8. Appendix A:8.1 Background information: Business group in India

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8. Appendix A:

8.1 Background information: Business group in India

The business groups in India have long existed for more than sixty years. They play an important role

in the Indian economy. The earliest Indian business groups were featured by the close connections

with the government. From the late 1950s through the 1970s, the Indian economy was characterized

by strong government interference of the economy.

Some important sectors, such as financial

service, telecommunication were reserved by the government as state-owned companies. During

this period, the government controlled “private sector’s ability to pursue growth opportunities,

access domestic finance, or collaborate with foreign technology or business partners” (Khanna

and Palepu 2004). In the mid-1980s, the government began move towards deregulation. In 1990s,

government accelerated the reform of its economy; several sectors such as telecom, aviation and

banking were opened to private sector. The economic reforms provide more opportunities and

challenges for the Indian business groups.

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8.2 Comparing Fitch’s rating results to my estimate EDF default probability

In order to gauge how accurate my default risk measures are, I would like to compare my

default probability estimates to those estimated from the professional credit rating agency.

Prowess provides the credit rating results for 85 debt issue companies published by Fitch. After

I exclude all the financial firms and the firms cannot be found in my sample, there are 45 firms

in Fitch’s rating overlap with my sample, including thirteen stand-alone companies and

thirty-two group-affiliated companies. The credit rating classification for Fitch is ranged from

AAA (the best creditworthiness) to D (the default category), totally twenty-four risk levels

being included. I assign the corresponding scores for each rating category. For example, score

one is for AAA rating, and the score two is for AA+ rating, etc. The worst debt rating in the

sample is BB, so the maximum score is 12.

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t+1. The first reason for checking the robustness is that as suggested by Da and Gao (2005), it is

necessary to skip a month between portfolio formation and holding period to control for the

impact of market microstructure noise and liquidity risk. The second reason as pointed out by

Garlappi et al. (2006) is; since the EDF is based on equity prices, skipping a month helps

alleviate the concern of detecting a spurious relationship between EDF and returns. The CAPM

model including the default risk measure EDF, as introduced in section 4, is used because of

these reasons.

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Table 1 the summary for literature review

No. Author Market Period Model Control Variable

1 Vassalou and Xing (2004) the U.S. 1971-1999 KMV model EMART,SMB,HML

2 Garlappi et al (2006) the U.S. 1969-2003 KMV model

Size, R&D expense, BM, asset tangibility

3 Dichev (1998) the U.S. 1981-1995

Z-score and

O-score MV, BM

4 Griffin and Lemmon (2002) the U.S. 1965-1996 O-score MV, BM

5 shumway (2001) the U.S. 1962-1992 hazard Market size

Result:

1. there is a positive relationship between default risk and euqity returns (No. 1, No.2) 2. there is a negative relationship between default risk and equity returns (No3, No4,

No.5)

Table 2 the assigned score for Fitch rating

Credit rating Corresponding score

AAA 1 AA+ 2 AA 3 AA- 4 A+ 5 A 6 A- 7 BBB+ 8 BBB 9 BB+ 10 BB 11 BB- 12

Table 3 the correlation between EDF and Fitch’s rating

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Table 4 the results of Robustness test

Dependent variable is the stock returns in month t+1, i.e., one month after the portfolio formation. The table reports the CAPM model including the default risk measure EDF. * indicates statistical significant at the 10% level, ** at the 5% level and *** at the 1% level

Constant EMKT EDF Adjusted-R2

All firms Coefficient

-0.024

0.906***

1.048**

0.662

t-value

-0.513

12.367

2.069

All stand-alone firms Coefficient

-0.012

0.879***

1.079**

0.630 t-value

-0.241

11.600

2.049

All group firms Coefficient

0.080 0.925***

-0.609

0.635

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9. Appendix B:

Table 1: summary statistics

Table 1 reports summary statistics for all the variables used in the replicated KMV-Merton Model and Fama French model. E is the market value of equity. F is the face value of debt, which is calculated as the current liabilities plus one half of long-term debt. V is the market value of the firms, which is calculated as the sum of firms’ market capitalization and the face value of debt. BM is book-to-market ratio is taken from Prowess as the inverse of P/B ratio. óV is the asset volatility measured in percentage per month. R is the expected equity return of the firms. EDF is the expected default frequency

Panel A:Means, Standard Deviations and Qurtiles for all companies

Variable Mean Ste. Dev. Min 0.25 Mdn 0.75 Max

E 1396.511 5514.943 2.070 53.016 148.520 629.376 149101.670 F 2000.860 10213.704 0.030 114.881 276.400 800.185 230071.625 BM 1.751 2.276 -50.000 0.503 1.136 2.772 33.333 V 3401.300 13175.150 10.905 197.133 484.490 1124.460 263424.105 VolV 0.126 0.415 0.008 0.126 0.126 0.126 0.126 return 0.162 1.030 -9.120 -0.345 0.090 0.605 54.550 EDF 0.057 0.120 0.000 0.057 0.000 0.035 1.000

