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



xi
LIST OF TABLES

Table 1. Expected signs on explanatory variables for sovereign sample 104
Table 2. Summary statistics for sovereign sample 105
Table 3. Sovereign spreads fixed effect regressions 106
Table 4. Expected signs on explanatory variables for domestic sample 107
Table 5. Summary statistics for domestic sample 108
Table 6. Domestic spreads fixed effect regressions 109
Table 7. Correlation structure of residuals 110
Table 8. Principal component analysis of residuals 112
Table 9. Sovereign and domestic regressions including the common factors 114
Table 10. Vector autoregression model with exogenous variables 115
Table 11. Summary statistics 116
Table 12. Extreme correlations using different number of tail exceedances 117
Table 13. Sovereign rating changes by Standard & Poor's 118
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

xii
Table 20. Cumulative Abnormal Returns (CAR) for stocks with international financing
125
Table 21. Cumulative Abnormal Returns (CAR) for all stocks following a sovereign
rating downgrade 126
Table 22. Cumulative Abnormal Returns (CAR) for all stocks following a sovereign
rating upgrade 129
Table 23. Countries included in this comparison 132
Table 24. Coverage for sovereign bonds on Datastream and Warga databases. 133

xiii
LIST OF FIGURES
Figure 1. First common component 135
Figure 2. Second common component 135
Figure 3. Q-Q Plots for the left tail and the right tail of the dollar return of the Mexican
equity index 136
Figure 4. Q-Q Plots for the left tail and the right tail of the dollar return of the Mexican
ADR equally weighted portfolio 137
Figure 5. Q-Q Plots for the left tail and the right tail of the dollar return of the S&P 500
equity index 138
Figure 6. Excess mean graphs for the left tail and the right tail of the dollar return of the
Mexican equity index 139
Figure 7. Excess mean graphs for the left tail and the right tail of the dollar return of the
Mexican ADR equally weighted portfolio 140
Figure 8. Excess mean graphs for the left tail and the right tail of the dollar return of the
S&P 500 equity index 141
Figure 9. Correlation between S&P and the Mexican stock market index and correlation
between S&P and Mexican ADRs 142
Figure 10. Correlation between S&P and the Chilean stock market index and correlation
between S&P and Chilean ADRs 142

xiv
Figure 11. Correlation between S&P and the Venezuelan stock market index and
correlation between S&P and Venezuelan ADRs 143
Figure 12. Correlation between S&P and the Colombian stock market index and
correlation between S&P and Colombian ADRs 143
Figure 13. Correlation between S&P and the Brazilian stock market index and correlation
between S&P and Brazilian ADRs 144

Figure 14. Correlation between S&P and the Argentinean stock market index and
correlation between S&P and Argentinean ADRs 144
Figure 15. Correlation between S&P and the Mexican stock market index and correlation
between S&P and Mexican ADRs before the 1995 Mexican crisis 145
Figure 16. Correlation between S&P and the Mexican stock market index and correlation
between S&P and Mexican ADRs after the 1995 Mexican crisis 145
Figure 17. Sovereign Downgrades (S&P) 146
Figure 18. Sovereign Upgrades (S&P) 146
Figure 21. Sovereign Downgrades (Moody’s) 147
Figure 20. Sovereign Upgrades (Moody’s) 147



1



CHAPTER 1

INTRODUCTION

The last twenty years have witnessed large reductions in regulations and barriers
that 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 debt spread
changes for domestic and sovereign debt after taking into account fundamentals are
related, and then proceeds to analyze the determinants of these common factors. This
dissertation essay looks at two groups of assets that had previously been studied only

separately. It focuses on credit spread changes of U.S domestic bonds and sovereign
bonds, making it the first paper to bring together these two groups of individual bonds to
study their joint dynamics.
Previous research in spread changes of U.S. domestic bonds identified a common
component unrelated to credit risk in the time-series and cross-section of the unexplained
portion of the spreads (Collin-Dufresne, Goldstein and Martin, 2001; Huang and Huang,
2003). If the U.S. and overseas market for dollar-denominated credit-risky bonds is

