Asian Review of Financial Research

pISSN: 1229-0351
eISSN: 2713-6531

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Asian Review of Financial Research / January 2018 Vol. 31 No. 4

A Study on the Optimal Dividend Policy based on the Permanence of Earnings

Sungmin Kim;Yongwon Jang

Asian Review of Financial Research :: Vol.31 No.4 pp.447-475

Abstract
A Study on the Optimal Dividend Policy based on the Permanence of Earnings ×

Shareholder activism in public pension funds, asset management firms, and foreign hedge funds have led to an increasing number of calls for dividend payouts, so listed firms on the Korean Stock Exchange should urgently prepare an optimal dividend policy for raising corporate value in the mid- to long-term. However, developing such a policy has not previously been discussed or analyzed. In this study a method of deriving the optimal dividend policy of a firm to maximize its value is suggested. Based on the arguments (Fama and Babiak, 1968; Marsh and Merton, 1987; Lee, 1996, etc.) that cash dividends rely on permanent earnings and on the empirical findings (Fama and French, 1998; Pinkowitz, Stulz, and Williamson, 2006 and etc.) that cash dividends contribute to an increase in corporate value, the effect of cash dividends, which are driven by the permanence of earnings, on corporate values is analyzed. In the Beveridge-Nelson method earnings are divided into permanent and temporary earnings. Empirical results show that as the proportion of cash dividend relative to permanent earnings increases, corporate value increases significantly. Second, it is possible to derive the optimal level of dividend for a company, as the proportion of cash dividend relative to the permanent earnings is nonlinear and takes a reverse U form. Specifically, we find that corporate value increases with the cash dividend proportion of permanent earnings up to the point of 41.47%, and it decreases as the percentage increases beyond this point. These results imply that domestic firms must realize their optimal dividend policy by considering the persistence of earnings, and that institutional investors need to monitor whether a firm's dividend policy at a micro level is aimed at achieving its optimal dividend level, which can maximize its shareholder value.

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Stop-Loss Strategies and National Pension Fund Active-Risk Management in Korean Stocks

Daeil Kang;Jong-Ho Park;Kyong Shik Eom

Asian Review of Financial Research :: Vol.31 No.4 pp.477-519

Abstract
Stop-Loss Strategies and National Pension Fund Active-Risk Management in Korean Stocks ×

A stop-loss strategy is an investment strategy that automatically sells a stock that is suffering a loss when its price reaches a stop price. It is well known that investors actively use these strategies to protect against downward risk in the face of (ultra-) short-term volatility and drastically dropping stock prices. Since a stop-loss strategy uses algorithms to determine when the stock should be sold, investors do not have to follow the market constantly. Therefore, investors can control their behavioral biases and prevent losses in advance, and in practice this strategy is generally known to be useful in improving returns on investment. However, according to Kaminski and Lo (2014), the stop-loss strategy has different effects depending on the return-generating process the stocks follow. If stock returns follow a momentum or a regime-switching process, then a stop-loss strategy can increase portfolio profits and/or reduce volatility. However, if they follow a random-walk or a mean-reverting process, then a stop-loss strategy can lower portfolio profits. This paper analyzes the performance and effectiveness of stop-loss strategies in the Korean stock market by analyzing a general stop-loss strategy and a specific stop-loss strategy. For the general stop-loss strategy, we use the one studied by Lei and Li (2009). For the specific stop-loss strategy, we use the Active Risk-Management Phase 3 of the Korea National Pension Service (NPS). We analyze the effects of the general stop-loss strategy on the stocks listed on the KOSPI and KOSDAQ markets from July 1996 to June 2016. We use block bootstrapping to compare the performances of the stop-loss strategy to the buy-hold strategy, and calculate the efficiency of the stop-loss strategy by calculating the stop-loss premium. To analyze the specific stop-loss strategy embedded in the NPS's Active Risk-Management Phase 3, we analyze the NPS's investment universe from January 2011 to December 2017. We compute the cumulative rate of returns after the entry of the Active Risk-Management Phase 3 under an algorithm simulation. Ever since the 2008 global financial crisis, the Korean stock market, like other leading global markets, has experienced ultra-short-term volatility and sudden liquidity droughts in the absence of any material news. Stop-loss orders are a basic risk-management tool under these circumstances. Despite these structural market conditions, the Korea Exchange (KRX) does not offer stop orders or stop-loss orders to investors. Therefore, it is important to determine whether stop-loss strategies can help control the downside risk to investors. This study also addresses how the interaction between the structural conditions of the Korean stock market and the implementation of mandatory stock trading under the risk-management rules affect the investment strategy of the NPS, which is a timely and important topic. The results of our analyses are as follows. First, in terms of performance, we cannot confirm that a general stop-loss strategy is statistically superior to a buy-hold strategy, or vice versa. However, in terms of risk management, a general stop-loss strategy is more effective at reducing volatility than a buy-hold strategy. Second, 75% of the stocks that enter Phase 1 exit and return to a normal status within fourteen trading days. Phase 1 only involves enhanced monitoring of the stock, and stop-loss orders are not applied to these. When a stock enters Phase 2, a report is generated, but no specific action is mandated. Once a stock enters Phase 3, NPS is mandated to consider placing a stop-loss order. We find that in Phase 2 it is beneficial to observe whether the stock return becomes positive or remains stable over the ensuing 2~3 months (60 trading days) or 4~5 months (120 trading days). If the return continues to be positive or stable, NPS should continue to hold the stock and not place a stop-loss order. However, if the return remains negative in Phase 2, it is desirable to sell the stock without waiting for it to enter Phase 3. If a stock enters Phase 3 and NPS still holds it, it is desirable to sell the stock and to invest the sales proceeds in safe assets, and then repurchase the stock if and when it meets the re-entry threshold. Third, as the cumulative return after entering Phase 3 is often negative for up to 240 trading days, the stop-loss strategy does not seem to hurt returns by realizing transitory losses. Any possible increase in volatility, which results from the introduction of static VI or the increase of the price limit, does not appear to adversely affect the stop-loss strategy. Fourth, we find that the general stop-loss strategy in the Korean stock market does not improve performance. However, in the case of active risk management of NPS, it is desirable to sell the stocks prior to or on entering Phase 3. The difference between the two results appears to be largely due to the differences of the specific parameters of the stop-loss strategies. In the end, the effectiveness of stop-loss strategies critically depends on matching the parameters of the strategy to the conditions in the Korean stock market.

