The following papers have been accepted for publication in future issues.
How Did Japanese Investments Influence International Art Prices?
Takato Hiraki, Akitoshi Ito, Darius Alexander Spieth, and Naoya Takezawa
We test the luxury consumption hypothesis of Ait-Sahalia, Parker, and Yogo (2004), using a unique international art price, import/export flow, and stock market data set. We find that the demand for art by Japanese collectors is positively correlated with art prices and Japanese stock prices. This correlation is magnified during the “bubble period” of the Japanese economy (the mid-1980s to the early 1990s), and gains even further strength for works of art typically favored by Japanese collectors. Our results suggest that Japanese investors (or Japanese asset markets) indeed affected international art prices – especially during the bubble period and its aftermath.
Asset Liquidity and Capital Structure
Valeriy Sibilkov
This paper tests alternative theories about the effect of asset liquidity on capital structure. Using data from a broad sample of U.S. public companies, I find that leverage is positively related to asset liquidity. Further analysis reveals that the relation between asset liquidity and secured debt is positive, whereas the relation between asset liquidity and unsecured debt is curvilinear. The results are consistent with the view that the costs of financial distress and inefficient liquidation are economically important and that they affect capital structure decisions. In addition, the results are consistent with the hypothesis that the costs of managerial discretion increase with asset liquidity.
Conflicts of Interest in the Stock Recommendations of Investment
Banks and Their Determinants
Chung-Hua Shen and Hsiang-Lin Chih
This study explores the phenomena associated with conflicts of interest, particularly as they pertain to the brokerage and proprietary trading divisions of investment banks. This distinguishes it from past studies, which have researched conflicts of interest between underwriting and brokerage divisions. We examine whether or not an investment bank issues buy recommendations to the market and buys (sells) the same recommended stocks through its proprietary trading division before (after) recommendations, and if so, to what extent this goes on. We find these conflicts of interest do exist and these investment banks can profit from their recommendations in the short run.
Why Do Demand Curves for Stocks Slope Down?
Antti Petajisto
Representative agent models are inconsistent with existing empirical evidence for steep demand curves for individual stocks. This paper resolves the puzzle by proposing that stock prices are instead set by two separate classes of investors. While the market portfolio is still priced by individual investors based on their collective risk aversion, those individual investors also delegate part of their wealth to active money managers who use that capital to price stocks in the cross-section. In equilibrium the fee charged by active managers has to equal the before-fee alpha they earn; this endogenously determines the amount of active capital and the slopes of demand curves. A calibration of the model reveals that demand curves can indeed be steep enough to match the magnitude of many empirical findings, including the price e¤ects for stocks added to (or deleted from) the S&P 500 index.
Pricing American Options
under the Constant Elasticity of Variance Model
and subject to Bankruptcy
João Pedro Vidal Nunes
This paper proposes an alternative characterization of the early exercise premium that is valid for any Markovian and diffusion underlying price process as well as for any parameterization of the exercise boundary. This new representation is shown to provide the best pricing alternative available in the literature for medium- and long-term American option contracts, under the Constant Elasticity of Variance model. Moreover, the proposed pricing methodology is also extended easily to the valuation of American options on defaultable equity, and possesses appropriate asymptotic properties.
Nonparametric Estimation of the Short Rate Diffusion
Process from a Panel of Yields
Abdoul G. Sam and George J. Jiang
In this paper, we propose a nonparametric estimator of the short rate diffusion process using observations of a panel of yields. The proposed estimator can greatly reduce the bias of the nonparametric estimator proposed in Stanton (1997) that uses a single time series of short rate observations. Simulations confirm that the new method significantly attenuates the spurious nonlinearity of the drift function as documented in Chapman and Pearson (2000). We apply the method to estimate the US short rate process using a panel of six Treasury yields. With 42 years’ daily observations of the panel of yields, the proposed drift function estimator achieves the same efficiency as the Stanton (1997) estimator based on 145 years of daily short rate observations. Finally, we show that the proposed estimator also has significant economic implications on the pricing of bonds and interest rate derivatives.
Stock Market Mispricing:
Money Illusion or Resale Option?
Carl R. Chen, Peter P. Lung, and F. Albert Wang
We examine two hypotheses to explain stock mispricing: (a) the money illusion hypothesis (Modigliani and Cohn (1979)) and (b) the resale option hypothesis (Scheinkman and Xiong (2003)). We find that the money illusion hypothesis may explain the level, but not the volatility of mispricing in the US market. By contrast, the stock resale option hypothesis, which stems from heterogeneous beliefs about future dividend growth rates and short-sales constraints, can explain both the level and the volatility of mispricing. The evidence suggests that while the two hypotheses complement each other in explaining the level of mispricing, the resale option hypothesis provides a more coherent explanation for asset price bubbles, in which extraordinarily high price levels are often accompanied by excessive volatility and frenzied trading.
