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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