Chotibhak Jotikasthira

Regulatory Pressure and Fire Sales in the Corporate Bond Market

This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. Regulations either prohibit or impose large capital requirements on the holdings of speculative-grade bonds. As insurance companies hold over one third of all outstanding investment-grade corporate bonds, the collective need to divest downgraded issues may be limited by a scarcity of counterparties and associated bargaining power. Using insurance company transaction data from 2001-2005, we find insurance companies that are relatively more constrained by regulation are, on average, more likely to sell downgraded bonds. This forced selling generates elevated selling pressure around the downgrade which causes price pressures and subsequent price reversals that are indicative of significant periods during which transaction prices deviate from fundamental values. Most importantly, bonds widely held by constrained insurance companies experience significantly larger price reversals. Investors providing liquidity to this market appear to earn abnormal returns. JEL classifications: G11; G12; G14; G18; G22

Why Do Term Structures in Different Currencies Comove

Yield curve fluctuations across different currencies are highly correlated. This paper investigates this phenomenon by exploring the channels through which macroeconomic shocks are transmitted across borders. Macroeconomic shocks affect current and expected future short-term rates as central banks react to changing economic environments. Investors could also respond to these shocks by altering their required compensation for risk. Macroeconomic shocks thus influence bond yields both through a policy channel and through a risk compensation channel. Using data from the US, the UK, and Germany, we find that world inflation and US yield level together explain over two-thirds of the covariance of yields at all maturities. Further, these effects operate largely through the risk compensation channel for long-term bonds.

Mark-to-Market Accounting and Systemic Risk: Evidence from the Insurance Industry

One of the most contentious issues raised during the recent crisis has been the potentially exacerbating role played by mark-to-market accounting. Many have proposed the use of historical cost accounting, promoting its ability to avoid the amplification of systemic risk. We caution against focusing on the accounting rule in isolation, and instead emphasize the interaction between accounting and the regulatory framework. First, historical cost accounting, through incentives that arise via interactions with complex capital adequacy regulation, does generate market distortions of its own. Second, while mark-to-market accounting may indeed generate fire sales during a crisis, forward-looking institutions that rationally internalize the probability of fire sales are incentivized to adopt a more prudent investment strategy during normal times which leads to a safer portfolio entering the crisis. Using detailed, position- and transaction-level data from the U.S. insurance industry, we show that (a) market prices do serve as ‘early warning signals’, (b) insurers that employed historical cost accounting engaged in greater degrees of regulatory arbitrage before the crisis and limited loss recognition during the crisis, and (c) insurers facing mark-to-market accounting tend to be more prudent in their portfolio allocations. Our identification relies on the sharp difference in statutory accounting rules between life and P&C companies as well as the heterogeneity in implementation of these rules within each insurance type across U.S. states. Rather than promoting a shift away from market-based information, our results indicate that regulatory simplicity may be preferred to the complexity of risk-weighted capital ratios that gives rise, through interactions with accounting rules, to distorted risk-taking incentives and potential build-up of systemic risk.

Governance under the Gun: Spillover Effects of Hedge Fund Activism

Hedge fund activism is an important monitoring mechanism associated with substantial improvements in the governance and performance of targets. In this paper, we investigate whether the managers of peer firms view activism in their industry as a threat, and undertake real policy changes to mitigate that threat. We find that they do – industry peers with fundamentals similar to those of previous targets reduce agency costs and improve operating performance along the same dimensions as the targets. These effects are distinct from those of product market competition or time-varying industry conditions, and are anticipated by the market as evidenced by increased valuations. Finally, we show that these policy and valuation improvements lower the peers’ ex-post probability of being targeted, suggesting that this “do-it-yourself” activism is indeed effective. Taken together, our results imply that shareholder activism, as an external governance device, reaches beyond the target firms.

Institutional Trading and Hedge Fund Activism

Hedge fund activists achieve substantial improvements in the performance and governance of target firms. These activists accumulate most of their holdings in the sixty days before a campaign when other institutions heavily sell target shares. Does institutional exit facilitate the emergence of value-enhancing activists? Three pieces of evidence indicate that the answer is yes. First, at the daily frequency, we identify a strong positive relationship between institutional selling and the activist’s purchases. Second, we find that institutional selling is driven by only a few investors who dispose of a disproportionately large fraction of their other holdings. This suggests that their sales of the target and the concurrent hedge fund purchases are not motivated by common firm-specific news. Third, we instrument an institution’s daily trading in the target by its trading in non-target stocks and establish a causal link between institutional sales and hedge fund purchases. Institutional exit lowers prices and increases turnover, creating favorable market conditions for an activist to acquire a block of target shares. Our results imply that even non-informational institutional trading can play an important corporate governance role by increasing the probability of activist interventions.

How do foreign investors impact domestic economic activity? Evidence from India and China

There has been renewed advocacy for restrictions on international financial flows in the wake of the recent financial crisis. Motivated by this trend, we explore the extent to which cross-border flows affect real economic activity. Unlike previous research efforts that focus on aggregated capital flows, we exploit novel data on forced trading by global mutual funds as a plausible source of exogenous flow shocks. Such forced trading is known to generate large liquidity and price effects, but its real impacts have not been studied extensively. We find that both country- and firm-level investment growth rates are significantly affected by these exogenous capital shocks, and that their effect is more pronounced for firms whose marginal investment decisions are more equity-reliant.