A Portfolio Optimality Test Based on the First-Order
Stochastic Dominance Criterion
Milos Kopa and Thierry Post
Existing approaches to testing for the efficiency of a given portfolio make strong parametric assumptions about investor preferences and return distributions. Stochastic dominance based procedures promise a useful non-parametric alternative. However, these procedures have been limited to considering binary choices. In this paper we consider a new approach that considers all diversified portfolios, and thereby introduce a new concept of first-order stochastic dominance (FSD) optimality of a given portfolio relative to all possible portfolios. Using our new test, we show that the US stock market portfolio is significantly FSD non-optimal relative to benchmark portfolios formed on market capitalization and book-to-market equity ratios. Without appealing to parametric assumptions about the return distribution, we conclude that no nonsatiable investor would hold the market portfolio in the face of the attractive premia of small caps and value stocks.
Management Quality, Financial and Investment Policies, and
Asymmetric Information
Thomas J. Chemmanur, Imants Paeglis, and Karen Simonyan
We develop measures of the management quality of firms and make use of a unique sample of hand-collected data to examine the relationship between the reputation and quality of a firm’s management and its financial and investment policies, a relationship that has so far received little attention in the literature. We hypothesize that better and more reputable managers are able to convey the intrinsic value of their firm more credibly to outsiders, thus reducing the information asymmetry facing their firm in the equity market. Given this, firms with better and more reputable managements will have more access to the equity market, so that we expect lower leverage ratios for these firms. In addition, they will have less need to signal using dividends, so that they will have lower dividend payout ratios. Further, since better managers are likely to select better projects (having a larger NPV for any given scale) and implement them more ably, higher management quality will also be associated with higher levels of investment. We present evidence consistent with the above hypotheses. Our direct tests of the relationship between management quality and asymmetric information also indicate that higher management quality leads to a reduction in the extent of information asymmetry facing a firm in the equity market.
Fixed-Strike European Arithmetic Asian Options
Wai-Man Tse, Eric C. Chang, and Henry M.K. Mok
We develop a simple closed-form formula for exact continuous arithmetic Asian option valuation under Markov security prices. Our derivation takes advantage of the fact that the limiting distribution of the log of the arithmetic sum of scaled geometric Gaussian prices is normal. Based on Monte Carlo simulation, our exact closed-form solution shows that the convergence from discrete to continuous Asian option values is slow, thus rendering most numerical techniques for pricing continuous European Asian options inexact.
The Relative Informational Efficiency of Stocks and
Bonds: An Intraday Analysis
Chris Downing, Shane Underwood, and Yuhang Xing
In light of recent improvements in the transparency of the corporate bond market, we examine the relation between high frequency returns on individual stocks and bonds. In contrast to the previous literature, we employ comprehensive transactions data for both classes of securities. We find that hourly stock returns lead bond returns for non-convertible junk- and BBB-rated bonds, and that stock returns lead bond returns for convertible bonds in all rating classes. Most of the non-convertible bonds that are predictable are issued by companies in financial distress, while the convertible bonds that are predictable are those with conversion options more deeply in-the-money. These results indicate that the corporate bond market is less informationally efficient than the stock market, notwithstanding the recent improvements in bond market transparency and associated reductions in corporate bond transaction costs.
Asset Substitution and Structured Financing
Joel M. Vanden
This article shows how structured financing can be used to solve the asset substitution problem in a dynamic setting. Structuring induces the firm’s owner to optimally choose the first best operating strategy even though the owner’s value function might be locally convex (concave), which would ordinarily lead to overinvestment (underinvestment) in risky projects. This result is demonstrated in two different continuous time settings—one that is based on the risk shifting framework of Leland (1998) and one that generalizes the scaled return model of Green (1984). It is shown that the contractual nature of the structuring is a key determinant of the issuing firm’s dynamic asset volatility. Furthermore, unlike non-structured financing, the default (conversion) probability of a structured debt security may be increasing (decreasing) in the firm’s total assets. Structured securities are therefore hedge assets, which potentially explains the popularity of structured securities among investors and third-party issuers.
Term Structure, Inflation, and Real Activity
Andrea Berardi
This paper estimates an internally consistent structural model that imposes crosssectional restrictions on the dynamics of the term structure of interest rates, inflation, and output growth. Distinct from previous term structure settings, this model introduces both time varying central tendencies and a stochastic conditional mean of output growth. The estimation of the model, which is based on U.S. data over a 1960 to 2005 sample period, provides reliable estimates for the implicit term structures of real interest rates, expected inflation rates, and inflation risk premia, as well as for expectations of macroeconomic variables. The model has better out-of-sample forecasting properties than a number of alternative models, and contradicts the puzzling evidence that during the “Great Moderation” in inflation subsequent to the mid-1980s, the forecasting ability of structural models deteriorated with respect to atheoretic statistical models.
