Essays on analyzing three financial instruments

Abstract

This dissertation consists of three essays on financial instruments: stock, derivatives, and real estate investment trusts (REITs). Specifically, we explore the effect of firm-specific daily investor sentiment on the cross-section of stock returns, investors’ reaction to unexpected funds from operation (FFO) and unexpected net income (NI) in REIT industry, and determinants of hedging with derivatives and their impact on firm value and firm risk.

The first essay examines the relation between investor sentiment and asset returns in the Korean stock market, which is characterized by significant information asymmetry and a high degree of market sentiment. We also analyze the role of firm characteristics in the significance of the effect of sentiment on individual stock returns by conducting a sorted comparison, regression for portfolios constructed based on firm characteristics, and regression for long-short portfolios. Our empirical results indicate that sentiment is positively related to realized stock returns in the short term. This result contrasts with findings of a longer-term relation in developed markets. Furthermore, the positive relation between sentiment and realized returns is more prominent for firms that are harder to value (e.g., smaller firms, more volatile firms, firms with higher book-to-market ratios, unprofitable firms, more distressed firms, and firms with fewer trades by arbitrageurs).

The second essay compares investors’ reaction to unexpected FFO and unexpected NI in the REIT industry by analyzing the market reactions to earnings surprises for FFO and NI. Using simple linear, asymmetric, and quadratic models, we find that models using FFO explain significantly more of the variance in cumulative abnormal returns around earnings announcement dates than models using NI do. This finding supports the claim of the REIT industry that FFO provides more appropriate information about REITs’ operating performance than NI does. We also find that the information content of FFO differs across REITs of different sizes. FFO does not provide useful information to investors in the case of large REITs, and thus, FFO’s superiority over NI in terms of information content disappears for large REITs. Finally, we show that gains or losses from sales of property, which is excluded from NI in calculating FFO, is relevant for valuing large REITs, which explains FFO’s inability to reflect the operating performance of large REITs.

The third essay investigate determinants of hedging with derivatives and its effect on firm value and firm risk for Korean firms. To avoid the endogeneity problem pointed out in previous studies, we use a two-stage analysis by using gains and losses from derivatives as instrument variable for hedging with derivatives. Our analysis on the determinants of hedging shows that firms that are more leveraged and less profitable, and with more growth opportunities are likely to hedge through derivatives. Additionally, large firms, firms less diversified into industry, and firms more diversified geographically are likely to use derivatives. Our two-stage analysis shows that indicators of hedging with derivatives have an insignificant effect on firm value, and the indicator of futures/forwards use and of swaps use have significant negative effect on firm value. Whereas, the extent of hedging with derivatives has positive effect on firm value for all types of foreign currency derivatives, which suggests that moderately low hedgers use derivatives inefficiently, but extensive hedgers use derivatives properly. With regard to firm risk, hedging with derivatives increases market-based risk, but decreases accounting-based risk. Thus, we conclude that Korean firms use derivatives to manage operational volatility rather than to manage market risk, and accounting-based risk reduction through hedging is not directly translated into higher firm value.