The impact of international diversification on corporate risk: moderating role of corporate governance and legal origin

(1)

The impact of international diversification on

corporate risk: moderating role of corporate

governance and legal origin

Abstract: This is an empirical study on the impact of corporate governance and legal origin on the relationship between international diversification and corporate risk. This research analyzes a sample of 34,973 firm-year observations from 4,326 firms over the period of 2002-2016. It finds statistical support for a positive relationship between the degree of internationalization and corporate risk. It does not provide statistically

significant evidence for an effect of corporate governance on this relationship. However, the findings do indicate that the effect of international diversification is significantly different for common law vs. civil countries.

Keywords: corporate risk, internationalization, corporate governance, legal origin

Student number: S2487411 Name student: Casper Mazier

Study Program: MSc International Financial Management Supervisor: Dr. H. Gonenc

Co-assessor: Dr. A. De Ridder

(2)

opportunities and threats. Internationalizing can allow a company access to foreign customers and capital but will simultaneously result in increased competition and complexity due to institutional differences (Brahm, 1994). In 2007, Hitt, Ireland and Hoskisson defined international diversification as “a strategy through which a firm expands the sales of its goods or services across the borders of global regions and countries into different geographic locations or markets” (p. 251). In essence,

international diversification can be considered an act of corporate risk-taking since it exposes a firm to additional threats and competition. The impact of international diversification on different dimensions of business has been studied extensively, yet results have often led to ambiguity rather than definite conclusions. Throughout recent history internationalization has been linked to changes in firm performance (Capar and Kotabe, 2003; Lu and Beamish, 2004; Bausch and Krist, 2007; Singla and George, 2013), and to changes in corporate risk (Hughes, Logue and Sweeney 1975; Rugman, 1976; Fatemi, 1984; Krapl et al. 2015, Gao and Chou, 2015). Many different studies have brought forth many different findings over the past decades. The relevance of international diversification is undisputed, but (the direction of) its impact on different business aspects remains ambiguous.

(4)

allow for risk diversification through diversified cash flows and operations (Hughes et al., 1975; Rugman 1976; Fatemi, 1984). Since then, contradictory findings have been

published by, amongst others, Bartov, Bodnar and Kaul (1996) and by Reeb, Kwok and Baek (1998), who argued that international diversification in fact might drive an increase in corporate risk due to increased agency costs, asymmetry in information, exchange rate risks, and political risk. More recently, in studies by Gamba and Triantis (2008); and Jang (2017), internationalization was found to allow for lower cost of capital which in turn provides firms with increased financial flexibility. An increase in financial flexibility means less dependence on the domestic capital market and therefore a more diversified and lower corporate risk. Similarly, Bruno and Shin (2014) argued that internationally operating firms have easier access to foreign capital than domestic firms do. The increased access to foreign capital allows multinationals to borrow money in regions where the conditions are best, ensuring lower discount rates and effectively higher Net Present Value (NPV) of investment projects. Hence, the lower cost of capital expectedly causes a decrease in systematic risk. The extant literature does not provide a definite direction of the relationship between international diversification and corporate risk. This builds up to the following research question:

In what direction, and to which extent, does international diversification impact corporate risk?

(5)

governance measures to increase corporate risk-taking, and thereby ultimately increase corporate risk. This implies that an initial decrease in corporate risk caused by financial flexibility, can indirectly lead to an increase in corporate risk by means of interventional corporate governance measures that usher a CEO to increase the level of risk-taking. This is in line with a research in 2006 by Coles et al., who found that corporate risk and corporate risk-taking enjoy feedback effects. Thus, an increase (decrease) in corporate risk-taking can result in an increase (decrease) in corporate risk. Similarly, greater corporate risk expressed in higher risk premiums can be a reason for shareholders to demand higher rates of return. Therefore, shareholders will stimulate corporate risk-taking through corporate governance measures, to match the risk premium. Based on this example, corporate governance expectedly moderates the relationship between internationalization and corporate risk positively.

The gap in expectations between shareholders and CEOs is a typical example of the well-known agency problem. Essentially, it can be expected that there will be a conflict of interest between executives and shareholders of a firm (Jensen and Meckling, 1976). As described by Sanders and Hambrick (2007), CEOs have both economic and

reputational ties to the firm which causes them to be more risk-averse than the generally more diversified shareholders. To counter the general risk-averse attitude of the CEO, shareholders can rely on corporate governance tools such as executive pay in equity-based options (Croci and Petmezas, 2015).

(6)

terms of investment returns because of the lower cost of capital, compared to their domestic competitors. Just like shareholders may use corporate governance to increase risk-taking, they can use measures of corporate governance to decrease risk-taking if they desire to. In reality this is rather uncommon. CEOs are typically more risk averse than shareholders (Eisenhardt, 1989) and do not have shareholder value maximization as their main priority (Bebchuck and Weisbach, 2010). While it may be uncommon for shareholders to usher management into reduced risk-taking, it is not unheard of. Thus, if international diversification leads to a significant increase in corporate risk, shareholders may rely on corporate governance measures to reduce corporate risk-taking and thereby corporate risk. Following this reasoning, corporate governance expectedly decreases the impact of international diversification on corporate risk, regardless of the direction. Meaning that a positive effect of internationalization on corporate risk would become less positive in case of high corporate governance, and similarly a negative effect of internationalization on corporate risk would become less negative. This leads to the following research question:

Does corporate governance reduce the impact of international diversification on corporate risk?