Can the Cross-Sectional Variation in Expected Stock Returns Explain Momentum?
George Bulkley and Vivekanand Nawosah
It has been hypothesized that momentum might be rationally explained as a consequence of the cross-sectional variation of unconditional expected returns. Stocks with relatively high unconditional expected returns will on average outperform in both the portfolio formation period and in the subsequent holding period. We evaluate this explanation by first removing unconditional expected returns for each stock from raw returns and then test for momentum in the resulting series. We measure the unconditional expected return on each stock as its mean return in the whole sample period. We find momentum effects vanish in demeaned returns.
Heterogeneous Beliefs and Momentum Profits
Michela Verardo
Recent theoretical models derive return continuation in a setting where investors have heterogeneous beliefs or receive heterogeneous information. This paper tests the link between heterogeneity of beliefs and return continuation in the cross-section of US stock returns. Heterogeneity of beliefs about a firm’s fundamentals is measured by the dispersion in analyst forecasts of earnings. The results show that momentum profits are significantly larger for portfolios characterized by higher heterogeneity of beliefs. Predictive crosssectional regressions show that heterogeneity of beliefs has a positive incremental effect on return continuation after controlling for variables measuring a stock’s visibility, the speed of information diffusion, uncertainty about fundamentals, information precision, and volatility. The results in this paper are robust to the potential presence of short-sale constraints and are not explained by arbitrage risk.
Information, Trading Volume, and International Stock Return Comovements: Evidence from Cross-listed Stocks
Louis Gagnon and G. Andrew Karolyi
We investigate the joint dynamics of returns and trading volume of 556 foreign stocks cross-listed on U.S. markets. Heterogeneous-agent trading models rationalize how trading volume reflects the quality of traders’ information signals and how it helps to disentangle whether returns are associated with portfoliorebalancing or information-motivated trades. Based on these models, we hypothesize that returns in the home (U.S.) market on high-volume days are more likely to continue to spill over into the U.S. (home) market for those cross-listed stocks subject to the risk of greater informed trading. Our empirical evidence provides support for these predictions, which confirm the link between information, trading volume, and international stock return comovements that has eluded previous empirical investigations.
Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers
Amar Gande and Craig M. Lewis
This paper documents significantly negative stock price reactions to shareholder initiated class action lawsuits. We find that shareholders partially anticipate these lawsuits based on lawsuit filings against other firms in the same industry and capitalize part of these losses prior to a lawsuit filing date. We show that the more likely a firm is to be sued, the larger is the partial anticipation effect (shareholder losses capitalized prior to a lawsuit filing date) and smaller is the filing date effect (shareholder losses measured on the lawsuit filing date). Our evidence suggests that previous research that typically focuses on the filing date effect understates the magnitude of shareholder losses, and such an understatement is greater for firms with a higher likelihood of being sued.
Is There an Intertemporal Relation between Downside Risk and
Expected Returns?
Turan G. Bali, K. Ozgur Demirtas, and Haim Levy
This paper examines the intertemporal relation between downside risk and expected stock returns. Value at risk (VaR), expected shortfall, and tail risk are used as measures of downside risk to determine the existence and significance of a risk-return tradeoff. We find a positive and significant relation between downside risk and the portfolio returns on NYSE/AMEX/Nasdaq stocks. VaR remains a superior measure of risk when compared to the traditional risk measures. These results are robust across different stock market indices, different measures of downside risk, loss probability levels, and after controlling for macroeconomic variables and volatility over different holding periods as originally proposed by Harrison and Zhang (1999).
Does Prior Performance Affect a Mutual Fund’s Choice of Risk? Theory and Further Empirical Evidence
Hsiu-lang Chen and George G. Pennacchi
Recent empirical studies of mutual fund competition examine the relation between a fund’s performance, the fund manager’s compensation, and the fund manager’s choice of portfolio risk. This paper models a manager’s portfolio choice for compensation rules that can be either a concave, linear, or convex function of the fund’s performance relative to that of a benchmark. For particular compensation structures, a manager increases the fund’s “tracking error” volatility as its relative performance declines. However, declining performance does not necessarily lead the manager to raise the volatility of the fund’s return. The paper performs non-parametric and parametric tests of the relation between mutual fund performance and risk-taking for more than 6,000 equity mutual funds over the 1962 to 2006 period. There is a tendency for mutual funds to increase the standard deviation of tracking errors, but not the standard deviations of returns, as their performance declines. This risk-shifting behavior appears more common for funds whose managers have longer tenures.
