Asian Review of Financial Research

pISSN: 1229-0351
eISSN: 2713-6531

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Asian Review of Financial Research / May 2016 Vol. 29 No. 2

The Index Arbitrage in Expiration Days: Normal Arbitrage Trading or Cross-Market Manipulation?

Cheol-Won Yang;Ji-Yeon Yoo

Asian Review of Financial Research :: Vol.29 No.2 pp.149-191

Abstract
The Index Arbitrage in Expiration Days: Normal Arbitrage Trading or Cross-Market Manipulation? ×

The closing price of KOSPI200 on Nov 11, 2010, the expiration day for options, was determined at 247.51 points following a severe fall of 7.11 points, which caused great disorder in the Korean financial market. The Korean Supervisory Service and the Korea Exchange investigated the event and discovered that Deutsche Bank had submitted a huge sales order for 2.44 trillion Won of 199 stocks simultaneously, on condition of holding a large amount of KOSPI200 put options. Deutsche Bank was later indicted for the cross-market manipulation based on the Financial Investment Services and Capital Markets Act (hereafter “Capital Market Act”). In this paper, we investigate the cross-market manipulation using index arbitrage in determining stock closing prices on expiration days. We deal withtwo aspects in relation to this issue. First, in terms of law, we explain the various types of cross-market manipulation regulated by the Capital Markets Act. Specifically, we discuss the concept of “existence of purpose” to satisfy the requirement for cross-market manipulation action. Second, in terms of finance, the hypotheses to verify the “existence of purpose” on the cross-market manipulation are established and tested empirically. This empirical test is also related to Kumar and Seppi's (1992) model, in which the manipulator earns a positive expected profit by holding a futures position and then manipulating the spot price used to compute the cash settlement on the expiration day. In empirical analysis, we identify that expiration effects exist in the Korean market, consistent with previous studies. The volatility and trading volume of the closing price on expiration days are distinctly higher than those on non-expiration days and those of non-KOSPI200 stocks. Then we establish the first hypothesis that if expiration-day effects are caused by index arbitrage activity, the effects are stronger in stocks where the trading volume for index arbitrage is higher. The results show that the portfolio with a greater transaction ratio of index arbitrage has higher volatility and trading volume on expiration days. The differences are statistically significant. The regression analysis using volatility and trading volume on expiration days as the independent variable and index arbitrage as the dependent variable also shows that volatility and trading volume on expiration days are positively correlated with index arbitrage. These results support our first hypothesis that index arbitrage are an important source of expiration-day effects. However, the positive relationship between the expiration-day effect and index arbitrage does not necessarily imply that cross-market manipulation activity exists in the market and affects the closing price on expiration days. Normal index arbitrage can also cause an increase in volatility and trading volume due to its tremendous trading size. To disentangle these two possibilities we use the order submission data of closing call auctions and establish the second hypothesis. Our second hypothesis is that a cross-market manipulator will submit a distinctly low-priced limit sale order or distinctly high-priced limit purchase order, both of which lack economic rationality, to move the closing price as much as possible on expiration days. According to the Kumar and Seppi (1992) model, the cross-market manipulator can earn a positive expected profit by manipulating the spot price used to compute the cash settlement on the expiration day because the profit from the futures position exceeds the loss from the spot position. Analysis of the index arbitrage order data in the closing call auctions on expiration days shows a significant increase in distinctly low-priced limit sale orders and distinctly high-priced limit purchase orders. The limit orders are also concentrated in the last minute of the closing call auction. Finally we test a third hypothesis to confirm the price impact of cross-market manipulation. Our third hypothesis is that orders for index arbitrage have a greater effect on price than other normal orders if there is cross-market manipulation on expiration days, because the manipulators try to maximize the price impact of their orders to maximize their profits in the futures position. The results show that the price impact of index arbitrage orders is larger than that of normal orders. Overall, these results imply that there exist index arbitrage orders issued for the purposes of cross-market manipulation on expiration days in Korea. The findings are also consistent with Kumar and Seppi's (1992) prediction that cross-market manipulators try to manipulate the spot price used in cash settlement on the expiration day.

