Essays on Financial Risks and the Subprime Crisis
Abstract: This thesis covers the impact of the financial crisis of 2007-2009, the non-linearity in the impact of bankruptcy risk on leverage and the effect of pessimism and doubt on the equity premium. It consists of four self-contained essays. The first essay develops a framework to investigate the impact of the financial crisis starting in 2007 and employs an extended GARCH model to test for spillover and contagion effects originating from the financial sector. It finds that the financial crisis affected financially distressed firms more heavily than undistressed firms and that financial constraints did not play an equally crucial role during the crisis. Overall, the analysis shows that the financial sector affected the returns of nonfinancial firms during the crisis. It finds little evidence that the turbulence in the financial sector expressed in terms of volatility fully encroached upon nonfinancial firms. The second essay introduces a model to explain the equity-premium puzzle. Consumers exhibit both pessimism and doubt. Consumers are pessimistic if their beliefs about the dividend are a translation of the objective dividend by an independent and identically distributed normal random variable with negative mean. Consumers exhibit doubt if their beliefs are a translation of the objective dividend by an independent and identically distributed normal random variable with mean zero. A cross-sectional empirical study using the SHARE database explores the differences between various European countries in terms of pessimism and doubt and tests the theoretical model empirically. The third essay investigates the impact of the financial crisis of 2007–2009 on corporate investment, particularly research and development (R&D) expenditures. It measures firms’ financial constraints and financial distress and investigates whether those measures have a significant predictive value on R&D during the financial crisis. It finds evidence that financial distress has little impact for our sample of listed technology firms and argues that the credit supply shock does not play a decisive role as financially constrained firms invest comparatively more than unconstrained firms during the crisis. The fourth essay investigates the effect of bankruptcy risk on firms’ financing decisions. More specifically, it analyzes if a higher probability of bankruptcy reduces incentives for debt financing due to an increase in expected bankruptcy cost. It argues that an increase in bankruptcy risk affects financial decisions only when the probability of bankruptcy is sufficiently high. It therefore models a non-linear relationship between changes in leverage and bankruptcy risk. The findings show that an increase in bankruptcy risk has a negative impact on changes in leverage and the impact is clearly non-linear.
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