated investors observe the payoffs of the game for both the investment bank and the issuer and they understand the potential conflict of interest between the investment bank and the issuer. Yet, they are not certain whether the project is good or bad, as they only have access to the investment bank’s report without being able to directly observe the IB’s signals about the project. On the other hand, naive investors simply assume that investment banks always truthfully evaluate the project. The main findings from this model are as follows. First, an IB which is affiliated with non-financial firms is more likely to produce distorted information than an independent IB is. Second, non-financial conglomerates are more likely to integrate with IBs if there are more naive investors in capital markets, if the fraction k is greater, and if the reputation costs are lower. Last, social welfare produced in the case when IBs are affiliated with non-financial conglomerates is always lower than that in the case when the IBs are independent. These results imply that separation of investment banking and commerce could be an important pre-condition for the successful introduction of IBs and their development.

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Structured financial products have gained increasing popularity in Korea over the recent years, and complaints by investors of such products have also increased. In particular, retail investors have failed some lawsuits regarding equity-linked securities (ELS) issued by brokerage companies for their hedging behaviors, calling for stronger investor protection system to be in place in structured financial product markets. Such need for regulatory reform has inspired this study. In this paper, we hope to provide some insight into more effective regulatory guidelines to better protect retail investors who invest in such products as ELS and ELD (equity-linked deposits). In 2009, in fact, Korea Exchange (KRX) and financial supervisory authorities introduced a new set of the hedge guideline for ELS for better investor protection. The key points of this guideline are as follows. The KRX hedge guideline requires the issuing entities to distribute the sell orders for underlying assets held to hedge their ELS positions at a maturity date to protect asset prices from deviating from fundamental values or fair values. In general, the ELS issuers or financial institutions dynamically execute delta-hedging based on their ELS positions according to the changes in underlying asset prices. In this case, if ELS embeds nonlinear derivatives such as digital options or barrier options, the number of shares of underlying assets that the entities should sell at a maturity date can increase infinitely, making it nearly impossible for them to implement optimal hedging for their positions. As such, ELS hedgers often exploit the sell-orders for underlying assets at a maturity date by manipulating the underlying asset prices, which is of course an unethical trading behavior. To avoid this situation, KRX has introduced the new requirement on the ELS issuing financial companies to distribute the sell orders for underlying assets at the maturity date. However, the more fundamental problems that lead to most of the lawsuits against the ELS products stems from the structural complexity of the structured products, much more than from the unethical behaviors of financial companies. Such products’ complex make-up complicates hedging, consequently making it difficult for the companies to hedge efficiently. As aforementioned, most retail structured products are embedded of nonlinear derivatives, which have infinite delta at a certain point of underlying asset prices at a maturity date under continuous price environments. According to extant literature, including Stoimenov and Wikens (2005) and Bergstresser (2008), the more complexity of structured products results in the higher margins taken by issuing entities. Because of increasing difficulty in hedging for the complex structured products, they tend to set their margins at higher levels than they would otherwise when issuing new securities. Ku et al. (2007) also support this result based on the empirical analysis in Korean ELD markets. Therefore, the regulatory reform that demands for change only in the hedging method without considering the structural complexity of the structured products will not effectively resolve the problem. When issuing entities cannot hedge their assets efficiently, no matter how strict the relevant regulations become, they will continue to engage in unethical hedging behavior to transfer their potential losses to retail investors who are net buyers of structured products. In this paper, therefore, we propose a new regulatory initiative that restricts the maximum delta of structured products at a maturity date. The delta of structured products has two components: the delta per unit and the volume of sales. More specifically, the maximum delta (maximum sell orders at maturity) is determined by the product of maximum delta per unit and the volume of sales. Here, while in continuous prices the structured products embedded with barrier options or digital options have infinite delta per unit, in the consideration of tick size they have finite delta per unit. By restricting this maximum delta (maximum delta per unit times volume) of the structured products, therefore, the newly proposed regulation reduces the possibility for the underlying prices to be distorted by ELS issuers’ self-serving hedging behaviors. In sum, the regulation on structuring is related to both maximum delta per unit and sales volume. Even for a severely structured product, its (overall) maximum delta at a maturity date can be relatively small if its sales volume remains considerably small. Similarly, a less structured product can have large maximum delta at maturity if it has a bigger sales volume, thereby more likely to result in distortion of the underlying asset prices. Hence, for the effective protection of investors in structured financial products from their issuers’ abusive hedging practices, it is important for the new regulation to focus on the structuring of such complex financial products as well as on hedging behaviors of issuing companies. In addition, we investigate the overnight risk induced by the inefficient hedging behaviors of issuing entities under the hedge guideline proposed by the KRX. The overnight risk is quantified by the VaR (Value at Risk) methodology for 6 major individual assets in Korean stock markets. These 6 individual companies are commonly used when structuring ELS and have representative nature in the country’s structured product markets. According to the results, the levels of VaR for those assets are not significantly large, but they can easily increase as the sales volume increases. To reduce the potential overnight risk for issuing entities, therefore, the regulation on structuring (deltas) is necessary. Nevertheless, some may raise a concern about our proposal’s potential risk by claiming that more restriction on the deltas of structured products may hamper the active growth of the structured product markets. However, we maintain that the markets can grow even better, once the structured products are well secured with varying maturity dates.