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Managerial Opportunism, Overconfidence and Stock Price Crash Risk

Byungmo Kim

Asian Review of Financial Research :: Vol.29 No.2 pp.193-233

Abstract
Managerial Opportunism, Overconfidence and Stock Price Crash Risk ×

A stock's price crashes when bad news accumulated within the firm is released all at once. I suggest two incentives for bad news hoarding-managerial opportunism and overconfidence-and examine their effects on firm-specific stock price crash risk. In a corporate setting in which there is separation of ownership and control, managers have multiple incentives to conceal bad news, such as extracting rent, securing their jobs, maintaining reputations and meeting the conditions for extra compensation. Overconfident managers also have incentives to ignore negative news. They tend to overestimate the cash flows of investment projects and misperceive negative news as temporary or untrue. They are reluctant to disclose negative news because doing so might prompt investors to halt the projects. Thus, both opportunism and overconfidence can motivate managers to hoard bad news, which in turn can lead to stock price crashes. These two incentives are not, however, mutually exclusive. Opportunism assumes that managers are rational expected-utility maximizers, whereas overconfident managers are expected to behave according to irrational psychological traits. This suggests that overconfident managers can conceal bad news even if they are benevolent to shareholders. The difference allows them to empirically decide which incentive is the main source of the stock price crash. I use tax avoidance (long-run effective tax rate) as a proxy for opportunism because it is widely involved in managerial opportunistic decisions such as earnings management and resource diversion. As a proxy for firm-level overconfidence, I use a dummy variable constructed following Schrand and Zechman (2012). Overconfidence is a persistent trait that affects all business decisions, suggesting that the level of overconfidence can be inferred from the firm's financial and investment decisions. Schrand and Zechman (2012) developed an overconfidence score using a list of financial and investment decisions typically conducted by overconfident managers. Following Chen, Chen, Cheng, and Shevlin (2001) and Hutton, Marcus, and Tehranian (2009), I use two measures of firm-specific stock price crash risk: the likelihood of extreme and negative firm-specific weekly returns and the negative conditional skewness of firm-specific weekly returns. Using non-financial firms listed on the Korea Stock Exchange for the 2001~2011 period, I find that while tax avoidance is positively related to stock price crash risk, overconfidence is not. The results are consistent with the hypothesis that opportunism motivates managers to hoard bad news, which leads to stock price crashes. The finding is robust when I control for firm-fixed effects and use alternative tax avoidance measures, such as the book-tax income difference and the long-term effective tax rate adjusted for earnings management. I also find that the relation between tax avoidance and crash risk is more pronounced in firms with greater information asymmetry. In contrast, information asymmetry does not help explain the relation between overconfidence and crash risk. I further examine the effect of investor protection on the relation between tax avoidance and crash risk. Investor protection variables include largest shareholder ownership, foreign ownership, proportion of outside directors, amount of external financing, big audit firm dummy, chaebol affiliation dummy and the disparity between control and cash flow rights. It appears that the effect of tax avoidance on crash risk is less pronounced for firms with greater investor protection. Specifically, firms with higher largest shareholder ownership and greater external financing, firms audited by big audit companies, non-chaebol firms and firms with lower disparity between control and cash flow rights all exhibit relatively weak relations between tax avoidance and crash risk. The results reinforce that opportunism is a more promising source of stock price crashes than overconfidence. Earlier studies have tried to find the determinants of stock price crashes, focusing on market mechanisms. Recently, related research expanded its focus to include firm-side mechanisms, but most studies have explained stock price crashes using the agency framework. This study complements those works by suggesting a managerial behavioral trait as a source of stock price crashes.

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Cyclical Patterns of Debt and Equity Financing in Korean Firms

Dongweon Lee;Jaeho Cho

Asian Review of Financial Research :: Vol.29 No.2 pp.235-264

Abstract
Cyclical Patterns of Debt and Equity Financing in Korean Firms ×

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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Did the Funding Structure of Foreign Bank Affiliates Affect Capital Outflows in the Great Recession? : Evidence from U.S. Global Banks

Eun-Joo Lee,Jungsoo Park

Asian Review of Financial Research :: Vol.29 No.2 pp.265-320

Abstract
Did the Funding Structure of Foreign Bank Affiliates Affect Capital Outflows in the Great Recession? : Evidence from U.S. Global Banks ×

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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