2
integrated, the information present in the unexplained portion of U.S. dollar sovereign
debt spread changes should be related to unexplained portion of U.S, domestic bonds
spread changes. This especially should be the case if that common component can be
explained by liquidity shocks, since such shocks are pervasive across markets (Chen,
Lesmond, and Wei, 2002; Chordia, Sarkar, and Subrahmanyam, 2003; Kamara, 1994).
Existing research investigates separately the existence of common components in
changes in credit spreads for domestic credit-risky debt (Collin-Dufresne, Goldstein and
Martin, 2001) and dollar-denominated sovereign debt (Scherer and Avellaneda, 2000;
Westphalen, 2003). The contribution of this dissertation essay is to study the relation
between the common components identified in domestic debt and the common
components found in sovereign credit spreads.
To conduct this analysis, a new dataset comprised of all domestic industrial and
U.S. dollar-denominated sovereign debt is constructed. This dataset contains data for 233
non-callable, non-puttable bonds issued by 37 emerging countries and 3097 domestic
corporate bonds issued by 649 different companies that traded between January 1990 and
January 2003. Results obtained help to discriminate between competing explanations for
the common component previously documented for domestic debt, and also might
suggest new explanations.
I find strong evidence of the existence of two common factors unrelated to credit
risk in debt spread changes of U.S. denominated sovereign debt and in the debt spread
changes of domestic bonds. While principal component analysis shows no evidence of

contemporaneous correlation between the two domestic and the two sovereign factors, a
vector autoregressive (VAR) model shows that domestic spread changes are related to the

3
lagged sovereign spread’s first principal component. Finally, I find that all four common
factors are related to the flows of money going into equity and bond funds, and the
second common component of each group is related to the net borrowed reserves from
the Federal Reserve, a macroeconomic measure of liquidity.
The second dissertation essay analyses the extent of the financial and economic
integration between Latin American countries and the United States by focusing on the
behavior of linkages between financial assets using a statistical technique known as
Extreme Value Theory (EVT). EVT is the study of outliers or extremal events. Since
large movements in returns are usually characteristic of financial crisis and since these
large movements can be considered outliers, the use of EVT seems to be warranted. This
approach has several advantages. First among these are the well-known results on
asymptotic behavior of the distribution of very high quantiles. Second, no assumptions
are needed about the true underlying distribution that generated data in the first place.
Since financial contagion usually occurs during periods of very high distress, it seems to
be best analyzed using techniques that focus on the tails of a distribution function. (Bae,
Karolyi and Stulz, 2003)
The financial assets I analyze are American Depositary Receipts (ADRs) and their
domestic counterparts in Latin America. Latin American firms can cross-list their shares
in the U.S. via ADR programs, and at the end of 2001 there were 1,322 non-U.S. firms
with sponsored programs, including 623 trading on American stock exchanges with a
total trading volume of $752 billion.
This chapter documents evidence of the asymmetric transmission of shocks from
U.S. stock 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 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 on elliptic distributions for the often temporary, but large,
movements in prices.
The third dissertation essay studies the effect of sovereign credit rating changes
on the cross-section of locally-traded firms. A sovereign credit rating reflects the rating
agency’s opinion on the ability and willingness of sovereign governments to service their
outstanding financial obligations and it reflects macroeconomic factors related to political
and financial stability. Sovereign credit ratings have large effects that spread to firms
located within their borders, and changes to these ratings constitute country-wide shocks
that can have sizable effects on the terms under which firms obtain financing and the
overall cost of capital.
This chapter contributes to the existing literature by extending our understanding
of how much information sovereign rating changes convey to individual stocks within
domestic markets. Specifically, I investigate if and why a country rating matters for firms
within a country. I show that sovereign rating changes affect the terms on which a
domestic firm can get credit, creating an exogenous change in the cost of capital. I divide
the results into two parts: I first present the effect of rating changes at the aggregate level
using national stock indices, and then proceed to study the effect of those sovereign
rating changes on the individual firms located within those countries. Index level results
are consistent with the extant literature on the effect of credit-rating changes on U.S.

