December 02, 2011 by Ian.Crumm
Three Philadelphia professors, including Ralph Walkling and Jie Cai from Drexel University, won an award Nov. 16 for their research about the impact of social ties on financial investments.
Walkling, the Stratakis Chair in Corporate Governance and Accountability, and Cai, professor of finance, worked with Lehigh University’s Ke Yang to investigate the social networks between firm directors and Wall Street executives. They concluded that more social ties result in higher trading costs for individual investors.
The professors recently received the Outstanding Paper recognition in the investments category for the 2011 Southern Finance Association Annual Meeting, which was held in Key West, Fla.
There were two components to their research: relationship observation and statistical analysis. BoardEx, a business networking service that examines relationships between executives, was used to track personal ties between firm directors and Wall Street. Over 18,000 firm observations from 2000 to 2008 were used to demonstrate the actual costs of trading.
“BoardEx is where the social connections come from,” Walkling said about the observational research. “[The statistical research] is based on actual stock priced movements of the companies.”
Social ties from employment positions, educational backgrounds and leisure activities were also observed. Nonverbal social cues expressed though these connections can have impacts on trading costs.
“I infer information from just watching what happens to my neighbor, driving a new expensive car or canceling a long-anticipated vacation,” Walkling said. They used these analyses of nonverbal social cues as part of their research, taking it beyond just numbers and statistics.
More information flows between connections established from educational backgrounds or leisure activities as opposed to employment connections. Nonprofessional ties tend to facilitate this transfer of information more. It is the concept of friends informing friends when something is happening in the financial world.
The professors found that firms operated by connected directors increase costs to shareholders, thus decreasing the shareholders’ wealth. They estimate that an average firm with eight connected directors has an increase in cost upward of $213 million.
The Sarbanes-Oxley Act holds companies accountable for more of their actions. It was passed in 2002 to decrease the flow of insider information and trading. On average the act has lowered the effect of social ties on trading by 60 percent.
“Sarbanes-Oxley increased the public awareness of corporate governance and the importance of protecting privileged information,” Walkling commented in an email.
Deaths of Wall Street executives and the costs of trading were also analyzed by the professors. They found that a death usually caused a reduction in bid-ask spread, which is the gap between a seller’s lowest selling price and a buyer’s highest buying price.
“The spread widens (trading costs increase) to adjust for the increased possibility of informed trading. When the connection is severed by the death of the executive, the spread decreases (trading costs are reduced),” Walkling wrote in an email about the reduction in bid-ask spread. “This effect reinforces the idea that social connections matter.”
Walkling, Cai and Yang submitted their award-winning paper to different academic journals to be considered for publication. They are looking further at the connections held within the financial world and continue to research the topic.