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January 17, 2008

Can a Firm's Last Resort Be Its Stock Price's Best Option?

When market shocks occur, firms that have the financial resources to repurchase their own shares experience less volatility.


In response to this summer’s subprime mortgage crisis, the Federal Reserve pumped more than $38 billion into the U.S. banking system to help shore up financial markets. The agency also played a similar role after the September 11 terrorist attacks. Because the Fed and other central banks often have a hand in such bailouts, they are frequently referred to as lenders of last resort.

Not every market shock is worthy of the Fed’s involvement, however. In cases where individual stocks become undervalued, can firms act as “buyers of last resort” to boost their own stock prices? Professor Jialin Yu recently examined this question and found that firms with the ability to repurchase their own shares can indeed have an impact on their stock prices.

“Firms often buy back their own shares after market shocks in the hope of making money,” Yu says. “Repurchasing also signals to the market that a company has confidence in its own value.”

The overall impact of repurchasing on a company’s stock price and volatility has been unclear, however. To better gauge the asset-pricing implications of firms acting as buyers of last resort for their own stocks, Yu and coresearchers Harrison Hong of Princeton University and Jiang Wang of MIT developed a model that measures the relationship between a company’s ability to buy back shares and its stock price’s short-term return variance (the rate of fluctuation in its stock price during a short period, such as one week or one month).

The researchers discovered that firms with a greater ability to repurchase shares — those that are financially unconstrained because they have available cash, for example — tend to experience less variation in short-term share prices. “If two firms, one unconstrained and one constrained, experience a liquidity shock and their stock prices drop, the unconstrained firm can buy back its own shares. The constrained firm cannot intervene, even though it knows its shares are now undervalued, because it does not have the cash to perform the buyback,” Yu explains. “So, in a crisis situation the unconstrained firm’s stock price will deviate less because it can step in and buy back some shares.”

To be certain that this intervention effect is not due to other factors — for example, that financially constrained firms are often less successful than unconstrained firms and therefore more likely to have volatile stocks — Yu and his coresearchers further examined the relationship between financing constraints and return variances. They expected the relationship to be stronger in time periods or environments in which the legal cost of repurchasing was cheaper.

The first evidence of this effect came from a 1982 U.S. regulatory reform that encouraged repurchases. Until then, it had been difficult and costly to buy back shares because, though the practice was legal, firms often faced lawsuits accusing them of manipulating stock prices through repurchases. After 1982, it became easier and cheaper to execute stock repurchases, and financially unconstrained firms embraced the practice.

Because of this change, Yu expected — and later confirmed — that the relationship between financial constraint and return variances would be stronger after 1982, when the legal cost of repurchasing went down.

Yu and his colleagues found additional evidence to support their intervention hypothesis when they looked at international stock-repurchase activity. Data from the world’s 10 largest stock markets (the United States, Japan, the UK, France, Germany, Canada, Italy, the Netherlands, Switzerland and Hong Kong) between 1993 and 1998 showed that the relationship between variance and constraint was strongest in the United States, the UK and Canada — the countries where repurchases were easiest to execute. In Germany and France, where repurchases were severely restricted, the relationship was much weaker.

One of the model’s innovations is that it treats firms as important participants in the trading process, alongside hedge-fund managers and stock traders, underscoring a somewhat surprising connection between asset pricing/market structure and corporate finance. “We found that the behavior of firms can actively influence stock-price characteristics such as volatility,” Yu says. “That means if you want to study stock-market-return volatility, you have to take corporate finance issues into account.”

Julian Yu is assistant professor of finance and economics at Columbia Business School.

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