Chris Florackis

Boards of Directors and Financial Risk during the Credit Crisis

Research Question/Issue: This research examines the relationship between board processes and corporate financial risk. Using a unique questionnaire survey about board behavior, several measures related to board processes are developed and used to explain certain aspects of financial risk during the recent crisis. Research Findings/Insights: In a sample of 141 companies with complete data collected from company chairs on both board structure and process, board process is found to be an important determinant of financial risk during the crisis of 2008-2009. In particular, financial risk is lower where non-executive directors have high effort norms and where board decision processes are characterized by a degree of cognitive conflict. The impact of cognitive conflict is however found to be less pronounced in boards with high levels of cohesiveness. Theoretical/Academic Implications: The study provides theoretical and empirical advancement of the governance literature towards an understanding of group process-oriented views of boards’ work and effectiveness. This study identifies the significance of board processes and their impact on financial risk supported by quantitative empirics. Findings of a strong relationship between board process and financial risk augment existing theories to suggest that the effects of boards work through group processes that bring executives and non-executives together in relations laced with control and collaboration.Practitioner/Policy Implications: Regulators, acting post the financial crisis have produced governance codes that emphasize risk management as a key responsibility of boards. The link between board process and financial risk established in this paper provides evidence for company chairs and other directors on the possibilities and potential effectiveness of boards in discharging this responsibility.

Dividend policy, managerial ownership and debt financing: A non-parametric perspective

This paper examines the relation between dividend policy, managerial ownership and debt-financing for a large sample of firms listed on NYSE, AMEX and NASDAQ. In addition to standard parametric estimation methods, we use a semi-parametric approach, which helps capture more effectively non-linearities in the data. In line with the alignment effect of managerial ownership, our results support a negative relationship between managerial ownership and dividends when managerial ownership is at relatively low levels. However, this negative relationship turns into a positive one at very high levels of managerial ownership. We also find that the nature of the relationship between managerial ownership and dividends may be more complex than it has been previously thought, and it also differs significantly across firms with different levels of debt/financial constraints. The results are consistent with the view that agency theory provides useful insights but cannot fully explain how firms determine their dividend policy.

Do Stock Returns Really Decrease with Default Risk? New International Evidence

This study constructs a unique dataset of bankruptcy filings for a large sample of non-U.S. firms in 14 developed markets and sheds new light on the cross-sectional relation between default risk and stock returns. Using the flexible approach of Campbell et al. (2008) to estimate default risk probabilities, this is the first study to offer conclusive evidence supporting the existence of an economically and statistically significant positive default risk premium in international markets. This finding is robust to different portfolio weighting schemes, data filters, sample periods and holding period definitions, and holds using both in-sample estimates of default probabilities during the period 1992-2010 and out-of-sample estimates during the period 2000-2010. We also show that the magnitude of the default risk premium is contingent upon a series of firm characteristics.

Disappointment aversion and the equity premium puzzle: new international evidence

Drawing upon the seminal study of Ang, Bekaert, and Liu [2005. “Why Stock May Disappoint?” Journal of Financial Economics 76 (3): 471–508], we incorporate disappointment aversion (DA, that is, aversion to outcomes that are worse than prior expectations) within a simple theoretical portfolio-choice model. Based on the results of this model, we then empirically address the portfolio allocation problem of an investor who chooses between a risky and a risk-free asset using international data from 19 countries. Our findings strongly support the view that DA leads investors to reduce their exposure to the stock market (i.e. DA significantly depresses the portfolio weights on equities in all cases considered). Overall, our study shows that in addition to risk aversion, DA plays an important role in explaining the equity premium puzzle around the world.

Idiosyncratic Risk, Risk-Taking Incentives and the Relation Between Managerial Ownership and Firm Value

In addition to its well-documented alignment effect, managerial ownership can also have value-destroying effects by shifting risk to managers and encouraging risk-substitution; that is, managers with relatively unhedged personal portfolios tend to pass up profitable projects with high idiosyncratic (firm-specific) risk in favor of less-profitable projects that have greater aggregate (market) risk. Using parametric and semi-parametric estimation methods, we examine how managerial ownership influences firm value in light of the trade-off between the alignment and the risk-substitution effects. We find that risk-substitution offsets the alignment effect of managerial ownership in firms that are exposed to severe risk-substitution problems, leading to a weak (or non-existent) association between managerial ownership and firm value. We identify a plausible channel for these effects by showing that firms exposed to risk-substitution exhibit more “conservative” investment and financing policies. We also show that the risk-substitution problem is partially mitigated by the inclusion of stock options in managerial compensation packages. Finally, our findings suggest that semi-parametric methods may prove useful for future studies aiming at capturing nonlinear features in the data.