Continuing on the notion that there might be external factors which impact the

(7)

experienced an increase in shareholders’ monitoring due to foreign legal environments. The findings and argumentation of La Porta et al. (1998, 2000) indicate that corporate governance is more entrenched in countries with common law. Becchetti et al. (2013) confirmed that there is a significant positive link between common law and corporate governance. As a result, I expect that in countries with common law the differences between the level of corporate governance are lower than in countries with civil law. This could also mean that the effect of corporate governance on the primary relationship is greater in countries with civil law, because it is easier to differentiate from competition through corporate governance. However, corporate governance is only an example of business facets that are affected by legal origin.

Legal systems can be a cause of economic development due to their effect on the domestic financial system. Financial systems are shaped within the boundaries of the law and therefore vary by legal origin (Graff, 2008). If a legal system can be an enabler of economic development, firms from different legal origins might experience different opportunities and threats once they internationalize. In line with Graff (2008), Cappiello (2010) argued that there is a vast and systematic difference between countries with civil law and countries with common law. Cappiello links common law to less regulation, more protection of property rights and lastly better economic growth than their

(8)

different legal origins, I expect that the origin of law will affect the relationship between internationalization and corporate risk.

Does the impact of internationalization on corporate risk differ depending on the legal origin?

This study contributes to existing literature in the field of international financial management for multiple reasons. Firstly, it provides new empirical evidence on the relationship between international diversification and corporate risk based from an international sample. Furthermore, in existing literature, corporate governance has not yet been widely studied as a moderator on this main relationship. However, corporate governance has been studied before as a tool to align the interests of shareholders and management, regarding corporate risk(-taking). Therefore, this study contributes by introducing the moderating effect that corporate governance has on the relationship between international diversification and corporate risk. Another interesting contribution is the effect of legal origin on the primary relationship. Legal origin has been linked to corporate governance, to differences in financial systems, economic development, and internationalization. This is, to my knowledge, the first study that studies the effect of legal origin on the relationship between internationalization and corporate risk. As such it has an international scope that studies financial management policies and implications.

This study covers 34,973 observations of 4,326 firms in 41 countries over the period of 2002-2016. I use an empirical approach and find that the degree of internationalization has a statistically positive impact on corporate risk, meaning that an increase in

(9)

corporate governance reduces the impact of internationalization on corporate risk is not backed up with statistical evidence. While the coefficients did show an expected change, the results were not statistically significant. Lastly, the legal origin of a country was found to have an effect on the main relationship. While the subset with civil law countries reported to significant effect of DOI on BETA, common law countries reported a significantly positive effect.

The remainder of this study is organized as follows. First, existing literature on

internationalization, corporate risk, corporate governance, and legal origin is reviewed. Based on the discussed literature, hypotheses are developed. Section 3 provides descriptive statistics as well as reasoning behind choice of variables. The fourth section shows the regression results for the main tests. Section 5 discusses the findings,

(10)

2. Literature review and hypotheses building

This section functions as a theoretical background that provides a better understanding of the research topic. It introduces and explains important concepts based on existing literature. Findings of relevant prior studies on internationalization, corporate risk, and corporate governance are analyzed, compared, and then used to build hypotheses on.

2.1 Internationalization

Internationalization has been a hot topic in studies worldwide for decades because of its impact on business. It is often used as (part of) a strategy to increase firm performance by accessing new markets and resources across national border, through which a firm tries to attain a competitive advantage and increase its efficiency (Attig et al., 2016). The fact that firms seek to gain advantages over competition by crossing borders is not surprising, as in prior research internationalization has been linked to many benefits. In 1975 (Hughes et al.), 1976 (Rugman), and later on in 1984 (Fatemi) multiple studies linked internationalization to diversification benefits. Furthermore, internationally diversified firms experience reduced probability of bankruptcy, lower idiosyncratic risk, and lower total risk than domestic firms (Michel and Shaked, 1986). In 2008, Gozzi et al. established that Internationalization can be used to bypass domicile institutional

(11)

simultaneously profiting from a lower cost of capital. In a recent study by Mihov and Naranjo (2019), supporting evidence is found for a negative relationship between internationalization and cost of capital. Furthermore, internationalization has also been found to have a significant positive relationship with CSR performance (Strike et al., 2006). It appears that there is a seemingly endless amount of studies that have found evidence that links internationalization to firm benefits. It is clear that internationalization is worth considering for firms. However, internationalization does not come without risk. Even without numbers it is not difficult to understand that new territory comes with increased competition. Furthermore, cultural differences, foreign regulations, currency risk, political risk, and many other factors can increase corporate risk as a result of internationalization. Besides, internationalizing firms may face hostile environments abroad and experience an increase in shareholder pressure (Zaheer, 1995; Zahra and Garvis, 2000). In fact, all the benefits that come from internationalization, might motivate firms to engage in more risky behavior. In support of this notion, Bruno and Shin (2014) already linked MNCs to increased risk-taking.

2.2 Internationalization and Corporate risk

(12)

Bartov, Bodnar and Kaul (1996); and Reeb, Kwok and Baek (1998), it appeared that international diversification might be related to increased corporate risk. In 2008 the findings of Reeb et al. were mostly confirmed by Olibe, Michello and Thorne (2008). Arguably, internationalization could increase corporate risk because multinational firms have to deal relatively more with agency costs, asymmetric information, and political risk. Together with the increase in systematic risk due to greater exchange rate risk faced by multinationals (Hutson and Laing, 2014; Francis et al., 2017) this could offset the benefits received from internationalization. The different reasonings for an increase or decrease in corporate risk as a result of internationalization are both interesting and comprehensive.

