Short-termism : an investigation of some UK evidence

Abstract

The aim of this thesis is to undertake an empirical investigation into the assertion that UK investors display short-term behaviour. The thesis starts by reviewing the existing literature which comprises a diverse set of explanations of the concept of short-termism. This survey results in, firstly, a more concise definition of short-termism and, secondly, a framework into which the various theories may be placed. The various approaches to short-termism are categorised into two effects: the numerator effect and the denominator effect. The former refers to the underestimation of future cash flows while the latter refers to those cases in which an excessively high discount rate is used. Both these effects result in the present value of a proposed project being reduced. therefore causing the project to be rejected when it might otherwise have been accepted.

Although the literature covers many different approaches to short-termism this thesis concentrates only on one aspect of short-termism. namely the denominator effect. Such an approach is advantageous in that it allows the consideration, and possible elimination, of a particular type of short-termism. thus giving direction to future research. By decomposing the discount rate into the following components: a time value of money, a liquidity premium, an equity risk premium and an exchange rate risk premium it becomes possible to distinguish between "true" short-term ism and "general" short-termism. "True" short-termism refers to the existence ofa high time value of money whilst "general" short-termism refers to the use of a high discount rate for whatever reason. whether it be a high time value of money, liquidity premium or equity risk premium.

A preliminary investigation into the existence of both types of short-termism is carried out by the comparison of international real rates of return and risk premia as a means of testing for differences in the behaviour of investors across countries. The results of this investigation lend little support to the assertion that UK investors are short-termist, but suggest that if short-termism is present it is in the form of "true" short-termism. Following these results, further empirical analysis is carried out into the issue of "true" short-termism. A key feature of this analysis is the relaxation of the assumption of the rational expectations in both the interest rate and foreign exchange market. The effect of this is two-fold: firstly, ex post and ex ante rates need no longer only differ by a random error, and secondly, a non-zero exchange rate risk premium may exist. Therefore the thesis also derives an ex ante interest rate series and an exchange rate volatility series using the methodology of Mishkin(1984a,b) and a Generalised Autoregressive Conditional Heteroscedasticity framework respectively.

Throughout the thesis a parallel hypothesis is considered of whether a distinction could be drawn between investor behaviour in countries with capital market-based financial systems and those with bank-based financial systems. The thesis finds little support, given the assumptions made and dataset used, for the assertion that UK investors are more short-termist than elsewhere and no evidence to support a distinction between investor behaviour across countries.