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Inspired by the recent increase in the turnover among analysts, this paper examines the efficiency of matching between analysts and brokerage houses in turnover, and the possibility of adverse selection between current and prospective brokerage houses due to asymmetric information on the analyst forecasting ability. We apply the implication of adverse selection provided by Akerlof (1970) and Wilson (1979) to our analysis of the turnover ratio or job matching among analysts, current and new brokerages. By nature, the current house tends to have hidden information about the predictive accuracy of the analyst additionally as well as publicly-known information such as recent EPS forecasting errors and the contents of her past reports. On the other hand, a prospective employer has to evaluate the analysts’ forecasting ability only based on their performance with the public information. Consequently, employers have to make the hiring decision based on limited information about the analysts’ actual ability to make accurate forecasts. Several studies such as Jackofsky (1984), Greenwald (1986), and Kim (2012) have already addressed the adverse selection issues in the context of analysts’ job separation or multi-period labor market theoretically. In addition to the body of work on this topic, our study proposes a simple model that can link the turnover ratio to the change in analysts’ EPS forecast error, and then tests it. For the model, we assume that there are two different types of analysts: low-type analysts with higher EPS forecast error and higher variance; and high-type analysts with lower EPS forecast error and lower variance. Either type is tempted to accept an offer from a new brokerage house whenever the offer is better than what they are currently receiving. Note that, however, high-type analysts are more likely to reject the offer in the end since the current employer will most definitely suggest a better counter-offer to keep them. On the other hand, low-type analysts may end up moving to another house as such counteroffer is much less likely to be made by their current employers. Based on this observation, we conjecture that as long information asymmetry exists between the prospective employer and the analysts on their true forecast ability, low-type analysts are more likely to move to another brokerage house than high-type ones do when the low-type analysts achieve high performance temporarily. For the test, we examine whether a group of analysts who move to a new brokerage house (“movers”) make more EPS forecast errors at the new house than they do at the previous workplace, compared to the other controlling group of analysts who do not change their workplace (“stayers”). We also consider the efficient matching effect to account for the case in which movers perform better at their new workplace compared to how they did in their previous one, because the matching efficiency can certainly help “the movers” to commit lower EPS forecast errors at new house than they do at the old one, compared to their counterparts. In this study, we adopt two variables to indicate the degree of information asymmetry between current and prospective employers: the years of experience of the analysts, and the number of analysts that cover one stock. The greater the two variables become, the better the predictive accuracy can be expected, which means less EPS forecast errors, allowing new employers the access to more information about the ability of the turnover analysts. In particular, this allows us to test not only the presence of the adverse selection problem, but also whether the extent of information asymmetry is different across different segments of analysts’ labor market. We construct data set on the Korean analysts’ turnover based on their reports from year 2004 to 2010. This paper applies the difference-in- difference method, which estimates the change in forecast errors of movers - experimental group, relative to stayers - the control group between before and after the turnover (job separation). For the overall sample analysis, we find that the EPS forecast error of movers does not in crease significantly after the separation relative to the “stayers,” implying that the adverse selection effect is negligible or limited if there is any. As we segment the analyst turnover market according to the experienced year and the number of competing analysts within the same company, the relative change in the EPS forecast error of movers turns out to vary depending on the criteria. Concretely, the group of movers, who have 3-year or less experience as analysts and also companies that are covered by 20 or fewer analysts, tend to have higher EPS forecast errors after separation, compared to the stayers’ group. Otherwise, the change in forecast errors is not different across movers and stayers. These findings imply that adverse selection exists only in some limited analyst labor market segments. The portion of the aforementioned analyst group (with3-years or less experience and covering stocks by 20 or fewer analysts) accounts for only 9.7% of the total analysts. This implies that the adverse selection issue is not too significant in the overall analyst turnover market. From this perspective, our results indicate that efficient matching has occurred despite sharply increasing wages and the possible adverse selection problem.