Commonality in Liquidity: A Global Perspective
Paul Brockman, Dennis Y. Chung, and Christophe Pérignon
We conduct a comprehensive study of commonality in liquidity using intraday spread and depth data from 47 stock exchanges. We find that firm-level changes in liquidity are significantly influenced by exchange-level changes across most of the world’s stock exchanges. Emerging Asian exchanges have exceptionally strong commonality, while those of Latin America exhibit little if any commonality. After documenting the pervasive role of commonality within individual exchanges, we examine commonality across exchanges. We find evidence of a distinct, global component in bid-ask spreads and depths. Local (exchange-level) sources of commonality represent roughly 39 percent of the firm’s total commonality in liquidity, while global sources contribute an additional 19 percent. We also investigate potential sources of exchange-level and global commonality. We show that commonality is driven by both domestic and US macroeconomic announcements.
Sudden Deaths: Taking Stock of Geographic Ties
Mara Faccio and David C. Parsley
Analysis of a world-wide sample of sudden deaths of politicians reveals a market adjusted 1.7% decline in the value of companies headquartered in the politician’s home town. The decline in value is followed by a drop in the rate of growth in sales and access to credit. Our results are particularly pronounced for family firms, firms with high growth prospects, firms in industries over which the politician has jurisdiction, and firms headquartered in highly corrupt countries.
Capital Market Imperfections and the Sensitivity of Investment to Stock Prices
Alexei V. Ovtchinnikov and John J. McConnell
Prior studies argue that investment by undervalued firms that require external equity is particularly sensitive to stock prices in irrational capital markets. We present a model in which investment can appear to be more sensitive to stock prices when capital markets are rational, but subject to imperfections such as debt overhang, information asymmetries, and financial distress costs. Our empirical tests support the rational (but imperfect) capital markets view. Specifically, investment-stock price sensitivity is related to firm leverage, financial slack, and probability of financial distress, but is not related to proxies for firm undervaluation. Because, in our model, stock prices reflect the NPVs of investment opportunities, our results are consistent with rational capital markets improving the allocation of capital by channeling more funds to firms with positive NPV projects.
Dynamic Style Preferences of Individual Investors and Stock Returns
Alok Kumar
This study shows that individual investors systematically shift their preferences across extreme style portfolios (small versus large, value versus growth). These preference shifts are influenced by past style returns and earnings differentials, and advice from investment newsletters, but are unaffected by innovations in macroeconomic variables or shifts in expectations about future cash flows. Furthermore, investors’ dynamic style preferences influence returns along multiple dimensions: (i) the contemporaneous relation between style returns and style-level preference shifts is strong, (ii) there is weak evidence of style return predictability, and (iii) the correlations among stocks within a style increase when investors move into or out of the style with greater intensity. Overall, the results indicate that stock categorization influences investors’ portfolio decisions and stock returns.
Managers’ and Investors’ Responses to Media Exposure of
Board Ineffectiveness
Jennifer R. Joe, Henock Louis, and Dahlia Robinson
We analyze the impact of the press on the behavior of various economic agents by examining how media exposure of board ineffectiveness affects corporate governance, investor trading behavior, and security prices. Our focus on board quality is motivated by the strong media criticism to which corporate boards and corporate America, in general, have been recently subjected. The results indicate that media releases of (noisy) information have significant economic consequences. In particular, media exposure of board ineffectiveness forces the targeted agents to take corrective actions and enhances shareholder wealth. Individual investors appear to react negatively to the media exposure whereas investment firms act as if they anticipate the targeted firms’ corrective actions.
Probability Judgment Error and Speculation in Laboratory Asset Market Bubbles
Lucy F. Ackert, Narat Charupat, Richard Deaves, and Brian D. Kluger
In twelve sessions conducted in a typical bubble-generating experimental environment, we design a pair of assets that can detect both irrationality and speculative behavior. The specific form of irrationality we investigate is probability judgment error associated with low-probability high-payoff outcomes. Independently, we test for speculation by comparing prices of identically paying assets in multi-period versus single period markets. We establish that aggregate irrationality measured in one dimension (probability judgment error) is associated with aggregate irrationality measured in another (bubble formation).
Testing for the Elasticity of Corporate Yield Spreads
Gady Jacoby, Rose C. Liao, and Jonathan A. Batten
What drives the compensation demanded by investors in risky bonds? Longstaff and Schwartz (1995) predict one key factor is the time-varying negative correlation between interest rates and the yield spreads on corporate bonds. However, the effects of callability and taxes also need to be considered in empirical analyses. Canadian bonds have no tax effects, yet, after controlling for callability, the correlation between riskless interest rates and corporate bond spreads remains negligible. Our results provide support for reduced-form models that explicitly define a default hazard process and untie the relation between the firm’s asset value and default probability.
