Gregory W. Brown

Managing Foreign Exchange Risk With Derivatives

This study investigates the foreign exchange risk management program of HDG Inc. (pseudonym), an industry leading manufacturer of durable equipment with sales in more than 50 countries. The analysis relies primarily on a three-month field study in the treasury of HDG. Precise examination of factors affecting why and how the firm manages its foreign exchange exposure are explored through the use of internal firm documents, discussions with managers, and data on 3110 foreign-exchange derivative transactions over a three and a half year period. Results indicate that several commonly cited reasons for corporate hedging are probably not the primary motivation for why HDG undertakes a risk management program. Instead, informational asymmetries, facilitation of internal contracting, and competitive pricing concerns seem to motivate hedging. How HDG hedges depends on accounting treatment, derivative market liquidity, foreign exchange volatility, exposure volatility, technical factors, and recent hedging outcomes.

The Effects of Derivatives on Firm Risk and Value

Using a large sample of nonfinancial firms from 47 countries, we examine the effect of derivative use on firm risk and value. We control for endogeneity by matching users and nonusers on the basis of their propensity to use derivatives. We also use a new technique to estimate the effect of omitted variable bias on our inferences. We find strong evidence that the use of financial derivatives reduces both total risk and systematic risk. The effect of derivative use on firm value is positive but more sensitive to endogeneity and omitted variable concerns. However, using derivatives is associated with significantly higher value, abnormal returns, and larger profits during the economic downturn in 2001–2002, suggesting that firms are hedging downside risk.

Why Are U.S. Stocks More Volatile

From 1991 to 2006, U.S. stocks are more volatile than stocks of similar foreign firms. A firm’s stock return volatility in a country can be higher than the stock return volatility of a similar firm in another country for reasons that contribute positively (good volatility) or negatively (bad volatility) to shareholder wealth and economic growth. We find that the volatility of U.S. firms is higher mostly because of good volatility. Specifically, firm stock volatility is higher in the U.S. because it increases with investor protection, stock market development, research intensity at the country level, and firm-level investment in R&D. These are all factors that are related to better growth opportunities for firms and better ability to take advantage of these opportunities. Though it is often argued that better disclosure is associated with greater volatility as more information is impounded in stock prices, we find instead that greater disclosure is associated with lower stock volatility.

Market reaction to public information: The atypical case of the Boston Celtics

Abstract The publicly traded Boston Celtics Limited Partnership shares provide a unique means of studying the impact of information on equity prices. The results of the Celtics’ basketball games significantly affect partnership share returns, trading volume, and volatility. Controlling for the expectedvalue of the signal using betting-market point spreads has little effect on these relations. Investors respond asymmetrically to wins and losses, and playoff games have a larger impact on returns than regular-season games. Opening prices do not fully reflect game results, consistent with previous findings that significant volatility is caused by traders acting on private information.

Why Do Foreign Firms Have Less Idiosyncratic Risk than U.S. Firms

Using a large panel of firms across the world from 1991-2006, we show that the median foreign firm has lower idiosyncratic risk than a comparable U.S. firm. Country characteristics help explain variation in idiosyncratic risk across countries in both level and change regressions, but less so than firm characteristics. There exists a strong negative relation between idiosyncratic risk and an index of government stability and quality. Further, idiosyncratic risk is positively related to financial development. Surprisingly, there is evidence that firms have less idiosyncratic risk in countries with greater transparency. Finally, idiosyncratic risk does not appear to be related to investor protection laws. Our results support theories predicting that better financial development leads firms to undertake riskier investments, but they are inconsistent with theories predicting that more firm-specific information increases idiosyncratic stock return volatility.

Constructing Binomial Trees From Multiple Implied Probability Distributions

Rubinsteins seminal work on implied binomial trees showed how to fit a tree to a set of market prices for options maturing on a single date. A problem with the technique is that the tree it produces cannot match option prices for multiple maturities, so it cannot simultaneously cover a full set of options traded in a given market. The tree structure needed for that task is significantly more complex than a simple binomial. Brown and Toft show how such a general tree may be implied out of a set of option market prices. They then illustrate the technique using S&P 500 index options and currency options on the deutschemark. The resulting trees even embody patterns of path dependence commonly observed in volatilities.

Do Private Equity Funds Manipulate Reported Returns

By their nature, private equity funds hold assets that are hard to value. This uncertainty in asset valuation gives rise to the potential for fund managers to manipulate reported net asset values (NAVs). Managers may have an incentive to game valuations in the short-run if these are used by investors to make decisions about commitments to subsequent funds managed by the same firm. Using a large dataset of buyout and venture funds, we test for the presence of reported NAV manipulation. We find evidence that some managers boost reported NAVs during times that fundraising activity is likely to occur. However, those managers are unlikely to raise a next fund, suggesting that investors see through the manipulation. In contrast, we find that top-performing funds under-report returns. This conservatism is consistent with these firms insuring against future bad luck that could make them appear as though they are NAV manipulators. Our results are robust to a variety of specifications and alternative explanations.Private equity funds hold assets that are hard to value. Managers may have an incentive to distort reported valuations if these are used by investors to decide on commitments to subsequent funds managed by the same firm. Using a large dataset of buyout and venture funds, we test for the presence of reported return manipulation. We find evidence that some under-performing managers boost reported returns during times when fundraising takes place. However, those managers are unlikely to raise a next fund, suggesting that investors see through much of the manipulation. In contrast, we find that top-performing funds likely understate their valuations.

How Important is Financial Risk

We explore the determinants of equity price risk for a large sample of non-financial corporations. By estimating both cross-sectional and time-series models, we show that operating and asset characteristics are by far the most important determinants of equity price risk. In contrast, for the average (median) firm, financial risk accounts for less than a third (15%) of observed stock price volatility. This explains why financial distress (as opposed to economic distress) was surprisingly uncommon in the nonfinancial sector during the recent crisis even as measures of equity volatility reached unprecedented highs.

What Do Different Commercial Data Sets Tell Us About Private Equity Performance

This paper examines private equity (both buyout and venture funds) performance around the globe using four data sets from leading commercial sources. For North American funds, our results echo recent research findings: buyout funds have outperformed public equities over long periods of time; in contrast, venture funds saw performance fall after spectacular results for vintages in the 1990s. For funds outside North America, buyout funds show performance similar to those in North America while venture fund performance is weaker than in North America. Venture samples outside North America are, however, relatively small and strong conclusions await further research. The similarity of performance estimates across the data sets strengthens confidence in conclusions about the results of private equity investing.

A New Lease on Life: Institutions, External Financing, and Business Growth

This research utilizes data from the World Bank Investment Climate Survey to examine the use of external capital for almost 70,000 small and medium-sized firms in 103 developing and developed countries. Contrary to conventional wisdom, we find that most small firms in even the poorest countries have access to some type of external financing, however, the sources differ systematically by institutional and firm characteristics. For example, firms in poorer countries, with generally weaker institutions, use far less leasing for new investment and instead rely more on informal sources of capital such as money lenders and credit cards. We confirm that access to external capital is related to faster growth. Surprisingly, leasing is the only source of external finance related to growth in GDP and the manufacturing sector.