Essays on Risk and Return

Perhaps the most fundamental prediction of financial theory is that the expected returns on financial assets are determined by the amount of risk contained in their payoffs. Assets with a riskier payoff pattern should provide higher expected returns than assets that are otherwise similar but provide payoffs that contain less risk. Financial theory also predicts that not all types of risks should be compensated with higher expected returns. It is well-known that the asset-specific risk can be diversified away, whereas the systematic component of risk that affects all assets remains even in large portfolios. Thus, the asset-specific risk that the investor can easily get rid of by diversification should not lead to higher expected returns, and only the shared movement of individual asset returns – the sensitivity of these assets to a set of systematic risk factors – should matter for asset pricing. It is within this framework that this thesis is situated. The first essay proposes a new systematic risk factor, hypothesized to be correlated with changes in investor risk aversion, which manages to explain a large fraction of the return variation in the cross-section of stock returns. The second and third essays investigate the pricing of asset-specific risk, uncorrelated with commonly used risk factors, in the cross-section of stock returns. The three essays mentioned above use stock market data from the U.S. The fourth essay presents a new total return stock market index for the Finnish stock market beginning from the opening of the Helsinki Stock Exchange in 1912 and ending in 1969 when other total return indices become available. Because a total return stock market index for the period prior to 1970 has not been available before, academics and stock market participants have not known the historical return that stock market investors in Finland could have achieved on their investments. The new stock market index presented in essay 4 makes it possible, for the first time, to calculate the historical average return on the Finnish stock market and to conduct further studies that require long time-series of data.

Corporate Governance in China (summary section only)

The negative relationship between economic growth and stock market return is not an anomaly according to evidence documented in many economies. It is argued that future economic growth is largely irrelevant for predicting future equity returns, since long-run equity returns depend mainly on dividend yields and the growth of per share dividends. The economic growth does result in a higher standard of living for consumers, but does not necessarily translate into higher returns for owners of the capital. The divergence in performance between the real sector and stock markets appears to support the above argument. However, this thesis strives to offer an alternative explanation to the apparent divergence within the framework of corporate governance. It argues that weak corporate governance standards in Chinese listed firms exacerbated by poor inventor protection results into a marginalized capital market. Each of the three essays in the thesis addresses one particular aspect of corporate governance on the Chinese stock market in a sequential way through gathering empirical evidence on three distinctive stock market activities. The first essay questions whether significant agency conflicts do exist by building a game on rights issues. It documents significant divergence in interests among shareholders holding different classes of shares. The second essay investigates the level of agency costs by examining value of control through constructing a sample of block transactions. It finds that block transactions that transfer ultimate control entail higher premiums. The third essay looks into possible avenues through which corporate governance standards could be improved by investigating the economic consequences of cross-listing on the Chinese stock market. It finds that, by adopting a higher disclosure standard through cross-listings, firms voluntarily commit themselves to reducing information asymmetry, and consequently command higher valuation than their counterparts.

Essays on Financial Analyst Forecasts and Recommendations

The trade of the financial analyst is currently a much-debated issue in today’s media. As a large part of the investment analysis is conducted under the broker firms’ regime, the incentives of the financial analyst and the investor do not always align. The broker firm’s commercial incentives may be to maximise its commission from securities trading and underwriting fees. The purpose of this thesis is to extend our understanding of the work of a financial analyst, the incentives he faces and how these affect his actions. The first essay investigates how the economic significance of the coverage of a particular firm impacts the analysts’ accuracy of estimation. The hypothesis is that analysts put more effort in analysing firms with a relatively higher trading volume, as these firms usually yield higher commissions. The second essay investigates how analysts interpret new financial statement information. The essay shows that analysts underreact or overreact to prior reported earnings, depending on the short-term pattern in reported earnings. The third essay investigates the possible investment value in Finnish stock recommendations, issued by sell side analysts. It is established that consensus recommendations issued on Finnish stocks contain investment value. Further, the investment value in consensus recommendations improves significantly through the exclusion of recommendations issued by banks. The fourth essay investigates investors’ behaviour prior to financial analysts’ earnings forecast revisions. Lately, the financial press have reported cases were financial analysts warn their preferred clients of possible earnings forecast revisions. However, in the light of the empirical results, it appears that the problem of analysts leaking information to some selected customers does not appear systematically on the Finnish stock market.