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Pay Multiple and Firm Performance: Korean Evidence

Jeongdae Yim;Seokchin Kim

Asian Review of Financial Research :: Vol.31 No.4 pp.521-555

Abstract
Pay Multiple and Firm Performance: Korean Evidence ×

Since the Korean currency crisis of 1997, Korean firms have followed the compensation system used in the U.S. With this shift, pay for executives has risen sharply and the pay multiple has increased. We investigate the effect of this increased pay multiple on the overall operating and stock performance of Korean firms. Our data comprise 15,438 firm-year observations in 1,745 non-financial firms listed on two Korean stock markets from 2004 to 2016. Researchers in the field of human resource management find that relative pay has greater relevance than absolute pay in shaping the behaviors or attitudes of lower-level employees. Accordingly, we conjecture that enlarged pay multiples have a negative effect on Korean firms, as Korea has a relatively more egalitarian culture and a less elaborate evaluation system. In addition, relative deprivation theory posits that employees feel deprived when they perceive that their executives are overpaid. Employees may accept that high pay for an executive is deserved if that executive has high managerial ability. However, the employees may feel that executives with low managerial ability are paid too much. We therefore estimate the managerial ability of executives by adopting the method suggested by Demerjian, Lev, and McVay (2012), and we divide our sample firms into high and low managerial ability groups. We hypothesize that the effects of pay multiple on firm performance differ according to whether the firms have high or low managerial ability. Our empirical results are as follows. First, pay multiple negatively affects the overall operating and stock performance of most Korean firms. This finding implies that most employees think their executives' pay is unjustifiably high, and it should be reduced. This sentiment seems to support relative deprivation theory. Second, the negative impact of pay multiple occurs only in the low managerial ability group. In the high managerial ability group, increased pay multiples have a positive effect. This finding indicates that employees in firms with low-ability managers feel deprived because of their executives' excessive pay, whereas employees in firms with high-ability managers accept that their executives' increased levels of pay are deserved. Third, the squared terms of pay multiple have negative coefficients. In other words, the negative effect of pay multiple becomes greater as pay multiple increases in the low managerial ability group. Meanwhile, this result indicates that the positive effect of pay multiple changes negatively as pay multiple increases in the high managerial ability group. In quintile analyses, we confirm that this non-linearity applies for both high and low managerial ability groups. In general, the negative effect becomes greater for each higher quintile of pay multiple in the low managerial ability group. We find that there is an inverted U-shaped relationship between pay multiple and firm performance in the high managerial ability group, which implies the existence of the optimal pay multiple. Fourth, we use an instrumental variable to check for potential endogeneity due to reverse causality between pay multiples and firm performances. Our empirical results are robustly confirmed. Finally, we further analyze various sub-samples of manufacturing and non-manufacturing firms, chaebol and non-chaebol firms, and Korea Stock Exchange (KSE) as compared to KOSDAQ firms. We obtain consistent results for all of the subsamples. In summary, we show that pay multiple has a negative effect on firm performance. However, this negative effect only occurs in low managerial ability firms, where the negative impact becomes more significant as the pay multiple grows larger. These findings are consistent with relative deprivation theory. This paper examines executive-employee pay multiples, rather than pay gaps among executives or employees. By linking the pay multiple to firm performance, we show that it is important to adopt a pay structure that includes both executives and employees. Furthermore, we contribute meaningful evidence concerning relative deprivation theory by analyzing how managerial ability is related to the relationship between pay multiple and firm performance. Our findings indicate that to enhance firm performance, executive pay structures need to reflect managerial ability.

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Asset Allocation and Determinants of Households with Debts

Wonnho Choi

Asian Review of Financial Research :: Vol.31 No.4 pp.557-594

Abstract
Asset Allocation and Determinants of Households with Debts ×

In this paper, I analyze household portfolios with and without household debts, each of which is supposedly subject to distinct financial target according to household characteristics and financial status, respectively. Four issues were identified through the 2011~2013 Household Financial Survey. First, households with debts have more financial assets in addition to real assets than those without debts, which include stocks, bonds, insurance, and mutual funds. Households with debts also own more real estate and durables such as automobiles and real assets, which is statistically significant. This result implies that households with debts invest aggressively in asset allocation and in specific assets, unlike those without debts. Second, disposable income is a main interest variable and reduces the share of financial assets at a low level but increases the share at a high level, irrespective of household debts. In contrast, At a low level, the net worth increases real assets, whereas it decreases at a high level. Thus, we conclude that households tend to diversify the portfolio risk of real assets through financial markets. Third, as previously found, household debts reduce household financial assets but reinforce the holdings of real assets, which is also prevalent in the sample of households with excessive debts. Finally, in terms of generations, middle-aged and older households with debts are more likely to prefer stocks, and significantly more likely than younger households.

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