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Literature Review on



Submitted to
Dr. Fan Yang

Prepared by
Shafayat Hussain
ID # 11232512
NSID # shh110
MSc in Finance (Fall 2017)

Edwards School of Business, University of Saskatchewan

Dated, 06 December 2017
“In 1983, 90% of American Media was owned by 50 companies. In 2011, that same 90% is
controlled by 6 companies.” (Lutz, 2012)

Although the statement refers to one specific industry in USA, the global scenario is somewhat
alike across various industries such as consumer goods, financial assets, TV channels, airlines,
automobiles, and even beers. Mergers and Acquisitions (M&A), defined in a simplistic way as
consolidation of companies, thus, have gained waves of popularity in recent times. This is why,
researches in the area of M&A are pivotal to reshape the future M&As within a well-structured

Current literatures have associated stock price with merger activities. For instance, Benjamin
Bennett & Robert Dam (2017) in their paper “Merger Activity, Stock Prices, and Measuring
Gains from M&A” showed that if M&A activity informs expectations about future activity, it
would create a positive link between changes in deal activity and stock prices. But the current
literatures do not show any association of merger activities with the second order derivative of
stock price, stock price standard deviation, commonly referred as market volatility. The objective
of this paper is to establish a relationship between stock market volatility and merger activities
specifically during the sixth merger wave which occurred during the years 2003 to 2007. Although
the sixth wave is not very commonly defined, Alexandridis (2012), and Muhammad Faizan
Malik, Melati Ahmad Anuar, Shehzad Khan & Faisal Khan (2014) defined the mergers in this
period as the sixth wave.

Literature Review
Mergers and Acquisitions (M&A)
Merger and Acquisition, although not exactly the same terminology in literal meaning, but are
often referred to interchangeably. In case of a merger, two or more firms amalgamate their
businesses and operate as one, while in case of an acquisition, one firm purchases a portion or
whole of another firm and bring the firm under their business portfolio. As defined by Alao (2010),
in merger, two or more than two organizations constitute one organization. As per definition of
Horne & John (2004), merger is the legal activity in which two or more organizations combine
and only one firm survive as a legal entity. According to Khan (2011), two or more firms close
together and form one or more firms. Georgios (2011) defined that, in a merger, two or more firms
approach together and become a single firm, while in acquisition big and financially sound firm
purchase the small firm. Lastly, Durga, Rao & Kumar (2013) provided the definition of M&A
as activities involving takeovers, corporate restructuring, or corporate control that changes in
ownership structure of firms.

The notion behind a firm entering into M&A is that working together with some other company
will often add more value rather than working alone. M&A results in an increased return on equity
as well as shareholders’ wealth, and at the same time, it lessens the operating cost for the firm.
(Georgios & Georgios 2011) Today’s market is fast-paced, and to survive in this situation, firms
enter into M&A to maximize shareholders’ wealth. Gattoufi et al (2009) found out that the
management of the firms are also in favor of M&A as it increases their authority which helps them
in achieving short and long-term goals of the firm.

Brief History of M&A

Mergers and Acquisitions is a significant means of penetrating an offshore market expanding the
business. (Goyal & Joshi, 2011) Dating back to the 18th century, M&A originated from the USA.
In the 19th century, M&A found its footmark in Europe. (Focarelli, Panetta & Salleo 2002) Most
of the researches that have been conducted on M&A covers mostly USA and Europe. In contrary,
research on M&A activities in developing countries such as India, Pakistan, Malaysia and
Bangladesh can be hardly found. Since the last 30 years, firms have been extensively considering
M&A as a medium of corporate restructuring. At the beginning, this trend of consolidation was
confined to only developed countries, particularly in the USA and the UK. Later on, developing
countries also began to follow the same footprint. Observing the growth scenario, Coopland
(2005) concluded that solely during the last decade of the 20th century, the USA witnessed a three
times increase in the number of M&A activities while this increase in fact fivefold in terms of

Understanding the Merger Waves

Researchers observed a clustering pattern in the M&A activity of the past century. These clusters
are defined as waves and these occurrences are followed by a certain period of inactivity.
(Sundarsanam, 2003) Researchers could not specify the length or the starting time of a merger
wave, but it has been observed that the end occurs in parallel with a major break in economy such
as war or beginning of a crisis/recession. The first and the second wave was only limited to the US
market. But the other waves, specially the fifth wave, were more sparse covering the geographical
regions of USA, UK, Europe, and also, Asia.