Inference on Cointegration in Vector Autoregressive Models (summary section only)

In the thesis we consider inference for cointegration in vector autoregressive (VAR) models. The thesis consists of an introduction and four papers. The first paper proposes a new test for cointegration in VAR models that is directly based on the eigenvalues of the least squares (LS) estimate of the autoregressive matrix. In the second paper we compare a small sample correction for the likelihood ratio (LR) test of cointegrating rank and the bootstrap. The simulation experiments show that the bootstrap works very well in practice and dominates the correction factor. The tests are applied to international stock prices data, and the .nite sample performance of the tests are investigated by simulating the data. The third paper studies the demand for money in Sweden 1970—2000 using the I(2) model. In the fourth paper we re-examine the evidence of cointegration between international stock prices. The paper shows that some of the previous empirical results can be explained by the small-sample bias and size distortion of Johansen’s LR tests for cointegration. In all papers we work with two data sets. The first data set is a Swedish money demand data set with observations on the money stock, the consumer price index, gross domestic product (GDP), the short-term interest rate and the long-term interest rate. The data are quarterly and the sample period is 1970(1)—2000(1). The second data set consists of month-end stock market index observations for Finland, France, Germany, Sweden, the United Kingdom and the United States from 1980(1) to 1997(2). Both data sets are typical of the sample sizes encountered in economic data, and the applications illustrate the usefulness of the models and tests discussed in the thesis.

New Evidence on the Properties of the Financial Statement Information Pricing Process

This study contributes to our knowledge of how information contained in financial statements is interpreted and priced by the stock market in two aspects. First, the empirical findings indicate that investors interpret some of the information contained in new financial statements in the context of the information of prior financial statements. Second, two central hypotheses offered in earlier literature to explain the significant connection between publicly available financial statement information and future abnormal returns, that the signals proxy for risk and that the information is priced with a delay, are evaluated utilizing a new methodology. It is found that the mentioned significant connection for some financial statement signals can be explained by that the signals proxy for risk and for other financial statement signals by that the information contained in the signals is priced with a delay.

Real Estate Investment and Uncertainty: Econometric Modelling using Finnish Data

The purpose of this paper is to test for the effect of uncertainty in a model of real estate investment in Finland during the hihhly cyclical period of 1975 to 1998. We use two alternative measures of uncertainty. The first measure is the volatility of stock market returns and the second measure is the heterogeneity in the answers of the quarterly business survey of the Confederation of Finnish Industry and Employers. The econometric analysis is based on the autoregressive distributed lag (ADL) model and the paper applies a 'general-to-specific' modelling approach. We find that the measure of heterogeneity is significant in the model, but the volatility of stock market returns is not. The empirical results give some evidence of an uncertainty-induced threshold slowing down real estate investment in Finland.

How Do Different Types of Investors React to New Financial Statement Information?

The study contributes to our understanding of the forces that drive the stock market by investigating how different types of investors react to new financial statement information. Using the extremely comprehensive official register of share holdings in Finland, we find that the majority of investors are more probable to sell (buy) stocks in a company after a positive (negative) earnings surprise, and show a bias towards buying after the disclosure of new financial statement information. Large investors, on the other hand, show behavior opposite to that of the majority of investors in the market. Further, foreign investors show behavior similar to that of domestic investors. We suggest investor overconfidence and asymmetric information as possible explanations for the documented behavior.

Performance of Finnish Mutual Funds: A Decomposition Approach

Mutual funds have increased in popularity among Finnish investors in recent years. In this study returns on domestic funds have been decomposed into several elements that measure different aspects of fund performance. The results indicate that fund managers in the long run tend to allocate fund capital between different stock categories in a profitable way. When it comes to the short term timing of their allocation decisions they are however unable to further improve overall performance. The evidence also suggests that managers possess the ability to pick above average performing stocks within the individual stock categories. During the investigated period most funds returned more than a broad benchmark index even after fees and indirect costs were taken into account.

Test of the Clustering Hypothesis in the Helsinki Exchanges

This paper investigates the clustering pattern in the Finnish stock market. Using trading volume and time as factors capturing the clustering pattern in the market, the Keim and Madhavan (1996) and the Engle and Russell (1998) model provide the framework for the analysis. The descriptive and the parametric analysis provide evidences that an important determinant of the famous U-shape pattern in the market is the rate of information arrivals as measured by large trading volumes and durations at the market open and close. Precisely, 1) the larger the trading volume, the greater the impact on prices both in the short and the long run, thus prices will differ across quantities. 2) Large trading volume is a non-linear function of price changes in the long run. 3) Arrival times are positively autocorrelated, indicating a clustering pattern and 4) Information arrivals as approximated by durations are negatively related to trading flow.

