Market timing hypothesis

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The market timing hypothesis is a theory of how firms and corporations in the economy decide whether to finance their investment with equity or with debt instruments. It is one of many such corporate finance theories, and is often contrasted with the pecking order theory and the trade-off theory, for example. The idea that firms pay attention to market conditions in an attempt to time the market is a very old hypothesis.

Corporation Separate legal entity that has been incorporated through a legislative or registration process established through legislation

A corporation is an organization, usually a group of people or a company, authorized to act as a single entity and recognized as such in law. Early incorporated entities were established by charter. Most jurisdictions now allow the creation of new corporations through registration.

Economics Social science that analyzes the production, distribution, and consumption of goods and services

Economics is the social science that studies the production, distribution, and consumption of goods and services.

Debt deferred payment, or series of payments, that is owed in the future

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

Baker and Wurgler (2002), claim that market timing is the first order determinant of a corporation's capital structure use of debt and equity. In other words, firms do not generally care whether they finance with debt or equity, they just choose the form of financing which, at that point in time, seems to be more valued by financial markets. [1]

Capital structure

In finance, particularly corporate finance capital structure is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

Market timing is sometimes classified as part of the behavioral finance literature, because it does not explain why there would be any asset mis-pricing, or why firms would be better able to tell when there was mis-pricing than financial markets. Rather it just assumes these mis-pricing exists, and describes the behavior of firms under the even stronger assumption that firms can detect this mis-pricing better than markets can. However, any theory with time varying costs and benefits is likely to generate time varying corporate issuing decisions. This is true whether decision makers are behavioral or rational.

Market (economics) Mechanisms whereby supply and demand confront each other and deals are made, involving places, processes and institutions in which exchanges occur.

A market is one of the many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers. It can be said that a market is the process by which the prices of goods and services are established. Markets facilitate trade and enable the distribution and resource allocation in a society. Markets allow any trade-able item to be evaluated and priced. A market emerges more or less spontaneously or may be constructed deliberately by human interaction in order to enable the exchange of rights of services and goods. Markets generally supplant gift economies and are often held in place through rules and customs, such as a booth fee, competitive pricing, and source of goods for sale.

The empirical evidence for this hypothesis is at best, mixed. Baker and Wurgler themselves show that an index of financing that reflects how much of the financing was done during hot equity periods and how much during hot debt periods is a good indicator of firm leverage over long periods subsequently. Alti studied issuance events. He found that the effect of market timing disappears after only two years. [2]

Empirical evidence Knowledge acquired by means of the senses

Empirical evidence is the information received by means of the senses, particularly by observation and documentation of patterns and behavior through experimentation. The term comes from the Greek word for experience, ἐμπειρία (empeiría).

Hypothesis Proposed explanation for an observation, phenomenon, or scientific problem

A hypothesis is a proposed explanation for a phenomenon. For a hypothesis to be a scientific hypothesis, the scientific method requires that one can test it. Scientists generally base scientific hypotheses on previous observations that cannot satisfactorily be explained with the available scientific theories. Even though the words "hypothesis" and "theory" are often used synonymously, a scientific hypothesis is not the same as a scientific theory. A working hypothesis is a provisionally accepted hypothesis proposed for further research, in a process beginning with an educated guess or thought.

In the study of financial markets Hot equity periods or Hot Issue Periods are periods of time in which many firms perform initial public offering (IPO) of their equity. Firms in modern economies often finance themselves by the issuance in public markets of shares, also called equity. It turns out that these initial public offerings tend to cluster in time, so that one year many firms might be doing an IPO, while next year very few firms do it. These periods, in which many firms perform an IPO are called Hot Equity Periods.

Beyond such academic studies, a complete market timing theory ought to explain why at the same moment in time some firms issue debt while other firms issue equity. As yet nobody has tried to explain this basic problem within a market timing model. The typical version of the market timing hypothesis is thus somewhat incomplete as a matter of theory.

See also

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

In corporate finance, the pecking order theory postulates that the cost of financing increases with asymmetric information.

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Finance Academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

Leveraged buyout acquired control over a company by the purchase of its shares with borrowed money

A leveraged buyout (LBO) is a financial transaction in which a company is purchased with a combination of equity and debt, such that the company's cash flow is the collateral used to secure and repay the borrowed money. The use of debt, which normally has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition. The cost of debt is lower because interest payments often reduce corporate income tax liability, whereas dividend payments normally do not. This reduced cost of financing allows greater gains to accrue to the equity, and, as a result, the debt serves as a lever to increase the returns to the equity.

Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". Its concern is thus the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. It has two main areas of focus: asset pricing and corporate finance; the first being the perspective of providers of capital, i.e. investors, and the second of users of capital.

Equity (finance) difference between the value of the assets/interest and the cost of the liabilities of something owned

In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:

Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the economic decisions of individuals and institutions and how those decisions vary from those implied by classical theory.

The Modigliani–Miller theorem is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.

In economics and accounting, the cost of capital is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, and risk analysis.

In corporate finance, a leveraged recapitalization is a change of the company's capital structure, usually substitution of equity for debt

In economics, a liquidity premium is the explanation for a difference between two types of financial securities, that have all the same qualities except liquidity. It is a segment of a three-part theory that works to explain the behavior of yield curves for interest rates. The upwards-curving component of the interest yield can be explained by the liquidity premium. The reason behind this is that short term securities are less risky compared to long term rates due to the difference in maturity dates. Therefore investors expect a premium, or risk premium for investing in the risky security. Liquidity risk premiums are recommended to be used with longer term investments, where those particular investments are illiquid.

In financial economics and accounting, the earnings response coefficient, or ERC, is the estimated relationship between equity returns and the unexpected portion of companies' earnings announcements.

The following outline is provided as an overview of and topical guide to finance:

Trade-off theory of capital structure

The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the literature is provided by Frank and Goyal.

Management is a type of labor but with a special role-coordinating the activities of inputs and carrying out the contracts agreed among inputs, all of which can be characterized as "decision making." Managers usually face disciplinary forces by making themselves irreplaceable in a way that the company would lose without them. A manager has an incentive to invest the firm's resources in assets whose value is higher under him than under the best alternative manager, even when such investments are not value-maximizing.

Financial innovation is the act of creating new financial instruments as well as new financial technologies, institutions, and markets. Recent financial innovations include hedge funds, private equity, weather derivatives, retail-structured products, exchange-traded funds, multi-family offices, and Islamic bonds (Sukuk). The shadow banking system has spawned an array of financial innovations including mortgage-backed securities products and collateralized debt obligations (CDOs).

In finance, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the Modigliani–Miller theorem that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.

Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

References

  1. Baker and Wurgler, "Market Timing and Capital Structure", The Journal of Finance, 2002. http://www.blackwellpublishing.com/content/BPL_Images/Journal_Samples/JOFI0022-1082~57~1~414%5C414.pdf
  2. AYDOĞAN ALTI. "How Persistent Is the Impact of Market Timing on Capital Structure?", The Journal of Finance, 2006. http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6261.2006.00886.x