Theory of M&A Clustering

There are three (3) different schools of thought explaining the motives for takeover. Neoclassical
model believes takeover waves to originate from industrial, economic, political or regulatory
shocks. Another model suggests that takeover clustering is influenced by the self-interest of the
managers e.g. herding, hubris or agency problem. The last model related takeovers to capital
market development, therefore saying that the waves occur because of managerial market timing.
Neoclassical Model

Neoclassical models dispatch the idea that restructuring happens in parallel with takeovers, and
factors that motivate restructuring, motivates mergers as well. Coase (1937) was one of the earliest
proponents of neoclassical model stating that technological changes stimulate takeover activities.
Afterwards, Gort (1969) posited the notion that economic disturbances, such as market
disequilibrium, might cause industry restructuring. Jovanovic & Rousseau (2001, 2002)
developed Gort’s proposition and unveiled the Q-theory which says that economic and
technological changes build a greater degree of corporate growth opportunity which gives rise to
capital reallocation to more productive and more efficient organization eventually leading to
takeovers. Some researchers explained takeover activity stating the relationship between industry
specific shocks and availability of inexpensive capital. Harford (1999) showcased a model that
expressed the idea that M&A takes place when firms have large cash reserve or limited access to
external sources of finance. Martynova & Renneboog (2006b) presented empirical evidence in
favor of this notion. Thus, neoclassical model explains takeover clusters happening in times of
capital market growth by industry and by country. Also, reaction to competitors’ actions can also
drive M&A clustering. (Persons & Warther, 1997)
Models of managerial hubris, herding, and agency problem

Some of the empirical literatures have showed that a notable portion of M&As, rather than adding
value, have diminished the value. This gave rise to another explanation of rationale behind M&A
from the perspective of managerial decision making. Roll (1986) explained M&A in terms of
managerial hubris which suggests that managers can get overconfident and thus overestimate the
generation of synergistic value. Herding is when firms tend to imitate the action of a first mover.
Scharfstein & Stein (1990), Graham (1999), Boot, Milbourn & Thakor (1999) and Devenow
& Welch (1996) explain M&A clustering in respect of managerial herding combined by hubris.
These imitating firms do not necessarily act on economic rationale, and this is why the following
mergers may not have the same efficiency as the first one had. This school of thought also explains
M&A from a behavioral perspective. Auster & Sirower (2002) defines three (3) stages in mergers
– development, diffusion and dissipation. They mentioned that waves create in response to macro
factors and the competitiveness of the environment. But if the M&As do not create expected
outcome, market forces then cause the wave to decline. Gorton, Kahl & Rosen (2000) posited
that an alternative value-destroying approach may also take place. Managers preferring their firms
remain independent, may involve in mergers fearing the danger of being taken over, resulting in
inefficient merger activities.
Models of managerial market timing

Recent articles explain M&A clustering from the standpoint of managerial market timing.
Following Myers & Majluf’s (1984) proposition that managers might base their decision to
purchase real asset on equity overvaluation, Shleifer & Vishny (2003) says that takeover waves
can also happen as a bullish state in financial market may tend to overvalue stocks in the short

Different Waves in Mergers

The existing literatures have listed five (5) distinct waves so far, and in some literatures, a sixth
wave has also been mentioned.
First Wave

1897 was the year of outset for the first merger wave and it ended in 1904. During this time,
horizontal mergers in the industries which were doing good such as railroads, light and power etc.
happened as the manufacturers thought they could capitalize from the market being a single seller
in the market, resulting in increased market concentration. (Fatima & Shehzad, 2014) Most of
the deals that were signed during this time did not make it through to reach their targeted
Second Wave

The second merger wave initiated in the year 1916 and existed till 1929. This time, the focus of
the organizations entering into mergers was oligopoly and not monopoly. Railroads and
transportation saw hi-tech expansion during this era. The second merger wave was vertical and
conglomerate. (Golubov & Petmezas, 2013) Producers of ore and mineral, food items, oil and
fuel, transport and chemical were the major participants in M&A in this time. Banks also lent
enormous support to make the M&A possible by offering loans on easy installments.
Third Wave

