Many investors confine their mutual fund holdings to a single fund family either for simplicity or through restrictions placed by their retirement savings plan. We find evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. We examine the sources of this increased correlation and find that it is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund, either in the same family or outside the family, would need to believe the inside fund offered an extra 50 to 70 basis points to have the same Sharpe ratio.
The pricing of corporate debt is still a challenging and active research area in corporate finance. Starting with Merton (1974), many authors proposed a structural approach in which the value of the assets of the firm is modeled by a stochastic process, and all other variables are derived from this basic process. These structural models have become more complex over time in order to capture more realistic aspects of bankruptcy proceedings. The literature in this area emphasizes closed-form solutions that are derived by either partial differential equation methods or analytical pricing techniques. However, it is not always possible to build a comprehensive model with realistic model features and achieve a closed-form solution at the same time. In this paper, we develop a binomial lattice method that can be used to handle complex structural models such as ones that include Chapter 11 proceedings of the U.S. bankruptcy code. Although lattice methods have been widely used in the option pricing literature, they are relatively new in corporate debt pricing. In particular, the limited liability requirement of the equity holders needs to be handled carefully in this context. Our method can be used to solve the Leland (1994) model and its extension to the finite maturity case, the more complex model of Broadie, Chernov, and Sundaresan (2007), and others.
Policy risk, rather than information asymmetry, explains the cross-sectional underpricing of privatized initial public offerings. The issuer governments of high policy risk issues tend to retain a large equity stake and underprice more with underpricing increasing in retained equity. While the issuer government’s retained equity is an observable signal for policy risk, we find that the quality of a country’s bureaucratic machinery is a more intuitive and practical measure of policy risk. Policy risk also explains the absence of a systematic relation between the initial returns on privatized and private initial public offerings.
I investigate what leads controlling families of publicly traded firms to sell their remaining ownership stake. The sale of a controlling stake is best explained in the context of theories of the firm related to optimal risk bearing, the separation of ownership and management expertise, the CEO succession process, and the monitoring provided by outside blockholders. A timing explanation is only marginally supported. The sale of a controlling stake is not explained by insufficient financial resources to fully invest in growth opportunities. This study offers insights into the final stage of the process in which entrepreneurs sequentially sell their firm to outside parties and also identifies the nature of costs of concentrated ownership.
We provide evidence of a link between firm dividend policy and stock market liquidity. In the cross section, owners of less (more) liquid common stock are more (less) likely to receive cash dividends. Predictions of the proportion of dividend payers based on 1963–1977 cross-sectional estimates account for most of the declining propensity of firms to pay dividends as documented by Fama and French (2001). Furthermore, historic liquidity is an important determinant of dividend initiations and omissions. Finally, we show that sensitivity of firm value to aggregate liquidity declines after dividend initiations, suggesting that investors view stock market liquidity and dividends as substitutes.
Beginning in the 1990s, firms often continue to trade on the major national exchanges after Chapter 11 bankruptcy filings. For bankruptcies filed from 1993–2003, we find that the more negative the filing period price reaction, the more favorable the immediate postfiling returns, on average. This reversal is not attributable to bid-ask bounce, it holds after controlling for other factors associated with post-filing returns, and it appears more attributable to the activities of large traders than to small traders. Supplementary tests reveal that the pattern of post-filing returns differs significantly for bankruptcies filed in bull versus bear markets. Bankruptcies filed during the 1993 to 1999 bull market enjoy substantial but short-lived reversals averaging one-third of the filing period price plunge. These reversals are inconsistent with efficient assimilation of the bankruptcy information. In contrast, we find no evidence of post-filing reversals for bankruptcies filed from 2000 to 2003.
In recent years, a number of firms and banks have decided to “go dark,” i.e., deregister with the Securities and Exchange Commission and delist from the major exchanges despite having a large number of outside shareholders. This paper seeks to answer two important questions: Why do firms choose to go dark? What are the consequences for shareholders? We find that firms with fewer valuable growth opportunities, greater insider ownership, lower institutional ownership, higher leverage, and lower market momentum are more likely to go dark. Furthermore, the cost of regulatory compliance is a driving force behind the going dark phenomenon.
This paper compares the newer uniform-price U.S. Treasury auctions to the traditional discriminatory mechanism and examines the extent to which the auction mechanisms are responsible for underpricing. Empirically, I find that even for the newer uniform-price auctions, the average price received by the Treasury is less than the price of the same securities in the concurrent secondary market although this underpricing is reduced by half relative to the older mechanism. From the summary statistics released by the Treasury, I calibrate common value auction models for the two mechanisms and predict the level of underpricing in each auction. I find that the observed magnitude of underpricing in the auctions is consistent with the model’s predictions.
Real option analysis typically assumes that projects are continuously evaluated and launched at precisely the time determined to be optimal, but real world projects cannot be managed in this way because of the costs of formally evaluating an investment opportunity. This paper shows that immediate investment is more attractive if evaluation costs are high or the amount of information to be revealed by an evaluation is large. The optimal delay until a reevaluation is long if evaluation costs are high or the amount of information to be revealed by an evaluation is small. The reduction in the value of project rights is especially severe when the value of the completed project is strongly mean reverting because then precision in investment timing is particularly important.
We develop empirical tests for stochastic dominance efficiency of a given investment portfolio relative to all possible portfolios formed from a given set of assets. Our tests use multivariate statistics, which result in superior statistical power properties compared to existing stochastic dominance efficiency tests and increase the comparability with existing mean-variance efficiency tests. Using our tests, we demonstrate that the mean-variance inefficiency of the CRSP all-share index relative to beta-sorted portfolios can be explained by tail risk not captured by variance.
This paper investigates the effect of closed overnight exchanges on option prices. During the trading day, asset prices follow the literature’s standard affine model that allows for stochastic volatility and random jumps. Independently, the overnight asset price process is modeled by a single jump. We find that the overnight component reduces the variation in the random jump process significantly. However, neither the random jumps nor the overnight jumps alone are able to empirically describe all features of option prices. We conclude that both random jumps during the day and overnight jumps are important in explaining option prices, where the latter account for about one quarter of total jump risk.