Asian Review of Financial Research

pISSN: 1229-0351
eISSN: 2713-6531

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Asian Review of Financial Research / August 2012 Vol. 25 No. 3

The Dynamics of Futures Trading and Stock Market Volatility Using Structural Vector Auto-Regression

Kwangsoo Ko;Taewoo Kim;Miyoun Paek;Ki Yool Ohk

Asian Review of Financial Research :: Vol.25 No.3 pp.325-355

Abstract
The Dynamics of Futures Trading and Stock Market Volatility Using Structural Vector Auto-Regression ×

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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Convertible Bond Arbitrage and Short Sales : Evidence from the Korean Stock Market

Hyuk Choe,Cheol-Won Yang

Asian Review of Financial Research :: Vol.25 No.3 pp.357-407

Abstract
Convertible Bond Arbitrage and Short Sales : Evidence from the Korean Stock Market ×

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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Style, Performance, Market Timing of Equity Mutual Funds in Korea

Shin Ik Yoo;Dongcheol Kim

Asian Review of Financial Research :: Vol.25 No.3 pp.409-450

Abstract
Style, Performance, Market Timing of Equity Mutual Funds in Korea ×

Since the introduction of the Act of Financial Investment Services and Capital Markets in 2009, the fund markets in Korea have enormously grown. In this study, we examine three salient composites: fund style, performance persistency, and market timing ability of fund managers. To this end we use all equity funds survived during the period of 2001 through 2009 (all 139 funds). In addition, we look into the relation between the persistency of fund style and the fund performance. We also study how the fund performance has been changed since the financial crisis in 2007. To classify fund styles and examine fund performance, we use a return-based style analysis as in Sharpe (1992). The return-based style analysis sort funds according to the magnitude of the coefficient estimates. Unlike Sharpe who uses simply a regression model comprised of several indexes, we use the Fama-French (1993) five-factor model composed of three equity factors and two bond market factors. The equity factors are the market factor and two factors related to size and book-to-market, namely SMB and HML, respectively; the bond market factors are term spread and default spread. The spread in yields between 5-year Korean Treasury Bonds (KTB) and 91-day Certificate of Deposit (CD) is used as term spread, and the spread in yields between BBB3-rated and AA3-rated corporate bonds is used as default spread. The reason we select the Fama-French 3 factor model to analyze equity funds in Korea is that, as recently reported by Kim, Kim, and Shin (2012), the Fama-French 3 factor model explains Korean stock returns best among many factor models considered. Our paper is the first paper that uses the bond market factors in analyzing equity mutual funds in Korea. Following Sharpe (1992), we classify fund style according to the estimated coefficients (or factor loadings) on each of the five factors. For example, if the magnitude of the factor loading of a fund on SMB is in the top (bottom) 30%, this fund is classified as small (large) fund. If the magnitude of the factor loading of a fund on HML is in the top (bottom) 30%, this fund is classified as value (growth) fund. If the magnitude of the factor loading of a fund on term spread is in the top (bottom) 30%, this fund is classified as business sensitive (insensitive) fund. If the magnitude of the factor loading of a fund on default spread is in the top (bottom) 30%, this fund is classified as high (low) credit risk fund. Of course, one fund can be classified into multiple funds. If the factor loading of a factor falls between top 30% and bottom 30%, this fund is not classified. The main results of this study are as follows: First, we confirm that the Fama-French 5-factor model shows the best goodness of fit and the lowest tracking errors for Korean equity mutual funds among many factor models considered, such as the Capital Asset Pricing Model (CAPM), the Fama-French (1993) three-factor model, and Carhart (1997) four-factor model. To compare the performance of the factor models, we estimated the models by observing the year-by-year rolling over for the three-year period for its monthly returns. We also find that the two bond factors are important for better understanding the performance of Korean mutual funds. In particular, since fund performance is affected by business cycles, the use of the bond factors would be essential in analyzing fund performance. Further, the bond factors are good proxies for business cycle. In fact, we confirm that mutual funds returns in Korea are significantly positively correlated with the Korea business-leading indicator and are sensitive to business cycles, which are also determined by the same indicator. Another important finding is that large and growth funds, rather than small, value funds, perform better and take more fund inflows in Korea. Also, Korean mutual fund managers tend to build their investment strategies toward value, large, business cycle-and creditsensitive fund styles. Fourth, only fund managers of a fraction of mutual funds show significant selection ability while most fund managers rarely show market timing ability. For some fund managers equipped with market timing ability, their market timing ability tends to be higher during the recent financial crisis (2007~2009) than during the other times. To analyze the market timing ability of fund managers, we use the conditional model on macroeconomic variables by following Ferson and Schadt (1996) to adjust for time-varying of the factor loadings. Fifth, while only a fraction of mutual funds show positive abnormal returns, they are shown to last just briefly. Rather, low performance (i.e., negative abnormal returns) tends to be strongly persistent. These results are somewhat consistent with the performance of U.S. mutual funds. Among the funds showing positive abnormal returns, growth and large funds show stronger persistence of good performance than do value and small funds. This result implies that the persistency of fund style could be related to good fund performance. Finally, there also exists in Korea the smart money effect, indicating that investors have an ability to identify superior fund managers and invest accordingly; this attests to the fact that fund inflows improve fund performance. Our study indicates, however, that this effect lasts only for three years.