(13)

existing literature, I expect to find a significant relationship between internationalization and corporate risk.

Hypothesis 1a: Internationalization has a positive effect on corporate risk

Hypothesis 1b: Internationalization has a negative effect on corporate risk

2.3 Corporate governance and corporate risk(-taking)

This paper focuses on the relationship between internationalization and corporate risk and the moderating role of corporate governance and origin of law on that relationship. Firstly, it is important to establish how corporate risk and corporate risk-taking are inherently related, yet not the same. Understanding how these concepts differ and how they are related is essential. Corporate risk is a product of a variety of components, and commonly divided into systematic risk and idiosyncratic risk (Tian, 2004; Henderson, 2005; Duan and Wei, 2005). Corporate risk-taking is commonly associated with corporate risk, as an increased level of corporate risk-taking will result in greater corporate risk and similarly lower risk-taking will result in lower corporate risk (Coles, 2006). In a 1996 article by Wright et al., corporate risk-taking was defined as “the analysis and selection of projects that have varying uncertainties associated with their expected outcomes and corresponding cash flow” (p. 442).

Corporate governance does not have a precise definition like other terms in the field, so researchers frequently have their own take on what it encompasses. Corporate

(14)

maintain different definitions, the majority seems to agree that corporate governance should be an instrument to incentivize corporate value-maximizing behavior and reduce the effect of personal benefits. In other words, corporate governance should ensure that the interests of shareholders and management are aligned. This can be achieved

through a variety of tools such as CEO compensation structures and independent boards.

The gap between shareholder and management interests which corporate governance tries to close comes forth from what is commonly known as the agency problem. The agency problem posits that an agent and principal have misaligned interests. It has been extensively studied in regard to publicly traded firms (Bebchuk and Weisbach, 2010). In this case, the agent (CEO) will seek personal value maximization, while the principal (shareholders) seeks shareholder value maximization. Their interests do not match, and both will be inclined to make strategic decisions that aid their own cause.

Building on the fact that shareholders will seek appropriate amounts of corporate risk-taking for their risk premiums, they may use corporate governance to influence the level of risk-taking. In turn, the altered level of risk-taking will likely be reflected in the level of corporate risk. So, whether a firm faces greater or lesser corporate risk due to

(15)

internationalization severely increased the risk, shareholders can apply measures to reduce risk-taking and ultimately risk. Vice versa, if they find a lack of corporate risk, they may opt to apply measures in an attempt to increase risk-taking and ultimately risk. This builds up to the second hypothesis:

Hypothesis 2: Corporate governance reduces the impact of internationalization on corporate risk

2.4 Origin of law

Across the globe there are two legal systems that are used at large: common law and civil law. As a basic distinction, civil law is codified and finds its origin in Roman jurisprudence, whereas common law originates from England and is predominantly formed based on precedents. While codified law could presumably provide clear

protection and security, Graff (2008) found financial laws in countries with civil law to be frequently based on outdated standards and procedures. The financial structure of a country is tied to its financial laws, which of course is tied to its legal origin. As such, legal origin can help shape the financial structure and thereby indirectly shape countries’ economic situation, growth, and development (Ciobanu, 2015).

(16)

essentially leads to a minimum set of standards that firms need to adhere to, causing an increase in firm level corporate governance. In 1998, La Porta et al. found that common law countries provide better investor protection. This difference is in investor protection was later on linked to the country level corporate governance (La Porta et al., 2000). The link between common law countries, investor protection and corporate governance provisions is one that has been studied more than once and found support frequently (Shleifer, 1997; La porta et al., 2000; Djankov et al., 2008). The risks that investor bear due to lesser governmental protection could potentially also be reflected in differences in risk premiums and even corporate risk. Arguably, investors in civil law countries who already bear greater risks due to lesser governmental protection, might be less willing to invest in firms with greater corporate risk.

To date, there has been no consistent support or strong argumentation in literature for a link between legal origin and corporate risk. However, legal origin has many ties to the financial and economic structure and potential of a country and thereby firms’

opportunities. Furthermore, it has clear links to investor protection and corporate governance. Therefore, I expect that the relationship between internationalization and corporate risk is different for countries with different legal origin:

Hypothesis 3: the relationship between internationalization and corporate risk reduces is

(17)

3. Data and Methodology

This section contains data and methodology information. It starts off with sample collection information and descriptive statistics, after which the variables are defined, and their measurements provided. Hereafter, the methodology is explained, and regression models are developed.

3.1 Sample Collection

The sample that has been used for this research contained 37,867 worldwide firm-year observations spread over the period of 2002-2016 and over 41 countries. All data was gathered from reliable resources. The firm level variables have been collected from Thomson Reuters Eikon and Datastream, whereas the country level variable was retrieved from the World Bank Global Financial Data Structure. In line with extant

literature, firms classified as part of the financial industry are excluded from this sample. Furthermore, countries have been split up into either common law or civil law and

industries that were non-financial have been split up by their respective SIC codes. The SIC codes have been reduced from four to two-digit codes with respective dummies to account for omitted variable bias, in line with prior studies (Coles et al., 2006; Croci and Petzemas, 2015). Besides industry fixed effects, I have also included year fixed effects to limited omitted variable bias. Furthermore, outliers have been dealt with by

winsorizing the data at the 1 st_{and 99} th_{percentile. Lastly, observations with missing} values have been removed from the original sample which led to a final data set of 34,973 firm year observations over 41 countries and 4,326 firms between 2002 – 2016.