5
firms. I do find evidence of a significant negative stock price reaction to sovereign rating
downgrades while I find no evidence of a stock price reaction to sovereign rating
upgrades. Further, I document that local stock markets react only to news of sovereign
rating downgrades issued by Standard & Poor’s.
To conduct this analysis I collected all sovereign rating changes issued by
Standard and Poor’s (S&P) and Moody’s on 29 emerging countries from 1986 until 2003.

I study the stock price reaction to 136 downgrades (81 from S&P and 55 from Moody’s)
and 100 upgrades (57 and 43 from S&P and Moody’s respectively). I also collect
information on 1281 individual firms located in 29 emerging countries. After computing
abnormal returns for each firm, cross-sectional regressions of those abnormal returns are
run on firm-specific characteristics and country-specific variables. I document how the
size and wealth of the country where a firm is domiciled are related to the extent to which
that a firm will be affected by a sovereign-rating change. 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.



6



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 research has focused on one type of bonds at
a time, making this paper the first one to bring together the credit spreads on these two
types of debt to study their joint dynamics. If the market for dollar-denominated credit-
risky bonds is integrated, we can expect credit and non-credit related shocks to affect all
bonds, i.e. the information present in the time series cross-section of the unexplained

portion of U.S. dollar sovereign debt spread changes should be related to the common
component unrelated to credit risk identified by previous research in spread changes of
U.S. domestic bonds (Collin-Dufresne, Goldstein and Martin, 2001; Huang and Huang,
2003). This should especially be the case if that common component can be explained by
liquidity shocks, since such shocks are pervasive across markets (Chen, Lesmond, and
Wei, 2002; Chordia, Sarkar, and Subrahmanyam, 2003; Kamara, 1994). In this chapter, I
investigate whether common factors that explain credit spread changes for domestic and
sovereign debt after taking into account fundamentals are related and analyze the
determinants of these common factors.

7
Existing research investigates separately the existence of common components in
changes in credit spreads for domestic credit-risky debt and dollar-denominated
sovereign debt. Scherer and Avellaneda (2000) identify the existence of two common
factors for sovereign debt spread changes. 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.
I extend the research on common components present in bond spreads by
examining whether the information in the dynamics of U.S. dollar denominated sovereign
debt spreads is associated with the common component found in U.S. corporate bond
spreads. Specifically, I estimate different models of spread changes for each type of
bonds – domestic and sovereign – because these two groups vary in their source of credit
risk. Using principal component analysis for each debt type, I extract common factors
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 relations I
uncover.
To conduct this analysis, I construct a new dataset that is comprised of all
domestic industrial and U.S. dollar-denominated sovereign debt. This dataset contains

8
data for 233 non-callable, non-puttable bonds issued by 37 emerging countries and 3097
domestic corporate bonds issued by 649 different companies that traded between January
1990 and January 2003. This dataset is different from the ones used by earlier studies in
at least three ways. First, extant bond studies that use Datastream bond data do not
include ‘dead’ issues, i.e., bonds that have matured or were retired, while I include them
to avoid a survivorship bias. Second, the Fixed Income Database used in some other
studies has a limited coverage of high-yield issues since it mainly covers investment-
grade bonds (Huang and Kong, 2003). I do not have this problem because my dataset
contains data for the complete universe of bonds covered by Datastream.
1
Finally, this
dataset covers a longer time period than any previous study.
My results help to discriminate between competing explanations for the common
component previously documented for domestic debt, and also suggest new explanations.
I find strong evidence of the existence of two common factors unrelated to credit risk in
debt spread changes of U.S. denominated sovereign debt and in the debt spread changes
of domestic bonds. While principal component analysis shows no evidence of
contemporaneous correlation between the two domestic and the two sovereign factors, a
vector autoregressive (VAR) model shows that domestic spread changes are related to the
lagged sovereign spread first common component. Finally, I find that all four common
factors are related to the flows of money going into equity and bond funds, as measured
by the Investment Company Institute (ICI), while only the second common component of

1
Informal conversations with Datastream’s customer service revealed that several large banks, including
Lehman Brothers, were among their providers for bond data. Since Lehman Brothers was the provider for
the FISD, we feel confident Datastream’s data includes what is covered in the FISD and has broader
coverage of high-yield bonds because of the additional data providers. A comparison between FISD and
Datastream sovereign bond data can be found in Annex A.