The third merger wave lasted from 1965 to 1969. Similarly as the second wave, mergers in this
period were also of a conglomerate nature. Owners’ capital as compared to debt from banks backed
the mergers during this tenure. In 1968, this wave saw the end of consolidation among unlike firms
since the financial performance was not satisfactory. (Fatima & Shehzad, 2014)
Fourth Wave

The fourth merger wave during 1981 to 1989 was marked by the extent of hostile mergers. By the
end of 1980s, hostile takeovers became tolerable among businesses. Organizations and speculators
affiliated to take over firms to make lofty gains in the short time. Takeovers during this wave are
considered to be either friendly or hostile depending on the endorsement of the Board of Directors
(BoD). If the BoD endorsed the deal, it was considered friendly, and vice-versa. Golubov &
Petmezas (2013) defined the fourth merger wave to consist mergers among oil and gas,
pharmaceutical, banking and airlines industries.
Fifth Wave

This wave initiated in 1992 gaining momentum from worldwide flourishment in share market, and
also, deregulation. Mergers were mostly seen within banks and telecom sectors. The M&A deals
were mostly financed by equity in parallel with debt. (Kouser & Saba, 2011) Long term business
strategies were focused by the organizations during this wave. This wave ended in 2000.
Sixth Wave

Metal, oil and gas, utilities, telecom, banking and health sectors formed the sixth merger wave
spanning from 2003 to 2007. This wave was inspired by increased globalization and endorsement
from governments of the countries of France, Italy and Russia in order to make national and
worldwide champion firms. Private equity financed about 25% of the deals during this era, while
cash financed deals were also more existent during this time. Accessibility of credit at very low
cost boosted the sixth merger wave. (Alexandridis, 2012)
Measurement of M&A Activity
Paul André, Maher Kooli & Jean-François L'Her (2004) in their paper “The Long-Run
Performance of Mergers and Acquisitions: Evidence from the Canadian Stock Market” obtained
data sets of mergers and acquisitions of Canadian firms from the Thomson Financial Securities
Data Corporation (SDC) Worldwide Mergers and Acquisitions database. They cleared the dataset
to meet a few criteria: firstly, observations are taken from 1980-2000; secondly, deals that have
been completed are taken; thirdly, deals can be mergers, exchange offers or acquisitions of
majority shares; fourthly, companies which have been involved in several M&As during the stated
period are included; fifth, only transactions over US$10 million are included; sixth, only
companies that have market data and financial statements available in the Research Insight
Compustat database over the years 1980 through 2001 are taken.

Till now, studies have usually used total number of mergers happening to measure merger activity
in their researches. Notwithstanding, some studies have taken the nominal value of stock market
index to identify aggregate merger activity.

Stock Market Volatility

Stock markets are volatile. This volatility actually differs among various countries. Usually,
developing countries’ stock markets are more volatile than those of developed countries. Market
volatility hampers the potential of saving and investing. In almost all models where there is a
utility-maximizing agent, under uncertainty, the more volatile the asset market, the less the agent
will save resulting in lesser investment. In reality, a certain degree of market volatility cannot be
avoided. And to some extent, this extent of volatility will be even desired, because then, the stock
market can be an indicator/signal of impact of different economic activities and this will result in
more efficient resource allocation. But, on the other hand, too much volatility unrelated to
economic fundamentals will diminish the signalling function and restrict resource allocation.

Measures of Volatility
Traditional Measure

The conventional measure of computing volatility is to first calculate the return of an asset at
time t (rt) with the following equation –
𝑟𝑡 = ln(𝑃𝑡 ) − ln(𝑃𝑡−1 )
……………………………………………………………………………… (1)
where Pt is the price at time t and Pt-1 denote the price at (t −1). Afterwards, standard deviations
over a specific timeframe of T is calculated using the formula –
𝑡=1(𝑟𝑡 −𝑟̅ )
𝜎̂ = √ ……………………………………………………………. (2)
∑ 𝑟̂𝑡
where 𝑟̅ is the average return from the sample as defined by .

This model is relatively simple to use and bears the capability of taking the probability of
occurrence of extreme events into consideration. But simultaneously, it has some drawbacks as
well. First of all, it can show result of very abrupt change in volatility when a shock is taken out
of the measurement sample. Also, if the shocks remain for a very long time in the measurement
sample, a large observation will then lead to an artificially high level of volatility in forecast
whereas the market is actually tranquil during this period. Most importantly, this model only
captures linear relationships and fail to capture the nonlinear dynamics amid the dataset.