(18)

The final sample consists of 34,973 global firm year observations, spread of 41 countries and 4,326 firms all between 2002 – 2016. Table 1 shows the summary statistics for variables that form the basis of this study. The dependent variable of this study is

corporate risk, defined as BETA, and shows a mean value of 1.000 with a median that is not far off (0.963). The standard deviation for the BETA variable is 0.366. The main independent variable, DOI (degree of internationalization), has a mean of 0.357, a median of 0.296 and a standard deviation 0.339. This means that on average, foreign sales account for 35.7% of the total sales. Minimum and maximum are of course 0 and 1, zero for firms with no foreign sales and one for firms with solely foreign sales.

Furthermore, the mean corporate governance score is 53.718 and the median is 60.880. The mean ‘legal origin’ is 1.635, with a minimum value of 1 (civil law) and maximum value of 2 (common law). Appendix A contains an overview of the distribution of countries and their legal origin, and Appendix B contains variable descriptions.

Table 2 displays the mean and median of the regressed variables for both the entire sample and for the subsets by legal origin. Furthermore, table 2 includes the test statistics for the independent samples T-test and Wilcoxon Rank Sum test. The mean and median for the variables of the subsets are notably different. In common law

countries the dependent variable corporate risk (BETA) is shown to have a higher mean as well as median. The independent variable, degree of internationalization, is higher for countries with civil law In line with existing literature and expectations, corporate

(19)

Table 3 displays the correlation matrix for the dependent variable and the independent plus control variables that have been used for the regression models. The correlation matrix is present to control for multicollinearity issues, where the threshold for

multicollinearity has been set at 0.5 (-0.5), in line with Adkins and Hill (2011). Table 3 reports no correlation above 0.5, with 0.483 being the highest level of correlation between two variables (Tobin’s Q and ROA). As such, there is no indication of multicollinearity in this study. Furthermore, table 3 shows a significantly positive correlation between firm risk and degree of internationalization. This does not indicate causality though, which is why I use a lagged variable of DOI for the regression.

Table 1: Descriptive statistics

This table shows the summary statistics for all variables that are used in this study. All variables have been winsorized at the 1st_{and 99}th_{percentile. The table shows number of observations, mean and median}

values, standard deviations and min. and max. values.

N MEAN MEDIAN ST. DEV MIN MAX Firm characteristics BETA 34.973 1.000 0.963 0.366 0.226 2.188 DOI 34.973 0.357 0.296 0.339 0.000 1.000 CGV 34.973 53.718 60.880 30.101 1.850 95.900 SIZE 34.973 15.340 15.302 1.450 11.609 18.843 Tobin’s Q 34.973 1.855 1.441 1.274 0.591 8.101 ROA 34.973 0.085 0.076 0.085 -0.203 0.374 CAPXR 34.973 0.056 0.041 0.053 0.001 0.294 LEV 34.973 0.364 0.356 0.245 0.000 1.000 COUNTRY CHARACTERISTIC LEGAL ORIGIN 34.973 1.635 2.000 0.481 1.000 2.000

Table 2: Descriptive statistics by legal origin

This table shows the summary statistics for all variables that are used in this study, by legal origin. . All variables have been winsorized at the 1 st_{and 99}th_{percentile. The table shows number of observations,}

(20)

FULL SAMPLE CIVIL LAW COMMON LAW

Mean Median Mean Median Mean Median T-test Wilcoxon

BETA 1.000 0.963 0.944 0.935 1.048 0.999 24.223 (0.000) 19.142 (0.000) DOI 0.357 0.296 0.396 0.379 0.337 0.258 -14.789 (0.000) -15.274 (0.000) CGV 53.718 60.880 29.689 19.97 67.256 73.600 127.190 (0.000) 101.217 (0.000) SIZE 15.340 15.302 15.766 15.677 15.137 15.124 -38.749 (0.000) -35.399 (0.000) Tobin’s Q 1.855 1.441 1.599 1.263 1.999 1.565 28.491 (0.000) 34.624 (0.000) ROA 0.085 0.076 0.075 0.065 0.095 0.086 21.881 (0.000) 27.700 (0.000) CAPXR 0.056 0.041 0.051 0.041 0.060 0.042 16.405 (0.000) 3.811 (0.001) LEV 0.364 0.356 0.372 0.374 0.354 0.342 -6.358 (0.000) -9.475 (0.000) COUNTRY CHARACTERISTIC LEGAL ORIGIN 1.635 2.000 1 1 2 2

N=34,973 for the full sample. N=12,771 for Civil Law. N= 22,202 for Common law.

Table 3: Correlation Matrix

This table shows the correlation matrix for all variables that are used in this study. All variables have been winsorized at the 1st_{and 99}th_{percentile. A * denotes statistical significance at the 1%}

level.

(21)

BETA 1.000 DOI 0.103* 1.000 CGV 0.127* 0.130* 1.000 SIZE 0.030* 0.098* 0.068* 1.000 TOBIN’S Q -0.029* 0.009 0.033* -0.322* 1.000 ROA -0.123* 0.034* 0.096* -0.055* 0.483* 1.000 CAPXR 0.118* -0.075* 0.036* -0.082* 0.031* 0.023* 1.000 LEV 0.001 -0.052* 0.063* 0.326* -0.199* -0.138* -0.008* 1.000 3.3 Variables 3.3.1 Dependent variable

The dependent variable in this research is corporate risk. According to Armstrong and Vashishtha (2012) “most studies measure total risk as the volatility of future returns and

disaggregate it into systematic and idiosyncratic components using either the capital asset pricing model (CAPM) or some other affine asset-pricing model”. Important is that

total risk is split up into systematic risk and idiosyncratic risk when testing the effect of internationalization on corporate risk. According to the modern portfolio theory

(Markowitz, 1952), idiosyncratic risk can be minimized through diversification and thus only systematic risk is important. Hence, in line with the modern portfolio theory, this study will use the BETA from CAPM to account for systematic risk.