9
each group is related to the net borrowed reserves form the Federal Reserve, a
macroeconomic measure of liquidity.
This chapter is the first one to bring together these two types of credit-risky
dollar-denominated debt to study the joint dynamics of the common factors in their credit
spreads. The results I obtain improve our understanding of the determinants of the cost of
debt for foreign countries and for domestic firms. For example, my results suggest that
the cost of debt for foreign countries and domestic firms is not only a function of their
own creditworthiness but also depends on shocks that affect the price of all debt.
Further, these results help us understand better the extent to which the sovereign
and domestic corporate bond markets are integrated. In a fully integrated dollar debt
market, we would expect the relation between domestic corporate credit spreads and
sovereign credit spreads to be contemporaneous. Further research should investigate
whether the lack of a contemporaneous relation is due to differences in liquidity and
infrequent trading or if this reflects a market inefficiency.
Finally, the lack of a relation between the common components of domestic
corporate credit spread changes and sovereign credit spread changes suggests that the
cost of debt for emerging markets depends mostly on country and emerging-market
specific considerations. This is surprising in light of a considerable literature that
emphasizes the impact of developed country developments for capital flows into
emerging markets (Calvo, Leiderman, and Reinhart, 1993; Chuhan, Claessens, and
Mamingi, 1998). Further investigation of the robustness of my results might shed greater
insight into this issue.

10
This chapter proceeds as follows. Section II describes the literature, sample,
variables and methodology used to model credit spread changes for sovereign bonds.
Section III does the same for credit spread changes for domestic corporate bonds. I
investigate, using a variety of techniques, the existence and nature of the factors affecting
debt spread changes in section IV. Section V analyzes the dynamics of the common
factors and investigates whether liquidity and/or demand related variables are related to
them. Section VI concludes.

2.2 Debt spreads of sovereign bonds
In order to examine whether a common factor is associated with the variation in
U.S. domestic corporate and U.S. dollar denominated sovereign spreads, the unexplained
variation in each spread (i.e. residuals) must be calculated. My choice of variables to
compute the credit risk portion of debt spread changes is based on the determinants of
bond spread changes specified by structural models. For sovereign bond spreads, I expect
bond-specific characteristics to be associated with bond spreads. Additionally, I expect
bond spreads to be related to macro or country-specific factors as well as systematic
factors. In this section, I review the relevant literature on U.S. dollar denominated
sovereign bond spreads (section 2.1), and then discuss the testable implications of the
extant literature and describe the proxies that are used to test the hypotheses derived from
it (section 2.2). I describe the sovereign bond sample next (section 2.3), present a model
to estimate debt spreads, discuss the results, and explain the computation of residuals
(section 2.4).


11
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 payments forced several emerging
market countries to the verge of default. To avoid the ripple effects of such a default on
the world’s financial system –which was still recovering from the 1987 stock market
crash the U.S. government helped put in place a plan that would allow these countries
to orderly restructure their debt schedule. The Brady plan, formulated in 1989 by then
Secretary of the Treasury Nicholas Brady in association with the World Bank and IMF,
called for the issuance of sovereign bonds to replace the loans of commercial banks.
2

Brady bonds opened a vast and untapped market for emerging market countries hungry
for U.S. dollars to help finance their growth, commercial deficits or simply to cover
current expenses. Bank loans, while still an important component in sovereign debt
balances, gave way to sovereign bonds as the principal financing instrument for emerging
countries in the 1990s. Bonds were clearly preferred for several reasons, for instance the
dispersion of creditors and the existence of a market where these bonds could be actively
traded, which provided investors with a transparent benchmark measure of country risk.


2
These bonds were coupon bearing (fixed, floating or hybrid), long maturity (ten to thirty years) issued in
registered or bearer form, whose principal and part of the interest were guaranteed by collateral of U.S.
Treasury bonds and other high grade securities. Some of them included special recovery rights (warrants)
that could be detached and traded separately. This last characteristic made the computations of yields for
these bonds especially tricky.