Panel B:Means, Standard Deviations and Qurtiles for stand-alone companies

E 1829.898 6808.625 2.070 60.920 188.160 767.895 122064.580 F 3426.120 15330.143 5.915 92.234 216.450 869.495 230071.625 BM 1.455 1.736 -8.333 0.385 0.877 1.923 16.667 V 5256.067 18768.881 14.375 177.009 453.003 2106.021 263424.105 VolV 0.135 0.632 0.008 0.061 0.092 0.145 69.166 return 0.170 1.120 -9.120 -0.340 0.090 0.600 54.550 EDF 0.058 0.123 0.000 0.000 0.000 0.034 1.000

Panel C: Means, Standard Deviations and Qurtiles for business group companies

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Table 2 summary statistics for Fitch rating

Table 2 reports the comparison result of Fitch rating between stand-alone firms and group-affiliated firms. Totally 13 stand-alone firms and 32 group-affiliated firms are included in the comparison. Fitch rating is measured by assigning corresponding score to each credit rating classification. The result is an average score for stand-alone firms and group-affiliated firm. The average EDF and average return are also reported in the table.

Number

Fitch Rating

Average EDF

Average return

stand-alone firms

13.000

4.077

0.052

0.112 group-affiliated firms

32.000

3.563

0.040

0.119 Table 3 Summary Statistics of Fama-French Factors

In Table 3, EDF is the average default probability of all portfolios; EMKT denotes the value-weighted excess return on the sample portfolio over the risk-free rate; SMB and HML are Fama-French factor. SMB denote size effect and HML denotes value effect. * indicates statistical significant at the 10% level, ** at the 5% level and *** at the 1% level

Panel A: correlation between EDF and Fama-French factors

EDF EMKT SMB HML

EDF 1

EMKT 0.149 1

SMB 0.209 0.109 1

HML 0.172 -0.003 0.358 1

Panel B: Time-series Regression of Fama-French Factors on EDF

Factor Constant EDF

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Table 4. Descriptive statistics:

Portfolio characteristics, returns and default likelihood

The number of firms in a portfolio is the equally populated number of firms in the portfolio over time. The average return on a portfolio is defined as the simple average of the returns on all stocks in the portfolio. Returns on individual stocks is defined as 30 days average return over a period, correcting for events such as stock splits, rights issues, and dividend payments, .EDF is equally weighted default likelihood of the portfolio.

firm number Average return

EDF

Small-cap firms

low B/M

stand-alone frims

17

0.258

0.022 group firms

26

0.217

0.047 Mid B/M

stand-alone frims

18

0.233

0.076 group-frims

26

0.215

0.106 High B/M

stand-alone frims

18

0.408

0.186 group firms

26

0.253

0.188 Mid-cap firms

low B/M

stand-alone frims

18

0.109

0.006 group firms

26

0.114

0.013 Mid B/M

stand-alone frims

18

0.098

0.008 group firms

26

0.147

0.026 High B/M

stand-alone frims

18

0.168

0.116 group firms

26

0.162

0.085 Large-cap firms

low B/M

stand-alone frims

17

0.056

0.037 group firms

26

0.085

0.002 Mid B/M

stand-alone frims

18

0.073

0.058 group firms

26

0.075

0.003 High B/M

stand-alone frims

18

0.124

0.140

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Table 5 Difference in Stock returns and EDF between group companies and stand-alone

companies

GRMINSA is calculated as the difference between the average return /or EDF on all group companies and the average return/or EDF on all stand-alones. GMS is calculated as the difference between the average return/ or EDF on the nine group company portfolios and the nine standalone portfolios. t-statistics (mean) is in parenthesis. * indicates statistical significant at the 10% level, ** at the 5% level and *** at the 1% level

Panel A: return differences

GMS

GRMINSA

All firms

Mean

-0.027

-0.013

(t=-1.091 p=0.278)

(t=-1.162 p=0.264)

Small-cap firms

Mean

-0.071*

-0.050*

(t=-1.963 p=0.053)

(t=-1.607 p=0.094)

Mid-cap frims

Mean

0.010 -0.001

(t=0.296 p=0.768)

(t=-0.031 p=0.967)

Large-cap firms

Mean

0.003

0.110 t=0.139 p=0.89

t=0.465 p=0.643

Panel B: EDF differences

GMS

GRMINSA

All firms

Mean

-0.021**

-0.001

(t= -2.765 P=0.007)

t= -1.126 p=0.258

Small-cap firms

Mean

0.010**

0.026**

t= 9.324 P=0.000

(t=13.648 p=0.000)

