In order to construct a system of simultaneous equations of our liquidity measure and the S&P T&D ranking for 3SLS and GMM estimation, we need to specify the models of the liquidity measure and the T&D final ranking. In each model, the dependent variable of the other equation will be used as one of the explanatory variables; that is, both the liquidity measure and the T&D ranking appear as endogenous variables in the simultaneous equations.
Besides, other determinants of the liquidity measure and disclosure practice must be used as exogenous instrumental variables and be controlled for the estimation and tests in this simultaneous system. Because there is more doubt about the extent of the quality of S&P T&D ranking measuring the disclosure practice, the determinants of T&D ranking have to satisfy several conditions for instrumental variables estimation. We discuss these conditions and filter out some inadequate instrumental variables later in Chapter 6.
4.1 The Determinants of the Liquidity Measure
Previous cross-sectional studies of spreads suggest a number of spread determinants other than disclosure policy that should be controlled in the empirical analysis (Welker, 1995).
The closing price, daily dollar volume, return volatility, number of trades per day, and market value, are most common determinants of the spread adopted in these studies such as Agrawal et al. (2004), Brockman and Chung (2003), LSB (1995), Stoll (2000), Van Ness et al. (2001), Welker (1995), and others. In particular, Stoll (2000) models the source of the spread, and find that the closing price, daily dollar volume, return volatility, number of trades per day, and market value, have significant relations to the proportional quoted half-spread. He finds that these variables can explain over 65 percent of the cross-sectional variance in proportional quoted half-spread. Therefore, in addition to the T&D ranking, we follow Stoll (2000) and use stock’s closing price (CLP), daily dollar volume (DOLVOL), return standard deviation
(RETSTD), number of trades (N), and market value (MKV) as our preliminary candidates of control variables of our liquidity measures (, i.e. the proportional quoted half-spread, the quoted half-spread, the effective spread, the relative effective spread, and the information asymmetry component). The definitions of these control variables of liquidity measures are described as follows:
CLPi= the average of closing prices of all trading days during our studying period for firm i. (9)
DOLVOL = the average of daily dollar volume of all trading days during our studying i
period for firm i. (10)
RETSTD
i = the standard deviation of stock’s daily returns in the prior year for firm i.(11)
N
i = the average of daily number of trades during our studying period for firm i. (12)MKV
i = the average of monthly market value during our studying period for firm i.(13)
According to the empirical evidence of Stoll (2000) and other studies mentioned above, we predict that the increases in the dollar volume, number of trades, and market value increase the liquidity of equity and lower the spread. The stock’s return volatility reflects the risk of price change of a stock, and thus we predict that higher return volatility is associated with higher spread. Price controls for the effect of discreteness and is an additional proxy for risk in that low price stocks tend to be riskier (Stoll, 2000).Therefore, we predict that price is positively related with the quoted half-spread, the effective spread and the information asymmetry component, but is negatively related with the proportional quoted half-spread, and
the relative effective spread because the quote midpoint, the denominator used to calculate these two measures, is highly related to the closing price.
4.2 The Determinants of Disclosure Practice
The determinants of disclosure practice used in our study are mainly referred to Lang and Lundholm (1993), Welker (1995), and Ho and Wong (2001). Lang and Lundholm (1993) find that both the market adjusted return and firm size are positively related to disclosure policy, and that the disclosure policy is negatively related to return standard deviation and return-earnings correlation. Welker (1995) follows the findings of Lang and Lundholm (1993) and uses share price, security offering, market adjusted return, and return standard deviation as the determinants of disclosure practice. Ho and Wong test a theoretical framework relating four major corporate governance attributes to the extent of voluntary disclosure provided by listed firms in Hong Kong. They follow several previous works investigating the decision of voluntary disclosure and use firm size (Chow and Won-Boren, 1987), asset-in-place (Hossain et al., 1994), financial leverage (Bradbury, 1992), profitability (Meek et al. 1995) and industry type (Meek et al., 1995) as control variables in their empirical model. Thus, following these studies, we preliminarily choose firm size (Size), return standard deviation (RETSTD), closing price (CLP), asset-in-place (AIP), financial leverage (LEV), profitability (PROFIT), and dummy variable of industry type as the initial candidates of control variables of firm’s disclosure practice. The empirical findings of previous studies mentioned above suggest that the firm size, price, asset-in-place, and profitability are positively related to firm’s disclosure practice, and that return volatility, and financial leverage are negatively related with firm’s disclosure quality.
The control variables of disclosure practice that we didn’t define yet in section 4.1 are defined as follows:
Size = the total assets of firm i at the end of 2002. (14) i
AIP = the ratio of net book value of fixed assets to total assets of firm i at the end of i
2002. (15)
LEV = the ratio of total debt to total equity of firm i at the end of 2002. (16) i
PROFIT
i= the return on capital employed at the end of 2002. (17)D1 =1, when the firm’s S&P Industry Index Code belongs to the Financials group i
with the codes 700-719, and zero otherwise. (18)
D2 =1, when the firm’s S&P Industry Index Code belongs to the Information i
Technology group with the codes 900-921, and zero otherwise. (19)