3.3.2 Independent variable

(22)

existing literature (Olibe et al., 2008; Li et al., 2011; Attig et al., 2016; Berger et al., 2016). Some studies limit FS/TS to a binary dummy variable. I prefer to use the ratio as I research the degree of internationalization, not just if a firm is internationalized.

3.3.3 Firm-level moderator

Corporate governance does not know one singular measure that is appreciated by all scholars. Throughout the years a multitude of Corporate governance (CGV) measures have been developed and practiced. Gompers, Ishii and Metrick’s (2003) (GIM) for instance developed their own equally-weighted index based on 24 corporate

governance provisions that were compiled by the Investor Responsibility Research Center. In a study in 2009 by Bebchuk et al., it was indicated that not all provisions should be weighted equally, and some might be correlated, so they created their own “entrenchment index”. Brown and Caylor (2006) used data from the Institutional Shareholder Services (ISS) to create their own governance index comprised of 51 governance features. In a study by Bhagat and Bolton (2016), the question is raised if a single board characteristic could be as effective a measure of corporate governance as indices with multiple governance provisions. They find that “ on both economic and econometric grounds it is possible for a single board characteristic, for example, board ownership, to be an effective measure of corporate governance.” Not only does board

ownership reflect corporate governance, it is also less prone to measurement errors than indices that are compiled of various features. However, indices that are compiled of several board characteristics, management compensation structures and other

(23)

that use indices, and based on data availability, the Thomson Reuters Corporate Governance Score (CSG) is used.

3.3.4 Control variables

This study takes several control variables into account that might influence the main relationships, based on results from prior studies. Control variables are used to ascertain that the perceived relationship between the independent and dependent variable is not a byproduct of other variables. Previous literature on corporate risk has found Firm Size

(SIZE), Return on Assets (ROA) , Tobin’s Q (Tobin’s Q), Capital expenditures ratio

(CAPXR), and Leverage (LEV) to impact corporate risk either positively or negatively.

For firm size (SIZE) I use the natural logarithm of total assets, similar to studies by Krapl (2015); and Dang et al (2018). Firms that are relatively large are less likely to go

bankrupt, in part due to their diversification (Logue and Merville, 1972; Breen and Lerner, 1973; Ang et al., 1985; Titman & Wessels, 1988). Furthermore, firm size can impact firm risk-taking and firm performance (Faccio et al., 2011). The return on assets and Tobin’s Q are used as indicators of respectively firm performance and firm value. In addition to these variables, CAPXR and LEV are used. The capital expenditure ratio is found by dividing a firm’s capital expenditures by its total sales. Leverage is measured as a firm’s long-term debt divided by its total assets. Since I am also interested in the effect of origin of law, countries are split up into either common law or civil law.

3.4 Methodology and regressions

(24)

unbalanced panel data. To analyze the data and test my hypotheses I use the Ordinary Least Squares method (OLS) robust to heteroskedasticity with clustered standard errors. As a way of dealing with endogeneity, I use lagged versions of the regressors.

Furthermore, I control for omitted variable bias by using year and industry fixed effects.

Since my data is unbalanced panel data, there are two main options for my regression: using a fixed effects or a random effects model. Omitted variable bias is a very common flaw which I try to avoid by including control variables. However, given the limited

number of variables in this study, there is still a real chance of presence of omitted

variable bias. Usually a fixed model is used to prevent this problem as much as possible. To be sure of my choice, I use the Hausman test to determine whether I should use a fixed effects or random effects model. The results of the Hausman test (p-value <0.05) gave reason to continue with a fixed effects model which I based on firm year fixed effects. Based on this, I developed the following regression for model 1, 3 and 4. Models 1,3, and 4 report the effect of DOI on BETA for respectively the entire sample, civil law countries, and common law countries.

Where all independent and control variables as well as industry and year effects are accounted for.

(25)

Where DOI * CGV captures the interaction effect between the degree of internationalization and corporate governance.

4. Results

The aim of this paper is to research the relationship between internationalization and corporate risk, and to determine if corporate governance and/or legal origin moderate this relationship. Corporate risk is proxied by BETA, the degree of internationalization is measured as the ratio of foreign sales divided by total sales. The legal origin is classified as either common law or civil law, while corporate governance scores been retrieved from the Thomson Reuters database. To mitigate endogeneity, the independent and control variables have been lagged by 1 year.

(26)

(e.g. Goldberg and Heflin, 1995). However, statistical significance at the 10% level is not as strong as other studies might show, and the coefficient size of 0.028 does not

suggest a very strong link. It appears that there are other variables that may influence corporate risk to a greater extent. Furthermore, corporate governance shows a strongly significant (1% level) link with firm risk, but at the same time it explains a very small portion of the variance (0.001). The control variables Size, Tobin’s Q, ROA, CAPXR and LEV all have significant coefficients. Besides ROA, which has a negative sign, all control variables have positive signs. The overall explanatory power of the model is rather low with an adjusted R squared of 0.100, leaving room for further research on predictors of the dependent variable. Regarding managerial implications based on the result on the main relationship; the relatively low coefficient does not suggest a need for drastic measures or policies.

