Market efficiency with respect to corporate credit conditions and internal capital allocation

This thesis consists of three key papers, which are presented in chapters 2, 3 and 4. The three chapters examine three different issues in financial risk management and corporate investment. Chapter 2 evaluates the effects of International Monetary Fund (IMF) programs on corporate default risk. Chapter 3 investigates the relationship between internal capital market efficiency and and diversified firm default risk. Chapter 4 studies the role of internal capital market efficiency in predicting the subsequent stock returns of diversified firms. Chapter 3 is the bridge that links the three key chapters in this thesis together. It shares the same scope with chapter 2 in the financial risk management area and with chapter 4 in the corporate investment area. Using firm-level expected default frequency (EDF) metrics from Moody's KMV and an event study style approach, chapter 2 investigates how corporate default risk responds to IMF intervention and whether the magnitude and direction of the effect are different for the financial versus non-financial sector and for various program sizes and types during the period from 1996 to 2012. Our findings suggest that corporate default risk increases consistently before and after IMF announcements, and is mainly driven by the financial sector in the countries receiving Standby Arrangement (SBA). We also find that countries receiving the smallest IMF program sizes experience greater increases in corporate default risk than the ones receiving the largest loan sizes. These results are robust to the control for the issue of endogeneity. Sharing the same scope with chapter 2 in the financial risk management area, chapter 3 seeks to establish the link between corporate investment and corporate default risk by studying the effect of Internal Capital Market Efficiency (ICM) on diversified firm default risk, and how this effect varies in firms with different levels of external financial constraints during the period 1997-2014. Following Billett and Mauer (2003), we define ICM as the movements of funds from the segments with low return on assets to the segments with high return on assets. Using panel data of 11,202 firm-year observations in the US, we find a negative association between diversified firm default risk and their use of internal funds. However, this relationship is only economically significant in highly leveraged firms. Our findings are robust to the three measures of credit risk: Merton-style default probabilities, the Altman Z-score and S&P credit rating. In addition, though the theory suggests that ICM has a stronger effect on the default risk of financially constrained firms, we find weak evidence supporting this argument. Our result shows that ICM only has a larger impact on financially constrained firm default risk in the case of the Altman Z-score. Taking the ICM computed in chapter 3 as a proxy for diversified firms' expected profitability, chapter 4 investigates the role of this measure in predicting stock returns of diversified firms during the period 1997-2015. Our expected profitability proxy is distinguished from other proxies suggested in the literature since our measure takes into account the firm's current level of external financial constraints. We find that ICM can help predict stock returns, and this predictive ability is incremental to the other stock return predictors identified in the literature such as book to market ratio, firm size, default risk, accruals and Piotroski's (2000) F-score. Furthermore, when examining the relationship between ICM and future stock returns separately for financially constrained and non-financially constrained firms, we find that ICM is only important in predicting stock returns in the former group.