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The Effect of Independent Outside Directors on Firm Value

Yun Sik Kang;Chan Pyo Kook

Asian Review of Financial Research :: Vol.25 No.3 pp.451-498

Abstract
The Effect of Independent Outside Directors on Firm Value ×

Many corporate governance literatures emphasize the importance of outside directors' monitoring role and their independence. Theoretically, board of directors performs crucial roles in modern corporations where ownership and management are separated. As fiduciaries of shareholders, outside directors monitor managers who may pursue their own interests. Hence, as an internal governance mechanism, the independence of outside directors is a crucial factor in determining the effectiveness of monitoring and disciplining the management. In spite of this theoretical background, previous empirical studies failed to show consistent evidences in support of the effect of outside directors. Perhaps the lack of consistency in proving an effect of outside directors on performance can be interpreted as an indication that they have failed to distinguish “independent” and “friendly” outside directors. If researchers do not correctly distinguish independent outside directors from those who are not, the effects of outside directors on firm value cannot be clearly discerned as positive effects of independent directors may get cancelled out by the potential negative effects of non-independent directors may have on the firm value on average. Unlike prior studies, this paper, using hand collected data on the independence of outside director, examines how independent or friendly outside directors affect firm value as the directors would engage in monitoring and supervising a firm's management. For the empirical analysis, we classify outside directors as ‘friendly' or ‘independent' by more refined and strict definition of independence of outside directors. Using this data classified into independent or friendly outside directors, first, we test the effect of independent (or friendly) outside directors on firm value. And then, we test whether the effect of independent (or friendly) outside directors on firm value varies with firm characteristics. Through these tests, we hope to verify that the value of outside directors depends on their independence alone. That is to say, the purpose of this paper is to provide new empirical evidence of the effectiveness of outside directors by focusing on the value of their independence in job performance. Our main finding supports that independent outside directors have a significant and positive effect on firm value. But friendly outside directors have either negative or no influence on the firm value. This result implies that independent outside directors play a pivotal role in enhancing firm value. We also explore how the relationship between the board independence and firm characteristics affect firm value. For this test, we run regression analysis using the interaction terms between board independence and the firm characteristics. According to the results about the effect of independent outside directors on firm value depending on firm characteristics, the firms with a longer corporate history, the higher level of capital expenditure, advertisement expenses, selling and management cost, the competitiveness in the industry, free cash flow and possibility of agency problems has more positive valuation effect of board independence. In other words, the interaction terms between the ratio of the independent outside directors variable and some of firm characteristics variables are positive and statistically significant in some firms' characteristics. However, given the ratio of friendly board members who have school or business ties with management or with the firm, firm value is lower when firms have the higher level of leverage, sales growth rate, volatility of equity returns, and ratio of fixed assets. In other words, the interaction terms between the ratio of friendly outside directors variable and some of firm characteristics variables are negative and statistically significant in some others firms' characteristics. This result implies that independent outside directors are very important on firm value in Korea regardless of firm characteristics. And finally, to mitigate the endogeneity problem and to check robustness of our previous results, we conduct additional tests as follows: First, to check robustness of our previous results, we run regression analysis using the alternative definition for independent outside director. The results using new definition are consistent with our previous results. Second, to deal with endogeneity problem, we run regression analysis using the data which show the change of the ratio of independent outside directors in board composition. By this regression, we are able to capture the importance of independence of BOD directly. This method can mitigate the endogeneity problem that has hampered previous attempts to estimate the effect of board independence. The results are consistent with our previous results. Third, to address the endogeneity problem caused by reverse causality, we run reverse regression by changing explanatory variables with dependent variables. According to the result, tobin's Q doesn't affect the level of board independence. Consequently, we confirm that our result is robust. In short, our results imply that the effectiveness of the boards' monitoring role depends on their independence and the independence of outside directors is important for enhancing firm value. All in all, this empirical evidence suggests that Korean listed companies should reinforce the independence of board of directors by appointing independent outside directors to improve the firm value and correct the current problems with outside director system. As shown, our study contributes to the literature by promoting enhanced understanding about the crucial effect the independence of outside board members have on improving firm value.

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