Nonfinancial Firms as Cross‐Market Arbitrageurs

• Published date: 01 December 2019
• Date: 01 December 2019
• Author: YUERAN MA
• DOI: http://doi.org/10.1111/jofi.12837

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 6 •DECEMBER 2019

Nonfinancial Firms as Cross-Market Arbitrageurs

YUERAN MA∗

ABSTRACT

I demonstrate that nonfinancial corporations act as cross-market arbitrageurs in

their own securities. Firms use one type of security to replace another in response

to shifts in relative valuations, inducing negatively correlated financing flows in dif-

ferent markets. Net equity repurchases and net debt issuance both increase when

expected excess returns on debt are particularly low,or when expected excess returns

on equity are relatively high. Credit valuations affect equity financing as much as eq-

uity valuations do, and vice versa. Cross-market corporate arbitrage is most prevalent

among large, unconstrained firms, and helps account for aggregate financing patterns.

IT IS WELL KNOWN THAT firms time capital markets to issue and repurchase se-

curities. In particular, prior studies show that financing activities in a given

market respond strongly to valuation conditions in that market: firms issue

more stock, for instance, when equity valuations are high, while they repur-

chase more stock when equity valuations are low (Ritter (1991), Baker and

Wurgler (2000), Hong, Wang, and Yu (2008)).1

In this paper, I demonstrate that nonfinancial firms in the United States act

as “cross-market arbitrageurs” in their own securities. While previous research

focuses mostly on a single asset class, firms issue securities in several different

capital markets, each of which may experience distinct pricing fluctuations. I

show that firms do not time a given market in isolation. Rather, they jointly

time multiple markets and engage in cross-market arbitrage, replacing one

type of security with another, in response to relative pricing between different

markets. For instance, when credit markets are a particularly cheap source of

funding, firms not only issue additional debt, but also repurchase more equity.

∗Yueran Ma is with the University of Chicago Booth School of Business. I am grateful to Robin

Greenwood, Sam Hanson, and Andrei Shleifer for their invaluable guidance; and to Malcolm Baker,

John Campbell, David Hirshleifer, Jeremy Stein, Adi Sunderam, Chunhui Yuan, Jeff Wurgler,Yao

Zeng, discussants Indraneel Chakraborty, Jess Cornaggia, Dirk Jenter, Natalia Reisel, seminar

participants at Harvard, and conference participants at WesternFinance Association Annual Meet-

ing, Miami Behavioral Finance Conference, FSU Suntrust Beach Conference, and FMA Applied

Finance Conference for very helpful comments. I thank the Editor, the Associate Editor, and two

anonymous referees for insightful suggestions. Previous versions have been circulated under the

title “Nonfinancial Firms as Arbitrageurs in Their Own Securities.” I have read the Journal of

Finance’s disclosure policy and have no conflicts of interest to disclose.

1Similarly, in the debt market, Baker, Greenwood, and Wurgler (2003) show that firms issue

more long-term bonds prior to periods of low excess bond returns, and Harford, Martos-Vila, and

Rhodes-Kropf (2015) find that firms issue more debt when credit ratings appear inflated.

DOI: 10.1111/jofi.12837

C2019 the American Finance Association

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3042 The Journal of Finance R

Conversely, when the cost of equity is especially low, firms issue equity and

reduce debt. Cross-market corporate arbitrage contributes to significant nega-

tive correlations between debt and equity financing, as well as the prevalence

of simultaneous issuance in one market together with repurchases in another

market. Moreover, financing activities in each market are driven not only by

conditions in that particular market, but also by valuations in other markets.

I begin by presenting two motivating facts about U.S. nonfinancial firms’

financing activities across debt and equity markets. First, a substantial amount

of financing activities comes from the firms that simultaneously issue in one

market and repurchase in another. For instance, among nonfinancial firms in

Compustat, about 45% of quarterly net equity repurchases in value come from

the firms that are concurrently net issuing debt, and about 50% of (seasoned)

net equity issuance comes from the firms that are net retiring debt. Similarly,

about 35% of net debt issuance comes from the firms that are concurrently

net repurchasing equity, and about 40% of net debt retirement comes from the

firms that are net issuing equity. Second, aggregate net equity repurchases

rise and fall with net debt issuance. For the nonfinancial corporate sector as a

whole, this correlation is above 0.3 over the past 30 years. These patterns are

particularly pronounced among large and financially unconstrained firms.