Institutional Versus Individual Investment in IPOs: The Importance of Firm Fundamentals
Laura Casares Field and Michelle Lowry
Consistent with institutions having an advantage over individuals, we find that newly public firms with the highest levels of institutional investment significantly outperform those with the lowest levels. While prior literature has attributed much of institutions’ higher returns around various corporate events to private information, we find that much of the difference simply reflects better interpretation of readily available public information. Individuals disproportionately invest in the types of firms that earn significantly lower abnormal returns over the long-run. Individuals either disregard or misinterpret the relevance of readily available public information, and as a result, they bear the brunt of IPO underperformance.
The Role of the Media in the Internet IPO Bubble
Utpal Bhattacharya, Neal Galpin, Rina Ray, and Xiaoyun Yu
We read all news items that came out between 1996 and 2000 on 458 internet IPOs and a matching sample of 458 non-internet IPOs—a total of 171,488 news items—and classify each news item as good news, neutral news, or bad news. We first document that the media was more positive for internet IPOs in the period of the dramatic rise in share prices, and was more negative for internet IPOs in the period of the dramatic fall in share prices. We then document that media hype is unable to explain the internet bubble: there was a 1646% difference in returns between internet stocks and non-internet stocks from January 1, 1997 through March 24, 2000 (the market peak), and the media can explain only 2.9% of that.
A Joint Framework for Consistently Pricing
Interest Rates and Interest Rate Derivatives
Massoud Heidari and Liuren Wu
Dynamic term structure models explain the yield curve variation well, but perform poorly in pricing and hedging interest rate options. Most existing option pricing practices take the yield curve as given, thus having little to say about the fair valuation of the underlying interest rates. In this paper, we propose an m+n model structure that bridges the gap in the literature by successfully pricing both interest rates and interest rate options. Under this framework, the first m factors capture the yield curve variation, whereas the latter n factors capture the interest rate options movements that cannot be effectively identified from the yield curve. We propose a sequential estimation procedure that identifies the m yield curve factors from the LIBOR and swap rates in the first step and then identifies the n options factors from interest rate caps in the second step. Our estimation exercise shows that three yield curve factors explain over 99% of the variation on the yield curve, but account for less than 50% of the variation on cap implied volatilities. Incorporating three additional options factors improves the explained variance on cap implied volatilities to over 99%.
Testing Theories of Capital Structure and Estimating the Speed of Adjustment
Rongbing Huang and Jay R. Ritter
This paper examines time-series patterns of external financing decisions and shows that publicly traded U.S. firms fund a much larger proportion of their financing deficit with external equity when the cost of equity capital is low. The historical values of the cost of equity capital have long-lasting effects on firms’ capital structures through their influence on firms’ historical financing decisions. We also introduce a new econometric technique to deal with biases in estimates of the speed of adjustment towards target leverage. We find that firms adjust toward target leverage at a moderate speed, with a half-life of 3.7 years for book leverage, even after controlling for the traditional determinants of capital structure and firm fixed effects.
Testing International Asset Pricing Models Using Implied Costs of Capital
Charles Lee, David Ng, and Bhaskaran Swaminathan
This paper tests international asset pricing models using firm-level expected returns estimated from an implied cost of capital approach. We show that the implied approach provides clear evidence of economic relations that would otherwise be obscured by the noise in realized returns. Among G-7 countries, expected returns based on implied costs of capital have less than one-tenth the volatility of those based on realized returns. Our tests show that firm-level expected returns increase with world market beta, idiosyncratic volatility, financial leverage, and book-to-market ratios, and decrease with currency beta and firm size.
Are the Wall Street Analyst Rankings Popularity Contests?
Douglas R. Emery and Xi Li
We investigate the (sell-side) analyst rankings of Institutional Investor (I/I) and The Wall Street Journal (WSJ) using data from 1993-2005. We find that factors with a primary component of recognition are the most important determinants of the rankings, although performance measures are statistically significant determinants in some cases. The single exception to this finding is with existing WSJ stars, where industry-adjusted-investment-recommendation performance is the only significant determinant of repeating as a star. Further, in the year after becoming stars, the recommendations of WSJ stars are significantly worse than those of non-stars; and the recommendations and earnings forecasts of I/I stars, as well as the earnings forecasts of WSJ stars, are not significantly different from those of non-stars. We conclude that these rankings are largely “popularity contests.”
