Innovations in Financial Risk

Malone, Sean Timothy
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This dissertation studies changes in financial risk around corporate decisions, improves the methodology to measure such changes, and explores the predictability of future changes in risk and their implications for future returns. The first essay examines how acquirers' bond spreads change around the announcement of an acquisition with a focus on the relationship between corporate governance, acquisition financing, and bondholder returns. Consistent with other event studies on changes in acquiring bondholder wealth, bond spreads increase on average. After controlling for sources of financing, we find that bond spreads increase less for firms with more provisions which weaken shareholder rights, except for poison pills. This finding is consistent with entrenched managers making investment decisions that are less risk increasing. Golden parachutes and poison pills appear to the most important governance policies to bondholders around acquisition announcements. We also find some evidence that entrenched managers are less likely to use debt. This paper contributes to the growing literature that finds that bondholders value some of the same corporate governance policies that shareholders oppose.

The second essay uses a simple model to explain much of individual stocks' implied volatility behavior with the market's implied volatility. Changes in standardized abnormal volatility, a measure based on model residuals, identify shocks to implied volatility independent of changes in market volatility. I use simulated data to examine the power of this measure using common statistical tests. The new method is more powerful than those in the existing literature. The change in standardized abnormal volatility identifies more than 90% of positive or negative volatility shocks as small as 75 basis points, while a characteristics-based matching method requires shocks 67% (33%) larger to perform at a similar level using t-tests (signed-rank tests). As case studies, I examine implied volatility around index changes and stock splits.

The third essay explores the predictive power of abnormal volatility. Higher levels of standardized abnormal volatility predict a decrease in implied volatility, an increase in idiosyncratic risk, and an increase in return volatility over the next month. A trading strategy based on standardized abnormal volatility generates significant returns not explained by common risk factors. A monthly zero-investment portfolio generates 0.53% (6.51% annualized) alpha. However, returns to an investment strategy that benefits from a hypothetical ability to perfectly predict the future change in implied volatility can explain the positive risk-adjusted returns to the abnormal volatility trading strategy. This suggests abnormal volatility's power to predict returns lies in its power to predict future innovations in implied volatility.

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bond spreads, corporate governance, event studies, implied volatility, mergers and acquisitions, predictability