For the second model, the interaction term between the degree of internationalization and corporate governance has been added to the equation. Hypothesis 2 was based on the expectation that corporate governance would reduce the impact of

internationalization on corporate risk. In fact, the model shows that the degree of internationalization, corporate governance, and the interaction term between those variables have an insignificant effect on the dependent variable. However, there is no significant support to accept the hypothesis and therefore hypothesis 2 is rejected. The model shows a weak similar explanatory power similar to the first model, with an

(27)

the explanatory variables do appear smaller than in the first model, which was expected, its statistical insignificance means the implications cannot be sustained.

Table 4

This table represents the results of the regressions for Model 1 and Model 2. Model 1 tests the effect of DOI on BETA, Model 2 tests the interaction term of DOI*CGV on the BETA. The dependent variable is corporate risk, measured as BETA from CAPM. The definition of all variables can be found in Appendix B. All variables are winsorized at the 1st_{and 99}th_percentile.

The robust standard errors are denoted in parentheses. *, **, ***, indicate statistical significance at the 10%, 5%, and 1% respectively.

INDEPENDENT VARIABLES MODEL 1 MODEL 2

(28)

ROA -0.249*** [0.052] -0.250*** [0.052] CAPXR 0.312*** [0.078] 0.311*** [0.078] LEV 0.039* [0.023] 0.039* [0.023] Constant 0.343*** [0.109] 0.355*** [0.109] Observations Adjusted R Squared Year fixed effects Industry fixed effects

30,280 0.100 YES YES 30,280 0.101 YES YES

The results for the effect of legal origin are showed in table 5. To determine the effect of legal origin, I split up my original sample into two subsets of Common law and civil law. Table 5 shows the coefficients and (in)significance of the results for respectively Model 3 civil law and Model 4 common law. Model 3 shows no significant effect of the degree of internationalization on corporate risk. The coefficient (-0.008) reports a negative sign meaning DOI would negatively impact corporate risk, however, there is no statistical significance to support this claim. Thus, for civil law countries in this study there is no empirical evidence that the DOI affects corporate risk measured as BETA. Furthermore, corporate governance, size, Tobin’s Q, and leverage show significantly positive signs. While the main relationship is not supported, it is interesting to see that corporate

governance is statistically significant as an explanatory variable for corporate risk, albeit of small explanatory power. Contradictory to civil law countries, Model 4 reports a

(29)

common vs. civil law countries. While DOI does not significantly affect corporate risk in civil law countries, it does in common law countries. Other variables also show different effects on corporate risk between civil and common law countries. While corporate governance was reported to be significantly positive in countries with a civil legal origin, it was insignificantly negative in countries with a common legal origin. Furthermore, ROA was found to be significantly negative at the 1% level in common law countries whilst insignificantly positive in civil law countries. Also, CAPXR had a significantly positive impact on corporate risk in common law countries, while leverage had a significantly positive effect on the dependent variable in civil law countries. Lastly, the difference in explanatory power of 0,241 for common law countries vs. that of 0,096 for civil law countries was reasonably large.

Table 5

This table represents the results of the regressions for Model 3 and Model 4. The dependent variable is corporate risk, measured as BETA from CAPM. The definition of all variables can be found in Appendix B. All variables are winsorized at the 1st_{and 99}th_{percentile. The robust standard errors are denoted in}

parentheses. *, **, ***, indicate statistical significance at the 10%, 5%, and 1% respectively. IND. VARIABLES MODEL 3 (CIVIL LAW) MODEL 4 (COMMON LAW)

(30)

[0.082] [0.064] CAPXR 0.062 [0.117] 0.401*** [0.097] LEV 0.077** [0.031] 0.028 [0.029] Constant 0.014 [0.166] 0.500*** [0.134] Observations 11,274 19,006 Adjusted R Squared 0,096 0,241

Year fixed effects YES YES

(31)

5. Conclusion

This study researches the effect of the degree of internationalization on corporate risk, the impact of corporate governance on this relationship, and the role legal origin plays on this relationship. All aspects of this study together make it an interesting contribution to literature on international financial management. Extant literature indicated links between internationalization, corporate risk(-taking), corporate governance, legal origin, and many more facets of international financial management. However, there was no widespread consensus on this specific research topic. The aim of this study was to prove that there was a definite relationship between internationalization and corporate risk, while also defining the effects of corporate governance and legal origin on this relationship. The used sample contained 34,973 global firm-year observations between 2002-2016. Several control variables were put in place, namely firm size, operating performance, market value, capital expenditures and leverage structure. The main relationship between DOI and BETA proved to be significantly positive.

For this study, there is statistically significant support that the degree of

internationalization positively impacts corporate risk. There is no statistical support for the effect of corporate governance on this relationship. Furthermore, it proved that countries that vary in terms of legal origin experience different effects for the degree of internationalization on corporate risk. Firms in common law countries show a

(32)

Based on the differences in effect between the two legal origins, and the drop in

significance from 5% to 10% from common law countries to the entire set, gives food for though on the impact DOI has in civil law countries. The differences in the effect of other explanatory variables between civil and common law countries elicit further research.

5.1 Limitations and further research

As studies are rarely flawless, so too do this research have limitations and therefore its results should be interpreted carefully. Firstly, there is a reasonable chance that it suffers from omitted variable bias. While there were several control variables and year and industry fixed effects to reduce its potential effect, there are other studies using different (control) variables which could arguably impact the results. Furthermore, corporate governance was measured as a general score accorded by Thomson

Reuters. Specific measures of corporate governance such as CEO compensation could prove to provide more valuable specific insights on the topic. Also, for the dependent variable this study has only regarded systematic risk. Idiosyncratic risk still plays a role in the total risk firms face, so one could opt to include idiosyncratic risk. While the time frame of this research is substantial is and chosen purposefully, it could also be argued to be a limitation. Based on changes in financial (reporting) regulations, the crisis of 2008 and other reasons, other time frames might be equally valuable or even more so.

