three essays in international finance

THREE ESSAYS IN INTERNATIONAL FINANCE DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Rodolfo Martell, M.A. The Ohio State University 2005 Dissertation Committee: Approved by Professor René M. Stulz, Adviser Professor G. Andrew Karolyi _________________ Adviser Professor Bernadette A. Minton Graduate Program in Business Administration ii ABSTRACT Recent research in international finance focuses on the extent to which markets are integrated across countries, how shocks propagate from one country to another and how firms in foreign countries react to country level shocks. This dissertation provides empirical evidence on the degree of integration in international bond markets, on the propagation of extreme shocks between cross-listed shares and domestic markets and on the dispersion in capital market reactions across firms to sovereign rating changes. In the first dissertation essay, I study the determinants of credit spread changes of individual U.S. dollar denominated bonds – domestic and foreign sovereign – using fundamentals specified by structural models. Credit spreads are important determinants of the cost of debt for all issuers and are fully determined by credit risk in structural models. I construct a new dataset of domestic corporate and sovereign U.S. dollar bonds, which I use to find that changes in spreads not explained by fundamentals have two large common components that are distinct for each type of debt I study. Using a vector autoregressive (VAR) model, I find that domestic spreads are related to the lagged first component of sovereign spreads. Consequently, even though there is no contemporaneous common component in bond spreads, there seems to be a common component when focusing on the dynamics of these spreads. Traditional macro liquidity iii variables are related to the common components found in domestic and sovereign spread changes. My findings suggest possible explanations for the common component documented by previous research in domestic debt spreads. My research shows that, after taking into account the dynamics of the common components in credit spreads across debt types, the cost of debt for firms and countries depends to some extent on shocks that affect all types of debt. The second dissertation essay studies the extreme linkages between Latin American equities and the US stock market using tools from Extreme Value Theory (EVT). Bivariate extreme value measures are applied on six different country pairs between the U.S. S&P500 Index and each of the following countries: Argentina, Brazil, Chile, Colombia, Mexico and Venezuela. I find evidence of: a) asymmetric behavior in the left and right tails of the joint marginal extreme distributions, and b) differences in extreme correlations for different instruments (investing in ADRs vs. investing directly in the local stock markets) when no difference was to be expected. There is also evidence of a structural change in the correlations for the Mexican case before and after the 1995 Mexican crisis. The third dissertation essay studies the effect of sovereign credit rating changes issued by Standard and Poor’s and Moody’s on the cross section of domestically traded stocks. I first establish, consistent with earlier literature that analyzed similar phenomena in the U.S. (e.g. Holthausen and Leftwich, 1986; Goh and Ederington, 1993), that local stock markets react only to news of sovereign credit rating downgrades. Cumulative abnormal returns of stock indices also show that investors react only to rating announcements made by Standard & Poor’s and not to those by Moody’s. I then study the iv cross sectional variation of the abnormal returns of individual firms associated with sovereign credit rating changes. I find that larger firms experience larger stock price drops after a sovereign credit downgrade. Also, firms located in more developed emerging countries experience smaller stock price reductions following sovereign credit downgrades. Finally, I document that firms that had access to international capital markets experience larger abnormal returns than firms that do not have access to international financial markets. v Dedicated to my family vi ACKNOWLEDGMENTS I wish to thank my adviser, René Stulz, for intellectual support, encouragement, and enthusiasm which made this dissertation possible, and for his patience in correcting both my stylistic and methodological errors. I thank Andrew Karolyi for stimulating discussions, guidance, and encouragement, not only with this dissertation but throughout my graduate studies. I am grateful to Bernadette Minton for discussing with me various aspects of this thesis, and for her insightful feedback. I also wish to thank Mike Cooper, Craig Doidge, Jean Helwege, Francis Longstaff, and seminar participants at Drexel University, Fordham University, Ohio State University, Purdue University, Queen’s University, and University of Virginia for helpful comments and suggestions. vii VITA July 9, 1972 Born – Puebla, Puebla, Mexico 1996 Bachelor of Arts in Economics, Udla-Puebla, Mexico 1996 – 1999 Analyst, Bancrecer Petroleos Mexicanos 2000 Master of Arts in Economics, Ohio State University PUBLICATIONS Research Publication 1. R. Martell and R. Stulz, “Equity Market Liberalizations as Country IPOs.” American Economic Review, 93(2), 97, (2003) FIELDS OF STUDY Major Field: Business Administration Concentration: Finance viii TABLE OF CONTENTS Abstract ii Dedication v Acknowledgments vi Vita vii List of tables xi List of figures xiii Chapter 1: Introduction 1 Chapter 2: Understanding common factors in domestic and international bond spreads 6 2.1. Introduction 6 2.2. Debt spreads of sovereign bonds 10 2.2.1. Sovereign debt literature 11 2.2.2. Implications of the literature and proxies used to test them. 14 2.2.2.1 Bond-specific variables 15 2.2.2.2. Country-specific variables 15 2.2.2.3. U.S. interest rate term structure. 