Incentive Contracts and Hedge Fund Management pp. 811–826
James E. Hodder and Jens Carsten Jackwerth
We investigate incentive effects of a typical hedge fund contract for a manager with power
utility. With a one-year horizon, the manager displays risk taking that varies dramatically
with fund value. We extend the model to multiple yearly evaluation periods and find that
the manager’s risk taking is rapidly moderated if the fund performs reasonably well. The
most realistic approach to modeling fund closure uses an endogenous shutdown barrier
where the manager optimally chooses to shut down. The manager increases risk taking
as fund value approaches that barrier, and this boundary behavior persists strongly with
multiyear horizons.
Do Market Timing Hedge Funds Time the Market? pp. 827–856
Yong Chen and Bing Liang
This paper examines whether self-described market timing hedge funds have the ability to
time the U.S. equity market. We propose a new measure for timing return and volatility
jointly that relates fund returns to the squared Sharpe ratio of the market portfolio. Using a
sample of 221 market timing funds during 1994–2005, we find evidence of timing ability
at both the aggregate and fund levels. Timing ability appears relatively strong in bear and
volatile market conditions. Our findings are robust to other explanations, including public
information-based strategies, options trading, and illiquid holdings. Bootstrap analysis
shows that the evidence is unlikely to be attributed to luck.
Bayesian Analysis of Linear Factor Models with Latent Factors, Multivariate Stochastic Volatility, and APT Pricing Restrictions pp. 857–892
Federico Nardari and John T. Scruggs
We analyze a new class of linear factor models in which the factors are latent and the
covariance matrix of excess returns follows a multivariate stochastic volatility process.
We evaluate cross-sectional restrictions suggested by the arbitrage pricing theory (APT),
compare competing stochastic volatility specifications for the covariance matrix, and test
for the number of factors. We also examine whether return predictability can be attributed
to time-varying factor risk premia. Analysis of these models is feasible due to recent
advances in Bayesian Markov chain Monte Carlo (MCMC) methods. We find that three
latent factors with multivariate stochastic volatility best explain excess returns for a sample
of 10 size decile portfolios. The data strongly favor models constrained by APT pricing
restrictions over otherwise identical unconstrained models.
Analysts’ Conflicts of Interest and Biases in Earnings Forecasts pp. 893–914
Louis K. C. Chan, Jason Karceski, and Josef Lakonishok
Analysts’ earnings forecasts are influenced by their desire to win investment banking
clients. We hypothesize that the equity bull market of the 1990s, along with the boom
in investment banking business, exacerbated analysts’ conflicts of interest and their incentives
to strategically adjust forecasts to avoid earnings disappointments. We document
shifts in the distribution of earnings surprises and related changes in the market’s response
to surprises and forecast revisions. The evidence for shifts is stronger for growth stocks,
where conflicts of interest are more pronounced. However, shifts are less notable for analysts
without ties to investment banking and in international markets.
Characterizing World Market Integration through Time pp. 915–940
Francesca Carrieri, Vihang Errunza, and Ked Hogan
International asset pricing models suggest that barriers to portfolio flows and availability
of market substitutes affect the degree and time variation of world market integration. We
use GARCH-in-mean methodology to assess the evolution in market integration for eight
emerging markets over the period 1977–2000. Our results suggest that while local risk
is still a relevant factor in explaining time variation of emerging market returns, none of
the countries appear to be completely segmented. We find that there are substantial crossmarket
differences in the degree of integration. The evolution toward more integrated
financial markets is apparent although at times we do observe reversals. In addition, we
provide clear evidence on the impropriety of directly using correlations of market-wide
index returns as a measure of market integration. Finally, financial market development
and financial liberalization policies play important roles in integrating emerging markets.
The Value of Outside Directors: Evidence from Corporate Governance Reform in Korea pp. 941–962
Jongmoo Jay Choi, Sae Woon Park, and Sean Sehyun Yoo
This paper examines the valuation impacts of outside independent directors in Korea,
where a regulation requiring outside directors was instituted after the Asian financial crisis.
In contrast to studies of U.S. firms, the effects of independent directors on firm performance
are strongly positive. Foreigners also have positive impacts. The effects of indigenous institutions
such as chaebol or family control are insignificant or negative. This implies that
the effect of outsiders depends on board composition as well as the nature of the market in
which the firm operates.
Forecasting Currency Excess Returns: Can the Forward Bias Be Exploited? pp. 963–990
O. Miguel Villanueva
The forward bias anomaly implies that currency excess returns are predictable by the forward
premium. Yet, recent studies suggest that statistical inference problems may spuriously
account for this predictability. This article demonstrates that while currency excess
returns are not predictable out of sample using a standard mean square forecast error criterion,
the forward premium nonetheless has directional predictability. This directional
forecasting accuracy translates into statistically significant profits from trading on the forward
bias anomaly.
The Effect of Shareholder Taxes on Corporate Payout Choice pp. 991–1020
William J. Moser
This study investigates whether the difference in individual shareholder tax rates between
dividend income and capital gain (the dividend tax penalty) affects a firm’s choice between
distributing funds to shareholders through dividends or share repurchases. The results of
this study suggest that, in periods in which the dividend tax penalty increases, firms are
more likely to distribute funds to shareholders through share repurchases as opposed to
dividends. The results also indicate that the relation between the dividend tax penalty
and corporate payout choice is affected by the types of shareholders who own stock in
the firm. As tax-disfavored institutional ownership increases and the dividend tax penalty
increases, firms are more likely to repurchase shares as opposed to distributing dividends.
In contrast, as tax-favored institutional ownership increases and the dividend tax penalty
increases, firms are less likely to repurchase shares as opposed to distributing dividends. As
senior managerial share ownership increases and the dividend tax penalty increases, firms
are more likely to make distributions to shareholders in the form of share repurchases.
Basis Convergence and Long Memory in Volatility When Dynamic Hedging with Futures pp. 1021–1040
Jonathan Dark
When market returns follow a long memory volatility process, standard approaches to estimating
dynamic minimum variance hedge ratios (MVHRs) are misspecified. Simulation
results and an application to the S&P 500 index document the magnitude of the misspecification
that results from failure to account for basis convergence and long memory in
volatility. These results have important implications for the estimation of MVHRs in the
S&P 500 example and other markets as well.
Reassessing the Impact of Option Introductions on Market Quality: A Less Restrictive Test for Event-Date Effects pp. 1041–1062
Bartley R. Danielsen, Bonnie F. Van Ness, and Richard S. Warr
Prior research concludes that option introductions improve the average liquidity of the
underlying stocks. We develop an improved, generalizable test to assess whether market
quality changes occur on or near an event date. Applying this method to option listing
events, we conclude that options do not systematically improve the market quality of the
underlying security; rather, the market quality of the underlying security improves before
the listing decision. Hazard model tests indicate that improving liquidity is a selection
criterion in the option listing decision. Moreover, these tests suggest that the size of a
stock’s bid-ask spread is the single most important option listing determinant.