(33)

(34)

Acknowledgments

First and foremost, I would like to show great appreciation for Dr. Halit Gonenc. You have undoubtedly helped me in more ways than you had to. Not only did you supervise my work and guide me into the right direction, moreover I experienced your patience and helpfulness with my specific situation to be exceptional. I have not been the most

(35)

References

Aggarwal, R., Erel, I., Ferreira, M., Matos, P., 2011. Does governance travel around the world? Evidence from institutional investors, Journal of Financial Economics 100, 154-181.

Armstrong, C. S., & Vashishtha, R., 2012. Executive stock options, differential risk-taking incentives, and firm value. Journal of Financial Economics, 104(1), 70–88.

Attig, N., Boubakri, N., El Ghoul, S., Guedhami, O., 2016. Firm internationalization and corporate social responsibility. Journal of Business Ethics 134, 171-197.

Bartov, E., G. Bodnar, and A. Kaul, 1996. Exchange rate variability and the riskiness of US multinational firms: Evidence from the breakdown of Bretton Woods. Journal of Financial Economics, 42: 105-132.

Bausch, A., Krist, M, 2007. The effect of context-related moderators on the internationalization-performance relationship: evidence from meta-analysis. Management International Review, 47(3): 319-347

Bebchuk, L., Cohen, A., Ferrel, A., 2009. What matters in corporate governance? Review of Financial Studies, 22, 783-827.

Bebchuk, L.A., & Weisbach, M., 2010. The state of corporate governance research. Review of Financial Studies, 23(3), 939–961.

(36)

Berger, A. N., El Ghoul, S., Guedhami, O., & Roman, R. A., 2016. Internationalization and bank risk. Management Science, 63(7), 2283-2301

Bhagat, S., Bolton, B., 2008. Corporate governance and firm performance. Journal of Corporate Finance 14, 257-273.

Brahm, R., 1994. The institutional embeddedness of international business strategy. Journal of Management Inquiry, 3(1), 40–50.

Bruno, V., & Shin, H. S., 2014. Globalization of corporate risk-taking. Journal of International Business Studies, 45(7), 800–820.

Capar, N., & Kotabe, M. 2003. The relationship between international diversification and performance in service firms. Journal of International Business Studies, 34, 345-355.

Cappiello, A., 2010. Legal Origins and Socio-economic Consequences: Can Legal Origins Really Explain the Main Differences in Economic and Juridical Performances? Nordic Journal of International Law, 79(4), 501-541.

Ciobanu, R., 2015. Mergers and Acquisitions: Does the Legal Origin Matter? Procedia Economics and Finance, 32, 1236-1247.

Coles, J. L., Daniel, N. D., & Naveen, L, 2006. Managerial incentives and risk-taking. Journal of Financial Economics, 79(2), 431–468.

(37)

Dang, C., Li, Z., Yang, C. 2018. Measuring firm size in empirical corporate finance.

Journal of Banking and Finance, 86: 159-176

Delios, A., & Beamish, P. W. 1999. Geographic scope, product diversification and the corporate performance of Japanese firms. Strategic Management Journal, 20: 711-721.

Djankov, S., La Porta, R., Lopez-de-Silanes, F., Shleifer, A., 2008. The law and economics of self-dealing. Journal of Financial Economics 88, 430-465

Duan, J., Wei, J., 2005. Executive stock options and incentive effects due to systematic risk ; Journal of Banking & Finance, 29, 1185-1211

Eisenhardt, K. M., 1989. Agency Theory : An Assessment and Review. The Academy of Management Review, 14(1), 57–74.

Faccio, M., Marchica, M. T., & Mura, R., 2011. Large shareholder diversification and corporate risk-taking. The Review of Financial Studies, 24(11), 3601-3641

Fatemi, A.M., 1984. Shareholder benefits from corporate international diversification. The Journal of Finance, 39, 1325–1344.

Francis, B. B., Hasan, I., Hunter, D. M., & Zhu, Y., 2017. Do managerial risk-taking incentives influence firms’ exchange rate exposure? Journal of Corporate Finance, 46, 154–169.

(38)

Gao, W., & Chou, J., 2015. Innovation efficiency, global diversification, and firm value. Journal of Corporate Finance, 30, 278–298.

Goldberg, S.R., Heflin, F.L., 1995. The Association between the Level of International Diversification and Risk. Journal of International Financial Management and Accounting, 6, 1-25.

Gompers, P., Ishii, J., Metrick, A., 2003. Corporate governance and equity prices. Quarterly Journal of Economics 118, 107-155.

Gozzi, J.G., Levine, R., and S.L. Schmukler, 2008, Internationalization and the Evolution of Corporate Valuation, Journal of Financial Economics, 88:607-632

Graff, M., 2008. Law and Finance: Common Law and Civil Law Countries Compared? An Empirical Critique. Economica, 75(297), 60-83.

Henderson, V., 2005. The impact of the market portfolio on the valuation, incentives, and optimality of executive stock options; Quantitative Finance, 5, . 35-47

Hitt, M. A., Ireland, R. D., & Hoskisson, R. E., 2007. Strategic management: Competitiveness and globalization (7th ed.). Mason, OH: South-Western.

