Asian Review of Financial Research

pISSN: 1229-0351
eISSN: 2713-6531

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Asian Review of Financial Research / January 2017 Vol. 30 No. 4

The Effect of Financial Constraints on Stock Returns in Korea

Byeung-Joo Lee;Dongcheol Kim

Asian Review of Financial Research :: Vol.30 No.4 pp.395-432

Abstract
The Effect of Financial Constraints on Stock Returns in Korea ×

This study examines the effect of financial constraints on stock returns in the Korean stock market from April 2002 to March 2016. Several studies have examined the relation between financial constraints and stock returns. The main issue in these studies is whether financial constraints are an undiversifiable risk and, if so, whether this risk is priced. However, the results have been inconsistent, and there is no consensus on this issue in the literature. Moreover, only a few studies have examined this issue specifically with respect to the Korean stock market. In this study, we thoroughly examine the relation between financial constraints and stock returns in the Korean stock market. Financial constraints arise due to frictions in the process of raising funds from capital markets. If firms have difficulty raising enough funds to invest in profitable projects or are financially constrained, they lose profitable investment opportunities, and then the value of such financially constrained firms declines. Thus, investors perceive financial constraints as risk and demand a premium for such risk. Lamont, Polk, and Saa-Requejo (2001) test whether financial constraints can be a common risk factor that affects stock prices. These authors construct a factor based on the degree of financial constraint by buying long financially constrained firms and selling short financially unconstrained firms. They find a negative relation between financial constraints and stock return. That is, financially constrained firms earn lower stock returns than do financially unconstrained firms. By decomposing the sample period into expansion and contraction periods, Campello and Chen (2010) find that the stock price of financially constrained firms rises more than that of financially unconstrained firms during expansion periods, whereas it falls more than that of financially unconstrained firms during contraction periods. They thus conclude that financial constraints can affect stock prices. To measure financial constraints, previous studies use an index, such as the Kaplan and Zingales (1997) (KZ) index, or individual proxy variables. Those researchers that use the KZ index use the estimated coefficients listed in it to directly compute the index value and in turn use this index value to measure the degree of financial constraint. However, Farre-Mensa and Ljungqvist (2016) argue that this method is problematic. Almeida, Campello, and Weisbach (2004) therefore suggest an approach to determine whether a given measure, such as the KZ index, precisely represents the degree of financial constraint. This approach is to use the sensitivity of cash flows to cash holdings. We use this approach to select the variables to be included in the index that we then use to measure the degree of financial constraint in the Korean stock market. We select the following variables for the index: R&D growth rate, cash and cash equivalents ratio, and sales growth rate. To our knowledge, this index is the first to measure financial constraints in the Korean literature. We construct five portfolios by sorting all Korean firms based on our index values, and we find that average stock returns tend to increase across the portfolios. In other words, more (less) financially constrained firms tend to earn higher (lower) returns. This result is somewhat different from those of Lamont et al. (2001), who examine the U.S. market. Furthermore, the difference in average return between the most and least financially constrained portfolios is positive and statistically significant. However, this significant difference is observable only during up-markets and not during down-markets. To examine whether financial constraints are a priced factor, we use two kinds of test: time-series and cross-sectional. To conduct time-series tests, we regress the financial constraint factor on the factors included in the well-known factor models, such as the CAPM and Fama and French (1993) three-factor model. We construct the financial constraint factor using a zero-investment strategy based on the degree of financial constraint. The time-series regression results show that the CAPM factor does not explain the financial constraint factor, although it is satisfactorily explained by the three-factor model. This indicates that financial constraints are subsumed by the factors related to size and especially the book-to-market ratio. In the cross-sectional regression tests, we find that the coefficient estimates on the financial constraint variable are statistically insignificant. In other words, financial constraints are not priced into stock returns in Korea. In summary, we find a positive relation between financial constraints and stock returns in Korea. However, it is hard to claim that financial constraints are a priced risk. This study contributes to the literature as follows. First, we provide an alternative way to construct the financial constraints index to measure the degree of financial constraint for Korean firms. Second, this study is the first in the Korea literature to test whether financial constraints are a priced risk in Korea.

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Can Trading Restrictions Explain the Performance of Free-Bonus Issues?

Eunyoung Cho,Cheol-Won Yang

Asian Review of Financial Research :: Vol.30 No.4 pp.433-459

Abstract
Can Trading Restrictions Explain the Performance of Free-Bonus Issues? ×

This article investigates the relation between market's response to corporate events and trading restrictions in a unique setting of free-bonus issues in Korea. Specifically, bonus-seeking investors face the trading restrictions that they must hold their current shares until ex-date to receive new shares, and cannot trade non-listed new shares until pay-date, while stock price is adjusted on the ex-date according to the bonus ratio. Moreover, investors face short-sale ban between the ex-date and pay-date. These trading restrictions reduce potential liquidity suppliers in the market, and it causes the excess demand for the stock. We hypothesize that the greater the trading restriction, the higher stock price. We find positive abnormal returns around both announcement date and ex-date, and strong positive relation between event returns and the degree of trading restriction measured by bonus ratio. Moreover, significant negative returns are observed near the pay-date as trading restrictions are expected to disappear. This article provides an evidence that trading restriction, which is one of market frictions, contributes to explaining the abnormal returns around corporate events.

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Investment Risk and Disposition Effect: Evidence from the Trading Behavior of Institutional Investors in Korea

Hyunnam Song,Jinho Jeong

Asian Review of Financial Research :: Vol.30 No.4 pp.461-478

Abstract
Investment Risk and Disposition Effect: Evidence from the Trading Behavior of Institutional Investors in Korea ×

This study investigates the trading behavior of institutional investors in Korea. The findings of this study are as follows. First, Korean investors are just as prone to the disposition effect as U.S. investors but less overconfident than U.S. investors. Second, bond fund shows a higher disposition effect than mixed and equity funds, suggesting that conservative investors tend to delay the needed changes in their portfolio composition when new information forces them to reanalyze the situation and prospects. Third, the disposition effect is sensitive to the reference point changes. Fourth, the disposition effect is positively associated with the length of the holding period, contradicting the findings of previous studies. Finally, the disposition effect in Korea disappears after the global financial crisis, suggesting that Korean investors trade more rationally since the crisis. Our findings indicate that the disposition effect is not a universal phenomenon. The results suggest that the degree of the disposition effect is very sensitive to the type of investor groups.

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An Empirical Study of Cumulative Prospect Theory in the Korean Stock Market

Tae-Jin Kim;Hyun-Sik Kim;Hoon Cho

Asian Review of Financial Research :: Vol.30 No.4 pp.479-517

Abstract
An Empirical Study of Cumulative Prospect Theory in the Korean Stock Market ×

This study tests whether cumulative prospect theory (Tversky and Kahneman, 1992) captures investors' psychological evaluations of individual stocks. It also tests the hypothesis that investors mentally evaluate a stock based on the historical distribution of returns. This study's major empirical findings are as follows. First, when evaluated only on positive terms (henceforth TK+) of the past 36 monthly market excess returns, cumulative prospect theory value shows a negative correlation with subsequent returns. Second, a long-short portfolio sorted on TK+ earns a return of 1.197% on average per month and remains significant for six months after the portfolio's formation. Moreover, the return predictability of TK+ remains significant even if we consider several wellknown control variables, such as beta, size, b/m ratio and momentum, and skewness-related variables. Finally, we find empirical support for the hypothesis that the probability weighting of cumulative prospect theory plays an important role in investors' preferences for lottery-like stocks. This study demonstrates that behavioral finance can be applied to the Korean stock market using statistical analysis.

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