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Research topics on the risk-return relationship and market beta have made significant contributions in the field of finance in both academia and practice. These topics, nonetheless, have continued to cause conflicting views. As pointed out in Pettengill et al. (1995, 2002), for instance, which has provided the motivation for this study, an ex-ante model has been defined by unobservable expected stock returns, whereas an ex-post model uses observable actual stock returns as a proxy. Expectedly, the difference between unobservable expected stock returns and observable actual stock returns can create confusion since the most significant property that can actually affect market beta is an actual change that becomes materialized in the market situation. In an up market, stocks with high market beta receive higher return compensation (positive risk premium) than stocks with low market beta. In a down market, on the contrary, stocks with high market beta have lower return compensation (negative risk premium) than stocks with low market beta. On the basis of Pettengill et al. (1995, 2002), therefore, this study attempts to gain more accurate understanding of this complex question by re-examining the cross-sectional relationships between the expected stock returns and the three factors associated with the Korean stock market, such as market beta, firm size, and book-to-market equity ratios. In addition, this study is to design an empirical framework on the basis of studies by Fama and French (1993) and Pettengill et al. (1995, 2002), using the three-step cross-sectional regression analysis proposed by Fama and MacBeth (1973). Specifically, this paper empirically investigates whether portfolio market beta, portfolio firm size, and portfolio book-to-market equity ratio in the past period could significantly explain the change in the portfolio’s excess return in the future period via the cross-sectional regression analysis. Data of stock, bond, and accounting during the period of January 1987 to December 2010 were obtained from the FnGuide. The sub-periods within the overall period were set according to Fama and French (1992). Here, an up market refers to a period showing a positive market excess return, whereas a down market refers to a negative market excess return. The observed results can be summarized as follows. First, as observed in the study of Fama and French (1992), the results from the models that do not reflect the real market situation have no statistical significance of portfolio market beta to account for the changes of the portfolio excess return in a future period. However, the portfolio firm size and portfolio book-to-market equity ratio are statistically significant. Second, through the results from the models that use market beta, which are classified into either up or down markets, as in the study of Pettengill et al. (1995, 2002), this study confirms that portfolio market beta, portfolio firm size, and portfolio book-to-market equity ratio in a past period can significantly explain the change of portfolio excess return in a future period. That is to say, the usefulness of market beta, firm size, and book-to-market equity ratio is confirmed in the cross-sectional relationship with the expected stock returns when considering market situation into market beta. Third, the results from the models that reflect market situation change into variables, such as market beta, company size, and book-tomarket equity ratio, evincing that all of the variables significantly account for the variation in the portfolio excess return in the future period. Finally, this study empirically confirms the robustness of the previous results mentioned, via additional test, reflecting the various influential factors in the empirical design. Simply, the results observed from the additional test show no difference from the previous results mentioned in this study. The results of this study corroborate that the cross-section of the expected stock returns in the Korean stock market might be much closer to that of Pettengill et al. (1995, 2002) than it is of Fama and French (1992), when considering the change in the market situation. On the basis of the observed evidence, this study also confirms as to whether the reflecting properties of the actual data in applications of the expected models might have an important effect on the observed results. In particular, this study finds that the pricing models in financial theories should sufficiently consider the market situation as a control factor when examining the validity of market beta as well as the risk-return relationship. To further expand this study, future researches can re-evaluate the three-factor pricing model with properties of market situation using the time series regression analysis of Black et al. (1972), as well as confirm the three-factor model’s capability to forecast the risk-return relationship.

