2.1 Market liquidity and bid-ask spread
Market markers play an important role in facilitating trades by providing stock liquidity in some stock exchanges. The notion of liquidity refers to the ability of a trader to execute a trade or liquidate a position quickly, anonymously with little or no cost, risk or inconvenience. Market liquidity measures the cost of taking ownership positions in firm’s equity like the notion of marketability. A stock with lower liquidity cost is always close to possess excellent marketability that benefit greatly to investors allocating their ownership positions. However even the big standardized markets are not perfectly liquid. The main source of liquidity costs is the bid-ask spread.
The quoted bid-ask spread is the difference between the ask price quoted by a trader and the bid price quoted by a trader at a point in time. Following Demsetz (1968), we can think of specialists as providing the service of immediate trading and bid-ask spreads cover the costs of market maker providing quick exchange. The literature of Stoll (1978) points out that the quoted bid-ask spread contains three costs faced a dealer: (1) order processing costs, the costs of settling trades, recording and clearing a transaction; (2) inventory holding costs, the price risk and opportunity cost of holding securities; and (3) adverse information costs which increase if investors trade on the basis of superior information.
In the early literature such as Demsetz (1968) and Tinic (1972), order processing costs receives greater emphasis, but all researches on the bid-ask spread recognize the importance of these costs. Stoll (1978) and Ho and Stoll (1981) find evidence that inventory holding costs arise from the risk assumed by a dealer, and Amihud
and Mendelson (1980) model the effect of constraints on inventory size. Recent academic studies have emphasized the importance of adverse information costs (e.g., Bagehot(1971), Copeland and Galai (1983), Glosten and Milgrom (1985), Kyle (1985) and Easley and O’Hara (1987)). Those papers model the equilibrium spreads in the presence of informed traders. Market makers trade against two sorts of investors, informed traders and uninformed traders4. Generally if some traders hold superior information, then the market maker loses on average to those traders. As a result the market maker will want to profit in their transactions with noise traders obtaining no private information by setting the spreads wide enough to guarantee that their profits in trades to uninformed traders will cover the expected losses from the trades with informed traders. However, when operating performance and financial condition of a firm are terrible, trading in the firm’s security may be increasingly dominated by informed investors. Thus the larger the proportion of informed traders in a given stock, the wider the bid-ask spread.
2.2 Proxies for the firm’s financial distress
Many famous studies assert a series of proxies for the firm’s financial distress, such as Tobin’s Q, default probability, common stock ranking and accounting measure. Several papers (e.g., Brook and Rao, 1994; Gilson, 1989; Lang et al., 1989;
Lindenberg and Ross, 1981) adopt Tobin’s Q as a measure of firm’s financial condition. Tobin’s Q is defined as [(market value of equity + book value of debt)/book value of total assets]. The lower the ratio of Tobin’s Q, the worse the firm’s performance.
4 Those possess private information and fail to reflected in the prices at the time of the trade are called informed traders. On the other hand, uninformed traders are who trade for reasons like liquidity demand, risk aversion, and possibly random speculation.
Several early literatures employ accounting items as a measure of firm’s financial distress. DeAngelo & DeAngelo (1990) verifies three groups of companies, high performance firms, medium performance firms and low performance firms, by income and pre-tax operating income. High performance firms are defined as having five years of positive income and pre-tax operating income. Firms with three years of negative income or negative pre-tax operating income during the five years proceeding the proxy year are defined as firms with low performance. Firms that do not fall in either category are classified as medium performance firms.
As for bond rating, this indicator is produced as measure of the firm’s default risk by credit rating companies. Agrawal, et al., (2004) and Odders-White and Ready (2004) use bond rating as a proxy for the firm’s default risk which contains a wide array of factors, such as the firm’s market value, collateral value of its assets, indenture provisions, existence of third party guarantees of debt service, potential third party insurance of timely debt service, leased assets, cash flows from segregated or trusted assets, security rights in assets. Thus bond rating fails to be recognized by any single accounting measure of default risk. Odders-White and Ready (2004) present a theoretical model that illustrates the potential linkage between a firm’s bond rating and the level of adverse selection in the trading of the firm’s equity. Also it suggests ways to decompose the standard adverse selection measures to better isolate the uncertainty parameters related to credit ratings. In their model, the value of a firm’s assets changes in response to both publicly observed and privately observed shocks. The paper concludes that bond ratings are able to capture more information than easily accounting variables and ratings changes can be predicted using current levels of adverse selection, which suggests that credit rating agencies fail to respond new information without delay. Moreover, Vassalou and Xing (2004) is the first research that uses Merton’s model to calculate default
probability for individual firms. They call the default risk measure as Default Likelihood Indicator (DLI)5. The finding asserts stocks with both of higher default risk and smaller size or higher book-to-market ratio possess greater equity return.
Agrawal, et al., (2004) also use common stock ranking as a proxy for financial condition. Obviously the common stock ranking is excellent than any single accounting measure because the ranking consists of many kinds of accounting items.
For example, the S&P Common Stock Ranking is another measure of historical performance and is an appraisal of past performance of a stock’s earnings and dividends and the stock’s relative standing as of a company’s current fiscal quarter end6. Growth and stability of earning and dividend are the most important factors in scoring S&P’s earnings and dividends rankings for common stocks.
Pay careful attention to previous studies has used either accounting measure or bond market information as the proxy for financial condition. There are some defects using accounting items to measure the firm’s financial distress. First, the accounting information is backward looking because financial statement aim to report a firm’s past performance, rather than its future scenario. Besides, another defect, the most important one, is that accounting models do not think about the volatility of a firm’s assets. Accounting models involve that the firms with similar financial ratios will be in the same financial condition.
In contrast, default likelihood indicator uses the market value of a firm’s equity to estimates its market value and volatility of a firm’s assets and calculate its default risk. Rather than using the book value of equity or assets, as the accounting models do. Furthermore, default likelihood indicator takes into account the volatility of a firm’s assets to obtain new information. The probability of default risk varies with
5 The detail content of DLI is introduced in section 3.2.1(page 11).
6 Source: Compustat Manual, Section 8-B, page 27.
different volatility of a firm’s assets. In other words, the volatility of a firm’s assets provides key information about the firm’s default risk.