By Bill Dockery

A series of papers written by a University of Tennessee finance professor almost two decades ago may furnish a clue to understanding and responding to events like the deep recession that has gripped global financial markets in the past year.

Ramon DeGennaro, the CBA Professor of Banking and Finance in the College of Business Administration, says that at the time he did the original research, stocks and money did not change hands for five business days after the buyer and seller agreed to the trade. The delay was required to allow paperwork to be exchanged. With the intervention of weekends and holidays, the actual delivery could be delayed for seven or eight days.

“I discovered that buyers and sellers put a premium on the sale price, a ‘surcharge’ to compensate the seller for the buyer’s continued use of the money for five more business days,” says DeGennaro. “Sophisticated investors have a good feel for how much the delay is worth, and competition ensures that this gets built into the price.”

Ramon DeGennaro says increases in the risk premium may have been an early indicator of market fragility.

In the intervening years, regulators and investors became concerned about what could happen to the stock in five business days. The five-day delay was reduced to the current three-day period in 1995.

“Now, if you buy stock from me on Tuesday, it will be Friday before I actually give you the stock and you give me the money,” DeGennaro says. “With a weekend or holiday in the mix, it can be five or six days before the transfer takes place. If the bottom falls out of the stock value during the intervening time, you’re still obligated to pay me our agreed-upon price.”

The recent financial turmoil, DeGennaro believes, may have generated a risk premium on stock prices similar to but larger than the surcharge he found in his earlier studies. “In a scenario like that of 2008, we’d expect the cost of the added risk to be built into the trade. The market’s volatility would be reflected in the price of stocks,” he says.

DeGennaro thinks the risk premium would be an indicator of the confidence—or lack thereof—that investors have in the health of the market or of a particular institution. “The risk premium can be an indication of what investors think the chances are that an institution handling the trade will fail,” he says. “What are the chances of a disruption of payments? Am I going to get paid on time if the institution is gone or swamped with transactions?”

He expects that an examination of the financial transactions of the 2008 period would reveal the existence of the risk premium as an unarticulated cost of the market’s volatility.

“If we had been watching the uptick in the risk premium in the summer of 2008, it might have alerted us early on that investors thought the markets were fragile.”

“The shorter the delivery terms, the better off we are,” DeGennaro concludes. “Once we’ve agreed to trade, only bad things can happen when the transactions are delayed.” Today, electronic trading and fund transfers make almost instantaneous delivery possible, so the three-day period no longer serves a valid function. “In today’s electronic environment, three days is a lifetime,” he says.

DeGennaro’s Research Agenda

DeGennaro does not limit his research interests to analyzing the immediacy of volatile markets; his research agenda extends to projects that explore the social dimensions of capital investment.

» He has talked with the Angel Capital Association, which is gathering data on investments made by small investors in start-up companies, with the intent of studying how much investors tend to earn on start-up ventures compared to other possible placements of capital. DeGennaro and the association also want to study the long-term results of investments in start-up companies.

» With UT colleague Harold Black, who serves as Smith Professor of Finance, and graduate student Laura Cole, DeGennaro plans to explore whether and how companies change when minorities are appointed to corporate boards. “There is very little academic research on the appointment of minority board members,” DeGennaro says. He and his colleagues want to determine whether minority directors are racial tokens appointed for what he calls political cover, or whether they can make concrete contributions to the guidance of a corporation.

» With UT colleague Deborah Murphy, DeGennaro plans to examine the disparate effects of corporate fraud on small firms versus large corporations. They are exploring how firm size and industry concentration affect the reputational penalties of corporations that are found guilty of fraud.