Anchoring Bias in Consensus Forecasts and Its Effect on Market Prices
Sean D. Campbell and Steven A. Sharpe
Previous empirical studies on the “rationality” of economic and financial forecasts generally test for generic properties such as bias or autocorrelated errors but provide only limited insight into the behavior behind inefficient forecasts. This paper tests for a specific form of forecast bias. In particular, we examine whether expert consensus forecasts of monthly economic releases are systematically biased toward the value of previous months’ releases. Such a bias would be consistent with the anchoring and adjustment heuristic described by Tversky and Kahneman (1974) or could arise from professional forecasters’ strategic incentives. We find broad-based and significant evidence for this form of bias, which in some cases results in sizable predictable forecast errors. To investigate whether market participants’ expectations are influenced by this bias, we examine interest rate reactions to economic news. We find that bond yields react only to the residual, or unpredictable, component of the forecast error and not to the component induced by anchoring, suggesting that expectations of market participants anticipate this bias embedded in expert forecasts.
Stock Options and Total Payout
Charles J. Cuny, Gerald S. Martin, and John J. Puthenpurackal
In this paper, we examine how stock option usage affects total corporate payout. Using fixed-effects panel data estimators on various samples of Execucomp firms from 1993 to 2005, we find the higher the executive stock options, the lower the total payout, ceteris paribus. We also find some evidence that firms increase payouts through repurchases in order to offset EPS dilution that occurs due to usage of executive and non-executive stock options. However, incentives from not having dividend protection for options appear to dominate that of anti-dilution, resulting in lower total payout for firms with higher options usage.
The Adaptive Markets Hypothesis: Evidence from the Foreign Exchange Market
Christopher J. Neely, Paul A. Weller, and Joshua M. Ulrich
We analyze the intertemporal stability of excess returns to technical trading rules in the foreign exchange market by conducting true, out-of-sample tests on previously studied rules. The excess returns of the 1970s and 1980s were genuine and not just the result of data mining. But these profit opportunities had disappeared by the early 1990s for filter and moving average rules. Returns to less-studied rules also have declined but have probably not completely disappeared. High volatility prevents precise estimation of mean returns. These regularities are consistent with the Adaptive Markets Hypothesis (Lo (2004)), but not with the Efficient Markets Hypothesis.
Founder-CEOs, Investment Decisions, and Stock
Market Performance
Rüdiger Fahlenbrach
Eleven percent of the largest public U.S. firms are headed by the CEO who founded the firm. Founder-CEO firms differ systematically from successor-CEO firms with respect to firm valuation, investment behavior, and stock market performance. Founder-CEO firms invest more in R&D, have higher capital expenditures, and make more focused mergers and acquisitions. An equal-weighted investment strategy that had invested in founder-CEO firms from 1993--2002 would have earned a benchmark-adjusted return of 8.3\% annually. The excess return is robust; after controlling for a wide variety of firm characteristics, CEO characteristics, and industry affiliation, the abnormal return is still 4.4\% annually. The implications of the investment behavior and stock market performance of founder-CEO led firms are discussed.
Money and the (C)CAPM
Ronald J. Balvers and Dayong Huang
We consider asset pricing in a monetary economy where liquid assets are held to lower transaction costs. The ensuing model extends the CAPM and the Consumption CAPM by deriving real money growth as an additional factor determining returns. Empirically, the two model versions compare favorably to other theoretical asset pricing models along several dimensions, supporting the traditional intertemporal asset pricing perspective. A value premium arises because value firms are sensitive to liquidity shocks but growth firms are not. Although no alternative factor drives out the money growth factor, the conditioning cay factors of Lettau and Ludvigson (2001) add explanatory power.
Hedge Funds for Retail Investors?
An Examination of Hedged Mutual Funds
Vikas Agarwal, Nicole M. Boyson, and Narayan Y. Naik
Recently, there has been rapid growth in the assets managed by “hedged mutual funds”—mutual funds mimicking hedge fund strategies. We examine the performance of these funds relative to hedge funds and traditional mutual funds. Despite using similar trading strategies, hedged mutual funds underperform hedge funds. We attribute this finding to hedge funds’ lighter regulation and better incentives. Conversely, hedged mutual funds outperform traditional mutual funds. Notably, this superior performance is driven by managers with experience implementing hedge fund strategies. Our findings have implications for investors seeking hedge-fund-like payoffs at a lower cost and within the comfort of a regulated environment.
Detecting Liquidity Traders
Avner Kalay and Avi Wohl
We develop a measure (based on the relative slopes of the demand and supply schedules) quantifying the asymmetric presence of liquidity traders in the market: a steeper slope of the demand (supply) schedule indicates a concentration of liquidity traders on the demand (supply) side. Using the opening session of the Tel Aviv Stock Exchange we demonstrate the predictive power of our measure. Consistent with theory, we find that the concentration of liquidity traders on the demand (supply) side is negatively (positively) correlated with future returns. We find that liquidity traders are likely to arrive at the market together (commonality).
