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Brexit: investor paranoia and the financing cost of firms

European Union and British Union flag , UK Brexit, European Union broken

Financial markets faced a bumpy ride in 2018. The Financial Times report that global bond and equity markets shrank $5tn last year. Two major risks have been disrupting the markets during the past year: US-China trade dispute and Brexit. The two risks, however, are essentially the same: both would cause new frictions and impediments to the existing trade frameworks and unsettle investors’ nerves.

The risks may have consequences on firms’ financing cost for real reasons. Take Brexit with no deal as an example. First, a firm’s revenue can decline due to the friction in the product market, especially for British firms that heavily depend on the European markets. Second, the friction in the labour market may increase a firm’s production cost. Both will lead to adverse effects on a firm’s cash flow and, consequently, the firm’s financing costs. However, the Brexit might also increase the firm’s financing cost just because the investors become paranoid and exaggerate such adverse impacts brought by Brexit.

Yet, to what extent does investor paranoia affect a firm’s financing cost? The question is interesting for two reasons. First, although economists have been assuming investors to be rational, empirical evidence has challenged this view. Answering this question not only contributes to the evidence of irrationality, but also quantifies the real impact of investor irrationality on firms. Second, irrationality drives the valuation from the fundamentals and, de facto, creates possibility for arbitrage.

Dr Hui (Frank) Xu
Dr Hui (Frank) Xu

A work in progress by Dr Hui (Frank) Xu, a research associate at the Cambridge Centre for Finance (CCFin), and his co-authors, studies the question by studying the yield difference of British corporate bonds maturing before and after 29 March 2019, the date on which Great Britain is set to leave the European Union. The idea is simple. Take a corporate bond which matures one day before 29 March and another identical bond which matures one day after 29 March: if the yield of the latter is significantly higher, then we can conclude that the yield difference captures the impact of investor paranoia on the firm’s debt financing cost. Even if Great Britain crashes out of the EU without a deal on 29 March, it can hardly affect a firm’s fundamentals, such as revenue and cost, within one day. Therefore, the only explanation for such a yield difference lies in investor paranoia.

Guided by the empirical design, the authors collect a small sample of British corporate bonds. The preliminary analysis does show that bonds maturing after the Brexit date have a higher yield than similar bonds maturing before the date, indicating the real financing cost on firms due to investor paranoia about Brexit risk. The authors are in the process of collecting more data and a working paper and more results will be published very soon.