16 2.2.3. Data description 16 2.2.4. A model for sovereign spreads 20 2.3. Debt spreads of domestic bonds 22 2.3.1. Domestic debt literature 23 2.3.2. Theoretical determinants of domestic debt spreads 25 2.3.2.1. Bond specific variables 25 2.3.2.2. Firm specific variables 25 ix 2.3.2.3 U.S. interest rate term structure 26 2.3.3. Data description 26 2.3.4. A model for domestic debt spreads 28 2.4. Analyzing the common factor 29 2.4.1. Establishing the existence of common factors 29 2.4.2. Explanatory power of the extracted components 33 2.5. Looking into the information content of the common factors 34 2.5.1. Lead-lag relations 34 2.6. Conclusions and future work 39 Chapter 3. Latin American and U.S. equities return linkages: An extreme value approach 41 3.1 Introduction 41 3.2. Literature review 44 3.2.1. The univariate case 47 3.2.2. The bivariate case 50 3.3. Data 51 3.4 A small test for the Mexican pairs 55 3.5. Concluding remarks 55 Chapter 4. The effect of sovereign credit rating changes on emerging stock markets 58 4.1. Introduction 58 4.2. Literature review 65 4.3. The effect of sovereign rating changes on stock market indices 71 4.3.1. Data 72 4.3.2. Methodology 74 4.3.3. Discussion of index level results 75 4.4. Impact of sovereign rating changes at the firm level 79 4.5. Conclusions 86 Chapter 5: Conclusions 88 Bibliography 91 x Appendix A. A comparison of sovereign bond coverage on Datastream and the NAIC . 99 Appendix B. Tables 103 Appendix C. Figures 134 [...]... Table 14 Sovereign rating changes by Moody's 119 Table 16 Stock index results using Moody's ratings 121 Table 17 Stock index results using initial ratings 122 Table 18 First ratings for Argentina 123 Table 19 Stock market reaction to the first rating by either agency 124 xi Table 20 Cumulative Abnormal Returns (CAR) for stocks with international financing ... on the work of Longin (1996) and 3 Longin and Solnik (2001) applying EVT in finance by examining the linkage between financial assets available to U.S investors looking for international exposure before and after main events such as the 1995 Mexican crisis It also adds to the growing literature on financial contagion by employing a statistical technique more “appropriate” than current approaches based... periods of increased co-movements among international financial markets For instance, Cantor and Packer (1996) and Eichengreen and Moody (1998) study the determinants of bond spreads at the issue level, finding that agency ratings include most of the information existing in macroeconomic variables More recently, Scherer and Avellaneda (2000), Joutz and Maxwell (2002) and Cifarelli and Paladino (2002)... grouped in five different categories according to their S&P rating It is evident from panel A that all groups display a high degree of non-normality Also, as expected, spreads increase as we move down in ratings The mean debt spread in the overall sample is 483 basis points, the maximum spread is 3939 basis points and the minimum is 1.9 basis points Interestingly, the standard deviation also increases... More importantly, I find that previous access to international capital markets is an important determinant of the extent to which a firm is affected by a sovereign credit rating change 5 CHAPTER 2 UNDERSTANDING COMMON FACTORS IN DOMESTIC AND INTERNATIONAL BOND SPREADS 2.1 Introduction In this chapter I analyze the determinants of credit spread changes of individual U.S domestic and sovereign bonds Previous... Westphalen (2003) finds evidence of a common factor for sovereign debt spread changes of bonds denominated in several currencies after controlling for country risk proxies Research on changes in domestic bond credit spreads by Collin-Dufresne, Goldstein and Martin (2001) finds one common component after controlling for fundamentals The relation between these common components has not been examined in the literature... from the unexplained portion of credit spread changes from these models I investigate whether the common factors in U.S dollar denominated sovereign debt are related to the common factors present in U.S corporate debt spread changes using both regressions explaining contemporaneous changes in spreads and a dynamic model of changes in spreads Finally, I attempt to provide an economic interpretation for... the results, and explain the computation of residuals (section 2.4) 10 2.2.1 Sovereign debt literature The international debt market changed dramatically in the past 25 years In the 1980s bank loans were the principal instrument of this market By the end of that decade, reckless lending and borrowing caused outstanding debt balances to skyrocket to unsustainable levels The crushing pressure of debt... prevented financial integration across countries As markets slowly became more integrated, brand new fields for financial research opened up Not only could we study if foreign markets behaved in a similar way to U.S markets, but we also could study issues surrounding the integration of U.S and international financial markets The first dissertation essay investigates whether common factors that explain credit... movements in Brady bond’s prices might be reflecting low volume and thin trading problems and not changes associated with the underlying value of the issuer and the overall liquidity of the market For instance, Mexico’s Ministry of Finance and Public Credit announced on April 7, 2003 that it was calling US$3,839 million of its dollar-denominated Series A and B Brady Par Bonds, which were the last outstanding . markets into domestic markets. It builds on the work of Longin (1996) and 4 Longin and Solnik (2001) applying EVT in finance by examining the linkage between financial assets available to U.S. investors. Professor Bernadette A. Minton Graduate Program in Business Administration ii ABSTRACT Recent research in international finance focuses on the extent to which markets are integrated across. right tails of the joint marginal extreme distributions, and b) differences in extreme correlations for different instruments (investing in ADRs vs. investing directly in the local stock markets)