Is the Value Premium a Proxy for Time-Varying Investment
Opportunities: Some Time-Series Evidence
Hui Guo, Robert Savickas, Zijun Wang, and Jian Yang
We uncover a positive stock market risk-return tradeoff after controlling for the covariance of market returns with the value premium. Fama and French (1996) conjecture that the value premium proxies for investment opportunities; therefore, by ignoring it, early specifications suffer from an omitted variable problem that causes a downward bias in the risk-return tradeoff estimation. We also document a positive relation between the value premium and its conditional variance, and the estimated conditional value premium is strongly countercyclical. The latter evidence supports the view that value is riskier than growth in bad times, when the price of risk is high.
Understanding the Penalties Associated with Corporate Misconduct:
An Empirical Examination of Earnings and Risk
Deborah L. Murphy, Ronald E. Shrieves, and Samuel L. Tibbs
We examine the relationship between allegations of corporate misconduct and changes in profitability and risk of the alleged offender. Profitability is measured as reported earnings and analysts’ earnings forecasts. Risk is measured as stock return volatility and concordance among analysts’ forecasts. Decreases in earnings and increases in risk are found to accompany allegations of misconduct, and although the results are somewhat sensitive to the earnings and risk metrics used, the changes are found to be consistently greater for related-party offenses. The importance of reputational penalties is underscored by analysis of the association between allegation-related changes in firm value and changes in earnings and risk.
The Information Content of Idiosyncratic Volatility
George J. Jiang, Danielle Xu, and Tong Yao
Ang, Hodrick, Xing, and Zhang (2006a) show that stocks with high idiosyncratic return volatility tend to have low future returns. This paper further documents that idiosyncratic volatility is inversely related to future earning shocks, and more importantly, the return-predictive power of idiosyncratic volatility is induced by its information content about future earnings. We examine various explanations of the triangular relation among idiosyncratic volatility, future earning shocks, and future stock returns. Our results show that the idiosyncratic volatility anomaly is not a simple manifestation of previously documented market anomalies related to excessive extrapolation on firm growth, over-investment tendency, accounting accruals, or investor underreaction to earnings news. On the other hand, there is evidence that the idiosyncratic volatility anomaly is related to corporate selective disclosure, and the anomaly is stronger among stocks with a less sophisticated investor base.
Stock and Bond Market Liquidity: A Long-Run Empirical
Analysis
Ruslan Y. Goyenko and Andrey D. Ukhov
This paper establishes liquidity linkage between stock and Treasury bond markets. There is a lead-lag relationship between illiquidity of the two markets and bi-directional Granger causality. The effect of stock illiquidity on bond illiquidity is consistent with flight-to-quality or flight-to-liquidity episodes. Monetary policy impacts illiquidity. The evidence indicates that bond illiquidity acts as a channel through which monetary policy shocks are transferred into the stock market. These effects are observed across illiquidity of bonds of different maturities and are especially pronounced for illiquidity of short-term maturities. The paper provides evidence of illiquidity integration between stock and bond markets.
Institutional Investors, Past Performance,
and Dynamic Loss Aversion
Paul G. J. O’Connell and Melvyn Teo
Using a proprietary database of currency trades, this paper explores the effects of trading gains and losses on risk-taking among large institutional investors. We find that institutional investors, unlike individuals, are not prone to the disposition effect. Instead, institutions aggressively reduce risk following losses and mildly increase risk following gains. This asymmetry is more pronounced later in the calendar year, and among older and more experienced funds. We show that such performance dependence is consistent with dynamic loss aversion (Barberis, Huang and Santos, QJE 2001) and overconfidence. In addition, prior institutional gains and losses have palpable implications for future prices.
Firm Characteristics, Relative Efficiency, and Equity Returns
Giao X. Nguyen and Peggy E. Swanson
This study uses a stochastic frontier approach to evaluate firm efficiency. The resulting efficiency score, based on firm characteristics, is the input for performance evaluation. The portfolio composed of highly efficient firms significantly underperforms the portfolio composed of inefficient firms even after adjustment for firm characteristics and risk factors, suggesting a required premium for the inefficient firms. The difference in performance between the two portfolios remains for at least 5-years after the portfolio formation year. In addition, firm efficiency exhibits significant explanatory power for average equity returns in cross-sectional analysis.
The Determinants of Credit Default Swap Premia
Jan Ericsson, Kris Jacobs, and Rodolfo Oviedo
Variables that in theory determine credit spreads have limited explanatory power in existing empirical work on corporate bond data. We investigate the linear relationship between theoretical determinants of default risk and default swap spreads. We find that estimated coefficients for a minimal set of theoretical determinants of default risk are consistent with theory and are significant statistically and economically. Volatility and leverage have substantial explanatory power in univariate regressions. A principal component analysis of residuals and spreads indicates limited evidence for a residual common factor, confirming that the theoretical variables explain a significant amount of the variation in the data.
