Journal of Financial and Quantitative Analysis
Vol. 38, No. 4, December 2003


Contents

Do Takeover Targets Underperform? Evidence from Operating and Stock Returns
Anup Agrawal and Jeffrey F. Jaffe

The Value of Trading Consolidation: Evidence from the Exercise of Warrants
Yakov Amihud, Beni Lauterbach, and Haim Mendelson

Trade Execution Costs and Market Quality after Decimalization
Hendrik Bessembinder

Agency Costs of Controlling Minority Shareholders
Henrik Cronqvist and Mattias Nilsson

Errors in Implied Volatility Estimation
Ludger Hentschel

A Multifactor Spot Rate Model for the Pricing of Interest Rate Derivatives
Sandra Peterson, Richard C. Stapleton, and Marti G. Subrahmanyam

An Examination of the Performance of the Trades and Stock Holdings of Fund Managers: Further Evidence
Matt Pinnuck

On Inferring the Direction of Option Trades
Robert Savickas and Arthur J. Wilson

Abstracts

Do Takeover Targets Underperform? Evidence from Operating and Stock Returns
Anup Agrawal and Jeffrey F. Jaffe
Financial economists seem to believe that takeovers are partly motivated by the desire to improve poorly performing firms. However, prior empirical evidence in support of this inefficient management hypothesis is rather weak. We provide a detailed re-examination of this hypothesis in a large scale empirical study. We find little evidence that target firms were performing poorly before acquisition, using either operating or stock returns. This result holds both for the sample as a whole and for subsamples of takeovers that are more likely to be disciplinary. We conclude that the conventional view that targets perform poorly is not supported by the data.
Unpublished Appendix


The Value of Trading Consolidation: Evidence from the Exercise of Warrants
Yakov Amihud, Beni Lauterbach, and Haim Mendelson
We study the effect of trading consolidation by examining the response of liquidity and stock price to the exercise of deep in-the-money corporate warrants. This enables a relatively clean test of the value of trading consolidation. The exercise at the warrant expiration is fully anticipated and has no information content. An effect can come from the value of trading consolidation that improves liquidity. Indeed, we find that liquidity and stock prices both increase significantly at warrant expiration. Further, the price increase is positively related to the pre-exercise extent of fragmentation, to post-exercise improvement in stock liquidity, and to the proportional increase in the number of shares following the warrant exercise.


Trade Execution Costs and Market Quality after Decimalization
Hendrik Bessembinder
This study assesses trade execution costs and market quality for NYSE and Nasdaq stocks before and after the 2001 change to decimal pricing. Several theoretical predictions are confirmed. Quoted bid-ask spreads declined substantially on each market, with the largest declines for heavily traded stocks. The percentage of shares receiving price improvement increased on the NYSE, but not on Nasdaq. However, those trades completed at prices within or outside the quotes were improved or disimproved by smaller amounts after decimalization, and trades completed outside the quotes saw the largest reductions in trade execution costs, as a class. Effective bid-ask spreads as a percentage of share price, arguably the most relevant measure of execution costs for smaller trades, averaged 0.33{\%} on a volume-weighted basis after decimalization for both NYSE and Nasdaq stocks. There is no evidence of systematic intraday reversals of quote changes on either market, as would be expected if decimalization had damaged liquidity supply.


Agency Costs of Controlling Minority Shareholders
Henrik Cronqvist and Mattias Nilsson
This paper estimates the agency costs of controlling minority shareholders (CMSs), who have control of a firm's votes, while owning only a minority of the cash flow rights. Analyzing a panel of 309 listed Swedish firms during 1991-1997, for which we have complete and detailed data on ownership and corporate control instruments, we provide these results; families employ CMS structures, via dual-class shares and other corporate control instruments, about 1.5-2 times more often than other categories of owners (corporations, financial institutions). Estimated agency costs of controlling shareholders are 6%-25% of firm value (Tobin's q) for the median firm among the different categories of controlling owners, ceteris paribus. Family CMSs are associated with the largest discount on firm value. The source of the discount seems to be partly what such owners/firms do: return on assets is significantly lower for firms with concentrated vote control. It also seems as if the discount is related to what such owners/firms do not do. Family CMSs seem to hang on to the control too long from the non-controlling shareholders' perspective; e.g., firms with family CMSs are about 50% less likely to be taken over compared to other firms.


Errors in Implied Volatility Estimation
Ludger Hentschel
Estimating implied volatility by inverting the Black-Scholes formula is subject to considerable error when option characteristics are observed with plausible errors. Especially for options away from the money, large changes in volatility produce small changes in option prices. Conversely, small errors in option prices and other option characteristics produce large errors in implied volatilities. In the presence of small measurement errors, unobserved truncation of option prices that violate lower bounds for absence of arbitrage can also lead to systematic volatility smiles. The paper proposes feasible GLS estimators that reduce the noise and bias in implied volatility estimates.


A Multifactor Spot Rate Model for the Pricing of Interest Rate Derivatives
Sandra Peterson, Richard C. Stapleton, and Marti G. Subrahmanyam
We propose a multifactor model in which the spot rate, LIBOR, follows a lognormal process, with a stochastic conditional mean, under the risk-neutral measure. In addition to the spot rate factor, the second factor is related to the premium of the first futures rate over the spot LIBOR. Similarly, the third factor is related to the premium of the second futures rate over the first futures rate. We calibrate the model to the initial term structure of futures rates and to the implied volatilities of interest rate caplets. We then apply the model to price interest rate derivatives such as European- and Bermudan-style swaptions, and yield-spread options. The model can be employed to price more complex interest rate derivatives such as path-dependent derivatives or multi-currency-dependent derivatives because of its Markovian property.


An Examination of the Performance of the Trades and Stock Holdings of Fund Managers: Further Evidence
Matt Pinnuck
Recent research has examined the performance of stocks held by U.S. mutual funds and found they realize abnormal returns. The result is significant as it stands in contrast to the general consensus from traditional performance studies that mutual funds do not possess superior information. Employing a unique dataset, I examine the performance of the monthly stock holdings and trades of a sample of Australian fund managers. When stock holdings are observable, performance measures can be constructed that are more precise than traditional fund manager performance measures. I find the stocks held by fund managers realize abnormal returns consistent with some stock selection ability across fund managers. Examining the performance of their individual trades, I find that the stocks they buy realize abnormal returns whereas for sell trades I find no evidence of abnormal returns. Overall, the results suggest fund managers have the ability to select stocks that realize positive abnormal returns thus providing out-of-sample support for similar recent findings for U.S. mutual funds.


On Inferring the Direction of Option Trades
Robert Savickas and Arthur J. Wilson
To sign option trades as buys and sells, researchers often employ stock trade classification rules including the quote, the Lee and Ready (1991), the Ellis, Michaely, and O'Hara (2000), and the tick methods. Using a proprietary CBOE dataset that reports trade direction, we find that these four rules sign correctly 83%, 80%, 77%, and 59% of all classifiable trades, respectively. These rates are based on separate classifiable samples because each of the four rules fails to classify some trades (e.g., the quote rule cannot classify midspread trades). Outside-quote and reversed-quote trades are highly misclassified by all four rules. The probability of such trades is related to trading frequency, trade size, moneyness, and maturity. Underlying asset price changes around the time of the trade improve classification precision. We find that the components of index option complex trades not executed on the Retail Automated Execution System are misclassified almost 50% of the time by any method. The elimination of these trades (15% of the sample) results in a success rate of over 87% for the quote rule.