The Determinants of Equity Liquidity and Corporate Governance

In order to construct a system of simultaneous equations for our liquidity measure, as well as the corporate governance measures for the 3SLS and GMM estimations, we need to specify the liquidity measure, the T&D final rankings and the two indexes models.

3.3.1 The Determinants of the Liquidity Measure

It has been suggested in many of the prior cross-sectional studies on spreads (for example,

24 Following Lin et al. (1995) and Van Ness et al. (2001), the logarithms of the transaction price and the quote midpoint are used to yield a continuously compounded rate of return for the dependent variable, and a relative spread for the independent variable. This transformation can generate estimates of the information asymmetry components as a percentage of the effective spread, and thereby reduce the problem of price discreteness.

Welker, 1995; Lin et al., 1995; Stoll, 2000; Van Ness et al., 2001; Brockman and Chung, 2003; Agrawal et al., 2004; and others) that any empirical analyses should control for a number of spread determinants, other than disclosure policy, with the closing price, daily dollar volume, return volatility, number of trades per day and market value being the most common determinants of spread adopted in these studies.

Stoll (2000), in particular, models the source of the spread, and finds that the closing price, daily dollar volume, return volatility, number of trades per day and market value are all significantly related to the proportional quoted half-spread. Stoll (2000) finds that these variables could explain over 65 per cent of the cross-sectional variance in the proportional quoted half-spread. Therefore, along with the T&D ranking, we follow Stoll (2000) to use the closing price of the stock (CLP), daily dollar volume (DOLVOL), return standard deviation (RETSTD), number of trades (N) and market value (MKV) as our preliminary candidates for control variables in the liquidity measures (i.e., the effective spread and the information asymmetry component).

In accordance with the empirical evidence provided by Stoll (2000), as well as the other aforementioned studies, we predict that any increase in the dollar volume, the number of trades and the market value will lead to an increase in equity liquidity and a lowering of the spread. The return volatility of a stock reflects the risk of any price change in that stock; thus, we predict that higher return volatility will be associated with a higher spread.

The definitions of the control variables in the liquidity measures are described as follows:

CLP_i = the closing price average of all trading days for firm i during the study period.

DOLVOL_i = the daily dollar volume average of all trading days for firm i during the study period.

RETSTD_i = the standard deviation of the daily returns of stocks in firm i during the previous year.

N_i = the average daily number of trades in firm i during the study period.

MKV_i = the average monthly market value of firm i during the study period.

Furthermore, price acts as a control for the effect of discreteness, and is an additional proxy for risk, insofar as low price stocks tend to be riskier (Stoll, 2000). We therefore predict that price will be positively related to the effective spread and the information asymmetry component.

3.3.2 The Determinants of Disclosure Practice

The determinants of disclosure practice used in this study relate mainly to those of Lang and Lundholm (1993), Welker (1995) and Ho and Wong (2001). Lang and Lundholm (1993) find that both market-adjusted return and firm size are positively correlated to disclosure policy, which in turn, has a negative association with return standard deviation and the return-earnings correlation.

Following on from these findings, Welker (1995) uses share price, security offering, market-adjusted return and the return standard deviation as the determinants of disclosure practice. Ho and Wong (2001) subsequently go on to test a theoretical framework relating four major corporate governance attributes to the extent of voluntary disclosure provided by firms listed on the Hong Kong stock market. Ho and Wong follow several of the prior works which have focused on investigations into voluntary disclosure decisions, using firm size (Chow and Won-Boren, 1987), assets-in-place (Hossain et al., 1994), financial leverage (Bradbury, 1992) and profitability and industry type (Meek et al. 1995) as the control variables in their empirical models.

Thus, following on from these studies, our preliminary candidates for control variables in the disclosure practices of firms are: firm size (SIZE), return standard deviation (RETSTD), closing price (CLP), assets-in-place (AIP), financial leverage (LEV), profitability (PROFIT) and a dummy variable for industry type. The empirical findings of the aforementioned studies suggest that firm size, price, assets-in-place and profitability are positively related to the disclosure practices of firms, and that return volatility has a negative correlation with the quality of the firms’ disclosure. The control variables for disclosure practices which have not yet been defined are as follows:

SIZE_i = the total assets of firm i at the end of 2002.

AIP_i = the ratio of the net book value of fixed assets to total assets for firm i at the end of 2002.

LEV_i = the ratio of total debt to total equity for firm i at the end of 2002.

PROFIT_i = the return on capital employed at the end of 2002.

D1_i = 1, when the firm’s S&P Industry Index Code is between 700 and 719 (the Financials group), otherwise 0.

D2_i = 1, when the firm’s S&P Industry Index Code is between 900 and 921 (Information Technology group), otherwise 0.

3.3.3 The Determinants of Governance Index and Entrenchment Index

The determinants of governance index used in this study relate mainly to Gomper et al. (2003).

Their results indicate that capital expenditures and corporate acquisitions are positively correlated to the governance index, which in turn, has a negative association with returns, firm value, profits and sales growth. Since the calculation of the entrenchment index is based on six provisions which are selected from a set of twenty-four provisions followed by the IRRC, the determinants of entrenchment index are similar with the governance index.

Following on from the previous studies, our preliminary candidates for control variables in the governance index and the entrenchment index of firms are: return on assets (ROA), capital expenditure scaled by sales (CE), book-to-market ratio (BM), financial leverage (LEV), external financial needs (EFN), past three-year sales growth (SG3) and a dummy variable for industry type. The empirical findings of the previous studies suggest that return on assets, book-to-market ratio and sales growth are negatively related to the governance index and entrenchment index of firms, and that capital expenditure and external financial needs may have a positive correlation with the two indexes. For the relationship between financial leverage and the two indexes, Chiyachantana et al. (2005) point out that the association between leverage and governance quality is not linear but parabolic and convex. In other words, they show that leverage is negatively related to governance quality up to a certain point and the relationship reverses and becomes positive as governance quality improves further. Since our sample firms are selected from the constituent firms in the S&P 500 index, we conjecture that financial leverage is negatively related to the two indexes. The control variables for the governance index and the entrenchment index which have not yet been defined are as follows:

ROA_i = the ratio of the net income to total assets for firm i at the end of 2002.

CE_i = the ratio of capital expenditure to sales for firm i at the end of 2002.

BM_i = the ratio of book value to market value for firm i at the end of 2002.

EFN_i = the past two-year geometric average growth rate in total assets minus the past two-year average sustainable growth rate for firm i at the end of 2002

SG3_i = the past three-year sales growth for firm i at the end of 2002.