Mid-cap frims

Mean

-0.022*

-0.006**

(t= -1.85 p=0.068)

(t= -2.257 t=0.027)

Large-cap firms

Mean

-0.023**

-0.250**

(t= -3.597 p=0.001)

(t= -18.798 p=0.000)

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Table 6 Portfolio sorted on the basis of EDF

From 1998 to 2004, at the end of each year, I sort stocks into quintiles based on their EDF measures rank, I then compute the equally weighted average returns over this period. Portfolio 1 is the portfolio with the lowest default risk and portfolio 5 is the portfolio with the highest default risk. “High-low” is the difference in the return and EDF between the high and low default risk portfolios. * indicates statistical significant at the 10% level, ** at the 5% level and *** at the 1% level

Low EDF High

1 2 3 4 5 High-low t-value

Panel A: stand-alone firms

Average return 0.09 0.099 0.171 0.195 0.297 0.208*** 3.893

Average EDF 0 0.001 0.008 0.06 0.205 0.218*** 22.835

Average size 3801.55 3332.8 1057.76 521.01 415.73

Average BM 0.33 0.819 1.116 2.101 2.909

Panel B: group firms

Average return 0.115 0.133 0.174 0.17 0.193 0.078 1.555

Average EDF 0 0.003 0.015 0.056 0.218 0.205*** 25.404

Average size 3902.59 1000.83 240.38 320.23 86.03

Average BM 0.575 1.269 1.734 2.558 3.576

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Table 7 the CAPM model regressions including EDF

The tests are performed on the excess returns of 18 equally weighted portfolios sorted by their size, B/M ratio and group-affiliation category, plus three portfolios of all group firms, all stand-alone firms and all firms in the sample. Dependent variables are the equally weighted return of each portfolio. Independent variable EMKT refers to the excess return on the value-weighted return of all the stocks in the sample over the risk-free rate. EDF is the default probabilities of the companies calculated from the replicated KMV model. * indicates statistical significant at the 10% level, ** at the 5% level and *** at the 1% level

Panel A: all companies

All firms Coefficient -0.064 0.886*** 1.926** 0.662

t-value -0.915 12.168 2.209

All stand-alone firms Coefficient

-0.016

0.913***

1.331**

0.64

t-value

-0.344

10.837

2.479

All group firms Coefficient

0.011 0.940***

0.733

0.633

t-value

-0.307

10.649

0.534 Panel B: Stand-alone companies

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Table 8 Fama-French regressions

The tests are performed on the excess returns of 18 equally weighted portfolios sorted by their size, B/M ratio and group-affiliation category, plus three portfolios of all group firms, all stand-alone firms and all firms in the sample. Dependent variables are the equally weighted return of each portfolio. Independent variable EMKT, SMB and HML represent the market, size and value effect. * indicates statistical significant at the 10% level, ** at the 5% level and *** at the 1% level

Panel A: all firms

Constant EMKT SMB HML Adjusted-R2

All firms Coefficient -0.045** 0.859*** 0.536*** 0.167** 0.851 t-value -2.026 17.858 9.047 2.088

Stand-alone firms Coefficient -0.026 0.835*** 0.572*** 0.148* 0.842 t-value -1.141 16.881 9.384 1.796

Group firms Coefficient -0.045* 0.882*** 0.503*** 0.184** 0.812

t-value -1.735 15.835 7.330 1.988 Panel B: Stand-alone firms

Constant EMKT SMB HML Adjusted-R2

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Table 9 Fama-French regressions including EDF

The tests are performed on the excess returns of 18 equally weighted portfolios sorted by their size, B/M ratio and group-affiliation category, plus three portfolios of all group firms, all stand-alone firms and all firms in the sample. Dependent variables are the equally weighted return of each portfolio. Independent variable EMKT, SMB and HML represent the market, size and value effect. EDF is the default probabilities of the companies calculated from the replicated KMV model. * indicates statistical significant at the 10% level, ** at the 5% level and *** at the 1% level

Panel A: all firms

Constant EMKT SMB HML EDF Adjusted-R2

All firms Coefficient -0.081** 0.853*** 0.527*** 0.158* 0.619 0.851 t-value -1.960 17.565 8.805 1.958 1.034

Stand-alone firms Coefficient -0.067** 0.811*** 0.560*** 0.130 0.653* 0.847 t-value -2.110 16.024 9.253 1.594 1.825

Group firms Coefficient -0.002 0.870*** 0.511*** 0.187** -0.799 0.811 t-value -0.026 14.990 7.352 2.014 -0.799

Panel B: Stand-alone companies

Constant EMKT SMB HML EDF Adjusted-R2

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