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To understand the dynamics of futures trading and stock market volatility, this study examines the relationships among the salient endogenous variables: stock market volatility, futures return, trading volume, and open interest. We use a structural vector auto-regression (SVAR) model, which is identified based on the empirical results of previous studies and reasonable inferences about capital markets. To just-identify the SVAR model, first, we assume that futures return shock does not have a contemporaneous effect on stock market volatility. This does not mean that it has no effect at all on stock market volatility. In fact, we conjecture that it must have some effect on the stock market volatility through lagged relationships among the variables. Second, futures return and trading volume shocks are assumed to have temporary effects on each variable. For these restrictions, we follow the method of Blanchard and Quah (1989). Finally, we believe open interest shock does not have contemporaneous effects on stock market volatility, futures return and trading volume because open interest shock is generally viewed as a natural aftermath of trading. Given the above just-identification of our SVAR model, we investigate the contemporaneous, lagged, and overall effects by over-identifying restrictions. The overall effect is classified into two components: contemporaneous and lagged effects. As known, a contemporaneous effect is defined as a concurrent impact of each shock on each variable. Lagged effects are estimated from the reduced-form VAR. Observing these two types of effects, we study the nature of the dynamic relations that exist among endogenous variables. A graphical representation of dynamic relations could be seen from impulse-response function analysis. Variance decomposition is also done to evaluate relative importance of each shock. Our major empirical findings are as follows. First, the volatility shock of stock market increases futures trading volume concurrently. Futures traders are very sensitive to spot volatility shock. In the sense of Black (1986) and Hong (2000), informed and uninformed traders quickly adjust their futures positions based on asymmetric information; consequently, such behavior increases futures trading volume. Second, the responses of open interest to other shocks reflect demand characteristics of hedgers who are not informed. If open interest is determined by hedgers’ demand as mentioned by Bessembinder and Seguin (1993), the contemporaneous effects of various shocks on open interest show the demand characteristics of hedgers, i.e., uninformed traders. The positive effect of volatility shock on open interest implies that volatility shock increases hedgers’ open interest. This is interpreted as hedgers’ behavior to manage spot market volatility. Statistically insignificant is the effect of futures return shock on open interest, which is concurrent irrelevance of futures return with hedgers’ demand behavior. On the other hand, volume shock decreases open interest concurrently. We interpret this phenomenon as hedgers’ liquidation of open interest, which results in increases in the trading volume. Third, futures trading plays a positive role in decreasing stock market volatility. The negative effect of volume shock on stock market volatility is consistent with the fact that the stock market uncertainty may be decreased by noise traders’ behavior. This finding supports the results of Cox (1976), Danthine (1978), Kwon and Park (1997), and Ohk (2005). Fourth, the impulse response function analysis also supports the results of hypothesis tests. Responses of volatility to various shocks fade away much more slowly than those of other variables. Stock market volatility does not respond to open interest at all. Negative response of stock market volatility to volume shock disappears more than twenty days later. On the other hand, responses of futures return, trading volume, and open interest to various shocks quickly disappear within 2 days at most. This behavior is consistent with the results of reducedand structural-form VAR estimation. Fifth, variance decomposition results show relative importance of each shock. Stock market volatility is explained by its own shock (69.48%) and volume shock (24.08%), while most of both futures return and open interest are explained by their own shock (94.02%) in the long-run. Similar to the case of stock market volatility, trading volume is also explained by volatility shock (66.56%) and its own shock (32.09%). These results confirm the close relationship between stock market volatility and trading volume. Finally, test results of hypotheses re-confirm the importance of concurrent relationships and indirect lag effects among overall effects. The validity of reduce-form VAR, however, is not evinced by the fact that indirect lag effects are important, because the contemporaneous effects are too substantial to overlook. Hence, we conclude that the SVAR estimation, accompanied by impulse response function and variance decomposition analyses, is an appropriate method for studying the relationships among the stock and futures market variables. While many other studies have previously investigated the same issue, our study stands out from the rest in research methodology. Most of previous studies estimate the dynamic relationships among the same variables as in this paper, but they used reduced-form VAR. This means that they are not able to consider contemporaneous effects of each variable. Unlike them, this study investigates an important issue of the dynamic relationships among stock and futures market variables using structural VAR. In this way, this paper makes an important contribution to extant research by suggesting that contemporaneous effects should be considered.

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This paper tests if uninformed short sales affect stock prices by examining short selling activities and stock price movements surrounding convertible bond (CB) issuance dates. We assume that short sales associated with CB arbitrage are uninformed since CB arbitrage is a hedge strategy to pursue market-neutral profits. By examining tick -by-tick data containing information on short sales as well as normal trades, we are able to extract a sample of CB arbitrage from all Korean companies which issued CBs during our sample period from January 2004 to June 2006. We find that short sales increase dramatically around the issuance dates of CBs, which clearly demonstrates the existence of CB arbitrages in Korea. Moreover, we find that the foreign investors, more likely hedge funds, are the major players of CB arbitrage. Then, we investigate the impact of uninformed short selling on stock prices. To control the announcement effect of CB issuances we use CB issuers that are not associated with short-selling activities as a control sample. We find that CB arbitrage does not reduce stock prices beyond the level that is normally affected by CB issuance without short selling. This result implies that stock market is efficient enough to absorb unexpectedly large amounts of uninformed short sales.

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