Hughes, J. S., Logue, D. E., & Sweeney, R. J., 1975. Corporate international diversification and market assigned measures of risk and diversification. Journal of Financial and Quantitative Analysis, 10(04), 627-637.

(39)

Jang, Y., 2017. International corporate diversification and financial flexibility. Review of Financial Studies, 30(12), 4133–4178.

Jensen, Michael C., and William H. Meckling, 1976, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics 3, 305-360.

John, K., Litov, L., & Yeung, B., 2008. Corporate Governance and Risk-Taking. The Journal of Finance, 63(4), 1679–1728.

Krapl, A. A., 2015. Corporate international diversification and risk. International Review of Financial Analysis, 37, 1–13.

La Porta, R., Lopez-de-Silanes,, F., Shleifer, A., & Vishny, R., 1998. Law and Finance. Journal of Political Economy, 16(6), 1113-1155

La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R.W., 2000. Agency problems and dividend policies around the world. The Journal of Finance, 55(1), 1-33

La Porta, R., Lopez-de-Silanes, F., & Shleifer, A., 2008. The Economic Consequences of Legal Origins. Journal of Economic Literature, 46(2), 285-332.

Li, S., Qiu, J., & Wan, C., 2011. Corporate globalization and bank lending. Journal of International Business Studies, 42, 1016–1042

(40)

Michel, A., Shaked, I., 1986. Multinational corporations vs. domestic corporations: Financial performance and characteristics Journal of International Business Studies, 17, 89-100

Mihov, Naranjo, 2019. Journal of International Business Studies, 50 (9), 1544-1565

Mishra, D., Tannous, G., 2010. Securities laws in the host countries and the capital structure of US multinationals. International Review of Economics and Finance, 19(2010), 483-500

Olibe, K.O., Michello, F.A.,Thorne, J., 2008. Systematic risk and international

diversification: An empirical perspective ; International Review of Financial Analysis, 17, 681-698

Reeb, D., Kwok, C., & Baek, H., 1998. Systematic Risk of the Multinational Corporation. Journal of International Business Studies, 29, 2, 263-279.

Rugman, A. M., 1976. Risk reduction by international diversification. Journal of International Business Studies, 7(2), 75-80.

Sanders, W. M. G., & Hambrick, D. C., 2007. Swinging for the fences: The effects of CEO stock options on company risk-taking and performance. Academy of Management Journal, 50(5), 1055–1078.

(41)

Singla, C., George, R. 2013. Internationalization and performance: a contextual analysis of Indian firms. Journal of Business Research, 66(12): 2500-2506.

Strike, V., Gao, J., Bansal, P., 2006. Being good while being bad: social responsibility and the international diversification of US firms. Journal of International Business Studies 37(6), 254- 280.

Tian, Y., 2004. Too much of a good incentive? The case of executive stock options ; Journal of Banking & Finance, 28, 1225-1245

Titman, S., Wessels, R., 1988. The determinants of capital structure choice ; The Journal of Finance, 43, 1-19

Wright, P., Ferris, S. P., Sarin, A., & Awasthi, V., 1996. Impact of corporate insider, blockholder, and institutional equity ownership on firm risk-taking. Academy of Management Journal, 39, 441-458.

Zaheer, S., 1995. Overcoming the liability of foreignness. Academy of Management Journal, 38, 341–363.

(42)

Appendix A Countries + legal origin

This table represents the countries that were part of this study and the amount of observations per country as well as their legal origin.

COUNTRY N LEGAL ORIGIN

AUS 1,970 Common Law

AUT 129 Civil Law

BEL 208 Civil Law

BRA 386 Civil Law

CAN 1,977 Common Law

CHE 544 Civil Law

CHL 116 Civil Law

CHN 449 Civil Law

COL 34 Civil Law

DEU 813 Civil Law

DNK 234 Civil Law

ESP 399 Civil Law

FIN 296 Civil Law

FRA 962 Civil Law

GBR 3,030 Common Law

GRC 148 Civil Law

HKG 1,041 Common Law

HUN 19 Civil Law

IDN 148 Common Law

IND 419 Civil Law

IRL 123 Common Law

ISR 77 Common Law

ITA 350 Civil Law

JPN 3,936 Civil Law

KOR 456 Civil Law

LUX 31 Civil Law

MEX 166 Civil Law

MYS 230 Common Law

NLD 333 Civil Law

NOR 259 Civil Law

NZL 138 Common Law

PER 9 Civil Law

PHL 84 Civil Law

POL 103 Civil Law

PRT 94 Civil Law

(43)

SWE 462 Civil Law

THA 129 Common Law

TUR 106 Civil Law

USA 9,014 Common Law

(44)

Appendix B: Variable description

This table defines and describes the variables that have been used for this study.

Variable Name Variable definition

BETA The BETA coefficient which represents the systematic risk, from the CAPM

DOI The degree of internationalization, measured as foreign sales divided by total sales

CGV The corporate governance score as obtained from the Thomson Reuters database

SIZE Firm size, measured as the natural logarithm of total assets Tobin’s Q The ratio between market value and its replacement value,

calculated as equity market value divided by book market value ROA The return on assets of a firm, measured by dividing net sales after

taxes by total assets

CAPXR Capital expenditure ratio, measured as the capital expenditures divided by a firm’s total sales

LEV The leverage ratio, measured as total debts divided by total assets Legal origin The origin of law. Countries are split up for this study into either

(45)

The impact of international diversification on corporate risk: moderating role of corporate governance and legal origin