Intraday Linkages across International Equity Markets

Utilizing concurrent 5-minute returns, the intraday dynamics and inter-market dependencies in international equity markets were investigated. A strong intraday cyclical autocorrelation structure in the volatility process was observed to be caused by the diurnal pattern. A major rise in contemporaneous cross correlation among European stock markets was also noticed to follow the opening of the New York Stock Exchange. Furthermore, the results indicated that the returns for UK and Germany responded to each other’s innovations, both in terms of the first and second moment dependencies. In contrast to earlier research, the US stock market did not cause significant volatility spillover to the European markets.

Nonlinear mixture autoregressive model: economic applications

The aim of this dissertation is to model economic variables by a mixture autoregressive (MAR) model. The MAR model is a generalization of linear autoregressive (AR) model. The MAR -model consists of K linear autoregressive components. At any given point of time one of these autoregressive components is randomly selected to generate a new observation for the time series. The mixture probability can be constant over time or a direct function of a some observable variable. Many economic time series contain properties which cannot be described by linear and stationary time series models. A nonlinear autoregressive model such as MAR model can a plausible alternative in the case of these time series. In this dissertation the MAR model is used to model stock market bubbles and a relationship between inflation and the interest rate. In the case of the inflation rate we arrived at the MAR model where inflation process is less mean reverting in the case of high inflation than in the case of normal inflation. The interest rate move one-for-one with expected inflation. We use the data from the Livingston survey as a proxy for inflation expectations. We have found that survey inflation expectations are not perfectly rational. According to our results information stickiness play an important role in the expectation formation. We also found that survey participants have a tendency to underestimate inflation. A MAR model has also used to model stock market bubbles and crashes. This model has two regimes: the bubble regime and the error correction regime. In the error correction regime price depends on a fundamental factor, the price-dividend ratio, and in the bubble regime, price is independent of fundamentals. In this model a stock market crash is usually caused by a regime switch from a bubble regime to an error-correction regime. According to our empirical results bubbles are related to a low inflation. Our model also imply that bubbles have influences investment return distribution in both short and long run.

Executive Stock Options: Exercise Policy and Market Reaction

In this paper I investigate the exercise policy, and the market reaction to that, of the executive stock option holders in Finland. The empirical tests are conducted with aggregated firm level data from 34 firms and 41 stock option programs. I find some evidence of an inverse relation between the exercise intensity of the options holders and the future abnormal return of the company share price. This finding is supported by the view that information about future company prospect seems to be the only theoretical attribute that could delay the exercise of the options. Moreover, a high concentration of exercises in the beginning of the exercise window is predicted and the market is expected to react to deviations from this. The empirical findings however show that the market does not react homogenously to the information revealed by the late exercises.

Empirical Studies on Labor Market Matching (summary section only)

This thesis analyzes how matching takes place at the Finnish labor market from three different angles. The Finnish labor market has undergone severe structural changes following the economic crisis in the early 1990s. The labor market has had problems adjusting from these changes and hence a high and persistent unemployment has followed. In this thesis I analyze if matching problems, and in particular if changes in matching, can explain some of this persistence. The thesis consists of three essays. In the first essay Finnish Evidence of Changes in the Labor Market Matching Process the matching process at the Finnish labor market is analyzed. The key finding is that the matching process has changed thoroughly between the booming 1980s and the post-crisis period. The importance of the number of unemployed, and in particular long-term unemployed, for the matching process has vanished. More unemployed do not increase matching as theory predicts but rather the opposite. In the second essay, The Aggregate Matching Function and Directed Search -Finnish Evidence, stock-flow matching as a potential micro foundation of the aggregate matching function is studied. In the essay I show that newly unemployed match mainly with the stock of vacancies while longer term unemployed match with the inflow of vacancies. When aggregating I still find evidence of the traditional aggregate matching function. This could explain the huge support the aggregate matching function has received despite its odd randomness assumption. The third essay, How do Registered Job Seekers really match? -Finnish occupational level Evidence, studies matching for nine occupational groups and finds that very different matching problems exist for different occupations. In this essay also misspecification stemming from non-corresponding variables is dealt with through the introduction of a completely new set of variables. The new outflow measure used is vacancies filled with registered job seekers and it is matched by the supply side measure registered job seekers.