To drive out the limitations of this model, more sophisticated models have been introduced by the
researchers, but still, this model is recognized as the benchmark for comparison of more complex
Concept of Entropy

Another way researchers adopt to measure stock market volatility is applying concepts of physics.
Researches have proven this approach to be successful in explaining financial or economic issues.
One such method is the concept of entropy.
Shannon Entropy

For a random discrete variable X with a given probability distribution of 𝑝𝑖 ≡ 𝑝(𝑋 = 𝑖) where i
= [0, 1, 2, …, n], Shannon’s entropy is defined as –
𝑆(𝑋) = − ∑𝑇𝑖=1 𝑝𝑖 𝑙𝑜𝑔(𝑝𝑖 ) ……………………………………………………….. (1)

Shannon entropy has been the most successful to treat equilibrium systems in which
short/space/temporal interactions with ergodicity and independence dominate i.e. it includes the
effects of all points of time given sufficient time. However, in nature, there are anomalies in
systems that disregard the simplified assumption of ergodicity and independence. To overcome
this limitation posed by Shannon entropy, Tsallis introduced a new measure of entropy.
Tsallis Entropy

For a random discrete variable X with a given probability distribution of 𝑝𝑖 ≡ 𝑝(𝑋 = 𝑖) where i
= [0, 1, 2, …, n], and for a non-negative real number q, Tsallis entropy is defined as –
𝑖=1 𝑝𝑖
𝑆𝑞 (𝑋) = 𝑘 …………………………………………………….. (2)
where q is defined by –
𝑥 𝑞−1 −1
𝑙𝑛𝑞 𝑥 ≡ ; (x≥0) …………………………………………………… (3)

The entropic index q tends to 1. q recovers S(X) as lnqx uniformly converges into natural log as
q→1. This index has a bias since, when q<1 the model privileges rare events while the model
privileges common events when q>1. The difference between these two entropies is that Shannon
entropy yields exponential equilibrium distribution and Tsallis entropy yields power-law
CBOE Market Volatility Index

The CBOE Market Volatility Index (VIX), coined by Jeff Fleming, Barbara Ostdiek & Robert
E. Whaley (1995), is an average of S&P 100 option (OEX) implied volatilities. It provides a
market-consensus estimate of future stock market volatility. The computation and acceptability of
VIX on a real-time basis imparts the practitioners with a new source of information. Everyday
decision making of the practitioners for different tasks e.g. asset allocation, covered-call writing,
portfolio insurance etc. often require up-to-the-minute prediction of stock market volatility.
Academicians on the other hand are more inclined toward temporal patterns in expected return and
risk. Changes in VIX denotes changes in conditional stock market volatility. The index is
constructed in such a way that this conditional volatility measure is market-determined, forward-
looking and has a constant (1-month) forecast horizon.

Investigating the statistical properties of VIX and evaluating its predictive power from the time-
series history of VIX, consistency of VIX with the empirical literature regarding conditional
volatility and the performance of VIX as a forecast of stock market volatility, it is found that VIX
shows a strong temporal relationship with stock market return, and performs very well as a
volatility forecast establishing a strong relationship with future realized stock market volatility.

Relationship between Stock Market and Merger Activities

Various prior examinations have been made to establish relationship between merger and business
cycle or other stock market variables in the USA and the UK, but mostly in the USA. Most of the
early investigations depend on basic correlations among mergers and different other factors. In
later times, various other modern papers have showed up. A classic paper by Nelson (1959) used
quarterly data to establish a relation among mergers, stock price and industrial production during
the tenure 1895-1956. Using simple regression model, he concluded that merger and stock price
are positively and significantly related while he could not establish any correlation between merger
and industrial production. Methodologies adopted by the recent studies are more sophisticated in
nature. Melicher et al. (1983) took quarterly data on merger activity in the USA during the
timeframe 1947-1977 and used multiple time-series analysis to related mergers with real and
capital market variables (stock price, bond yield etc.). Geroski (1984) examined the relationship
between mergers and the stock market index in four data sets. Using Granger causality tests, he
found no causal relationship between mergers and stock prices. But Clark et al. (1988) found
evidence in favor of Granger causality between stock price and mergers in USA during 1919-1971.
On the other hand, Guerard (1989) found no evidence of Granger causality between stock price
or industrial production and mergers examining US data for the years 1895-1964.
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