Journal of Financial and Quantitative Analysis
Vol. 40, No. 2, June 2005


Contents

Volatility Spillover Effects in European Equity Markets
Lieven Baele

Term Structure Forecasts of Long-Term Consumption Growth
Andrea Berardi and Walter Torous

Stock Market Liquidity and the Cost of Issuing Equity
Alexander W. Butler, Gustavo Grullon, and James P. Weston

Horses and Rabbits? Trade-Off Theory and Optimal Capital Structure
Nengjiu Ju, Robert Parrino, Allen M. Poteshman, and Michael S. Weisbach

Pricing of Seasoned Equity Offers and Earnings Management
Yongtae Kim and Myung Seok Park

Misreaction
C. N. V. Krishnan and Paul A. Laux

Learning with Information Capacity Constraints
Lin Peng

Determinants of Board Size and Composition: A Theory of Corporate Boards
Charu G. Raheja

Multifactor Evaluation of Style Rotation
Kevin Q. Wang

Abstracts

Volatility Spillover Effects in European Equity Markets
Lieven Baele

This paper investigates to what extent globalization and regional integration lead to increasing equity market interdependence. I focus on Western Europe, as this region has gone through a unique period of economic, financial, and monetary integration. More specifically, I quantify the magnitude and time-varying nature of volatility spillovers from the aggregate European (EU) and U.S. market to 13 local European equity markets. To account for time-varying integration, I use a regime-switching model to allow the shock sensitivities to change over time. I find regime switches to be both statistically and economically important. Both the EU and U.S. shock spillover intensity increased substantially over the 1980s and 1990s, though the rise is more pronounced for EU spillovers. Shock spillover intensities increased most strongly in the second half of the 1980s and the first half of the 1990s. I show that increased trade integration, equity market development, and low inflation contribute to the increase in EU shock spillover intensity. I also find evidence for contagion from the U.S. market to a number of local European equity markets during periods of high world market volatility.


Term Structure Forecasts of Long-Term Consumption Growth
Andrea Berardi and Walter Torous

Relying on a simple general equilibrium model of the term structure, we show that both nominal yields and real consumption growth rates can be affine in the unobservable state variables. We can then express real consumption growth rates in terms of nominal yields rather than the unobservable state variables with the coefficients of the resultant forecasting relation being endogenously determined by the term structure model. Using term structure data over the 1985 to 2000 sample period, the empirical evidence is consistent with our model more accurately predicting real consumption growth rates than a regression model based on the term spread.


Stock Market Liquidity and the Cost of Issuing Equity
Alexander W. Butler, Gustavo Grullon, and James P. Weston

We show that stock market liquidity is an important determinant of the cost of raising external capital. Using a large sample of seasoned equity offerings, we find that, ceteris paribus, investment banks' fees are significantly lower for firms with more liquid stock. We estimate that the difference in the investment banking fee for firms in the most liquid vs. the least liquid quintile is about 101 basis points or 21% of the average investment banking fee in our sample. Our findings suggest that firms can reduce the cost of raising capital by improving the market liquidity of their stock.


Horses and Rabbits? Trade-Off Theory and Optimal Capital Structure
Nengjiu Ju, Robert Parrino, Allen M. Poteshman, and Michael S. Weisbach

This paper examines optimal capital structure choice using a dynamic capital structure model that is calibrated to reflect actual firm characteristics. The model uses contingent claim methods to value interest tax shields, allows for reorganization in bankruptcy, and maintains a long-run target debt to total capital ratio by refinancing maturing debt. Using this model, we calculate optimal capital structures in a realistic representation of the traditional trade-off model. In contrast to previous research, the calculated optimal capital structures do not imply that firms tend to use too little leverage in practice. We also estimate the costs borne by a firm whose capital structure deviates from its optimal target debt to total capital ratio. The costs of moderate deviations are relatively small, suggesting that a policy of adjusting leverage infrequently is likely to be reasonable for many firms.


Pricing of Seasoned Equity Offers and Earnings Management
Yongtae Kim and Myung Seok Park

This study examines the relations between earnings management by firms offering seasoned equity issues and the pricing of their offers. We hypothesize that seasoned equity offering (SEO) firms that employ aggressive accounting decisions also more aggressively push up their offer prices, thereby leading to a decrease in the degree of underpricing. Consistent with our prediction (the issuer's greed hypothesis), evidence indicates that SEO firms that make opportunistic accounting decisions issue new shares at inflated prices. Our findings remain robust after controlling for other determinants of SEO underpricing and the possible endogeneity of pricing and earnings management.


Misreaction
C. N. V. Krishnan and Paul A. Laux

To learn about investors' information processing, we examine the issuances of trust preferred stock, a leverage-neutral hybrid security. Specific benefits of trust preferred stock issuance have become focal points for issuers. These focal benefits include tax and financial distress avoidance, for example. We find these benefits are associated with short-run stock price misreactions. For those issuers that do not have a focal issuance benefit, mean short-run abnormal returns tend to be negative but long-run abnormal returns tend to be positive. Unanticipated changes in long-run profit opportunities, not short-run operating profits, appear to be the key to the misreaction.


Learning with Information Capacity Constraints
Lin Peng

Motivated by the fact that investors have limited time and attention to process information, this paper provides a continuous-time equilibrium model to analyze the effects of a capacity constraint in the learning process of a representative investor, who optimally allocates her information capacity across multiple sources of uncertainty. Consequently, the cross-sectional structure of information and the resulting asset price dynamics are determined endogenously. The model provides implications on both consumption behavior and the cross-sectional differences in price informativeness in terms of supply of information, speed of price adjustments to fundamental shocks, and price reactions to firm disclosures.


Determinants of Board Size and Composition: A Theory of Corporate Boards
Charu G. Raheja

This paper models the interaction of firm insiders and outsiders on a corporate board and addresses the question of the board's ideal size and composition. In the model, the board is responsible for monitoring projects and making CEO succession decisions. Inside directors are better informed regarding the quality of firm investment projects, but outsiders can use CEO succession to motivate insiders to reveal their superior information and help the board implement higher value projects. The optimal board structure is determined by the trade-off between maximizing the incentive for insiders to reveal their private information, minimizing coordination costs among outsiders and maximizing the ability of outsiders to reject inferior projects. I show that optimal board size and composition are functions of the directors' and the firm's characteristics. I also develop testable implications for cross-sectional variations in the optimal board structure across firms.


Multifactor Evaluation of Style Rotation
Kevin Q. Wang

A growing literature documents that various strategies of rotating across equity styles generate significant returns. However, the conventional risk adjustment regression is problematic in evaluating the gains from style rotation. I propose a weight-based multifactor risk adjustment approach as a solution. When interpreted as a performance attribution procedure, this approach extends Sharpe's (1992) classic method by emphasizing factor loading rotation. I use a logit-based timing strategy to show that the conventional procedure produces misleading results and the new method leads to the opposite conclusion.