What drives these strong cross-market substitutions? I explore the role of

relative valuations across debt and equity markets. I outline a framework fol-

lowing Stein (1996) to understand firms’ cross-market arbitrage, which guides

my subsequent empirical analyses. By cross-market corporate arbitrage, I refer

to simultaneously increasing the net issuance of securities in one market and

the net retirement of securities in another market for advantageously different

pricing. As issuance effectively involves selling cash flow claims to investors,

one can also view such arbitrage as the transfer of cash flow claims from one

market (increase net repurchases) to another (increase net issuance) for advan-

tageously different pricing. In practice, few arbitrage trades are riskless as in

the strict textbook definition, but I discuss why firms can be well positioned to

act as arbitrageurs when private arbitrage is imperfect. In the analysis of cross-

market corporate arbitrage, I also allow for distinct pricing fluctuations in debt

and equity markets, rather than postulating that debt and equity valuations

are perfectly correlated (e.g., driven by common misvaluations of firm value

as in Dong, Hirshleifer, and Teoh (2012) and Gao and Lou (2013)). The sepa-

rate pricing fluctuations can derive from misvaluations of other factors such as

volatility and tail risks, shifts in investor preferences, or market segmentation,

and they shed light on a richer set of firm activities.

When firms engage in cross-market arbitrage, financing activities display

two key features. First, financing activities in each market are influenced

by both debt and equity valuations. Second, shifts in relative pricing induce

negatively correlated financing flows across debt and equity markets. Cross-

market corporate arbitrage would be most pronounced among firms that are

less financially constrained and close to optimal scale (e.g., firms for which the

marginal returns to additional investment and cash holdings diminish signifi-

cantly). Furthermore, the two key features hold not only at the firm level, but

Nonfinancial Firms as Cross-Market Arbitrageurs 3043

also in aggregate, given that aggregate financing activities are driven by the

largest firms, which tend to be unconstrained and most active in cross-market

arbitrage.

Guided by these predictions, I empirically analyze cross-market corporate

arbitrage both at the firm level and in aggregate.

The firm-level tests proceed in three steps. First, I study a baseline regres-

sion of financing activities on measures of both equity valuations (i.e., vari-

ables known to predict excess stock returns) and debt valuations. I document

that net equity repurchases increase when expected excess returns on debt

are low, and when expected excess returns on equity are high. At the same

time, net debt issuance increases by a similar amount. As the first feature of

cross-market arbitrage highlights, financing activities in each market can be

better understood by taking into account valuation conditions in other mar-

kets. Indeed, in the data, credit market conditions affect equity financing as

much as equity valuations do, and vice versa. As the second feature highlights,

valuation conditions induce financing flows in opposite directions across debt

and equity markets. I find that the valuation measures can account for strong

substitutions in financing activities, while control variables for fundamentals

(e.g., cash flows, investment demand, business cycles, etc.) do not produce a

similar effect. Finally, as predicted, the cross-market spillovers are especially

pronounced among large and unconstrained firms.

Second, I further confirm the simultaneous movements in equity and debt

financing activities. I construct indicator variables that equal one when a firm

net issues in one market and net repurchases in another market in the same

quarter (or alternatively, has above-average net issuance in one market and

above-average net repurchases in another market for robustness checks). I find

that simultaneous net equity repurchase and net debt issuance activities are

more likely to occur when expected excess returns on debt are particularly

low, and when expected excess returns on equity are relatively high. Similarly,

simultaneous net equity issuance and net debt retirement is more likely to

occur when expected excess returns on debt are high, and when expected excess

returns on equity are low.

Third, I provide further evidence for pricing discrepancies between debt and

equity markets through the lens of subsequent relative security returns. Specif-

ically, when firms increase debt and reduce equity, future debt returns tend to

be particularly low compared to what model benchmarks would predict based

on stock returns (constructed using hedge ratios following Schaefer and Strebu-

laev (2008)). On average, when firms simultaneously issue debt and repurchase

equity, subsequent annual debt returns are 0.5 to 0.6 percentage points lower

relative to hedge ratio-adjusted equity returns. Conversely, when firms simul-

taneously issue equity and retire debt, subsequent annual debt returns are 0.3

to 0.4 percentage points higher relative to hedge ratio-adjusted equity returns.

These differences are meaningful compared to an average annual (real) cost of

capital of 6 percentage points for U.S. nonfinancial firms (Fama and French

(1999)). To the extent that firms’ actions can weaken mispricing, subsequent

security returns may also understate the average returns to firms.