Does Sentiment Drive the Retail Demand for IPOs?
Daniel Dorn
Individual and institutional investors can trade German initial public equity offerings on an as-if/when-issued basis before the start of secondary trading. Using actual when-issued trades made by a sample of clients at a large German retail broker during 1999 and 2000, the paper documents that retail buyers consistently overpay for IPOs in the when-issued market relative to the immediate aftermarket. The observed willingness to overpay points to sentiment as a driver of retail trading decisions. Consistent with this interpretation and with sentiment affecting prices, IPOs that are aggressively bought by individuals in the when-issued market exhibit high first-day returns as well as poor aftermarket returns relative to benchmarks of similar stocks.
Using Innovative Securities under Asymmetric Information:
Why Do Some Firms Pay with Contingent Value Rights?
Sris Chatterjee and An Yan
This paper provides the first theoretical explanation and the first empirical analysis of contingent value rights (CVRs), which have been used as a means of payment in acquisitions, exchange offers, debt restructurings, chapter 11 reorganizations, and lawsuit settlements. A CVR is a put option committing to pay additional cash or securities to CVR holders, contingent on the issuer's share price falling below a pre-specified reference level. In this paper, we develop a model to show that CVRs can help a higher-intrinsic-value firm to reveal its firm type when the firm faces an asymmetric information problem. Our model predicts that (1) when CVRs are offered along with cash or stock, the announcement period abnormal stock return is greater than that in stock offers, (2) firms facing more severe asymmetric information problems are more likely to offer CVRs to signal their firm type, and (3) firms that are relatively more cash-constrained are more likely to offer CVRs rather than cash. We test all three predictions using a sample of mergers and acquisitions. Our empirical results are consistent with the predictions of the model.
Managerial Traits and Capital Structure Decisions
Dirk Hackbarth
This article incorporates well-documented managerial traits into a tradeoff model of capital structure to study their impact on corporate financial policy and firm value. Optimistic and/or overconfident managers choose higher debt levels and issue new debt more often, but need not follow a pecking order. The model also surprisingly uncovers that these managerial traits can play a positive role. Biased managers’ higher debt levels restrain them from diverting funds, which increases firm value by reducing this manager-shareholder conflict. Though higher debt levels delay investment, mildly biased managers’ investment decisions can increase firm value by reducing this bondholder-shareholder conflict.
Investment Banking and Analyst Objectivity:
Evidence from Analysts Affiliated with M&A Advisors
Adam C. Kolasinski and S.P. Kothari
We find evidence that conflicts of interest arising from M&A relations influence analysts’ recommendations, corroborating regulators’ and practitioners’ suspicions in a setting, i.e. M&A relations, not previously examined in research on analyst conflicts. In addition, the M&A context allows us to disentangle the conflict of interest effect from selection bias. We find that analysts affiliated with acquirer advisors upgrade acquirer stocks around M&A deals, even around all-cash deals, wherein selection bias is unlikely. Also consistent with conflict of interest, but not selection bias, target-affiliated analysts publish optimistic reports about acquirers after, but not before, the exchange ratio of an all-stock deal is set.
Star Power:
The Effect of Morningstar Ratings on Mutual Fund Flow
Diane Del Guercio and Paula A. Tkac
We apply an event-study methodology on over 10,000 Morningstar star rating changes and find that Morningstar has substantial independent influence on the investment allocation decisions of retail mutual fund investors. It is the discrete change in the star rating itself, and not the change in the underlying performance measures that drives flow. We document economically and statistically significant positive abnormal flow following rating upgrades, and negative abnormal flow following rating downgrades. In contrast to the cross-sectional flow-performance literature, we find evidence of investor punishment of performance declines, some of which is evident immediately in the month of the rating change.
Style Investing and Institutional Investors
Kenneth Froot and Melvyn Teo
This paper explores the importance and price implications of style investing by institutional investors in the stock market. To analyze styles, we assign stocks to deciles or segments across three style dimensions: size, value/growth, and sector. We find strong evidence that institutional investors reallocate across style groupings more intensively than across random stock groupings. In addition, we show that own segment style inflows and returns positively forecast future stock returns while distant segment style inflows and returns forecast negatively. We argue that behavioral theories play a role in explaining these results.
Can Tests Based on Option Hedging Errors
Correctly Identify Volatility Risk Premia?
Nicole Branger and Christian Schlag
Tests for the existence and the sign of the volatility risk premium are often based on expected option hedging errors. When the hedge is performed under the ideal conditions of continuous trading and correct model specification, the sign of the premium is the same as the sign of the mean hedging error for a large class of models. We show that discrete trading and model mis-specification may cause the standard test to yield unreliable results. In particular, ignoring jump risk premia can lead to incorrect conclusions. We also show that delta-gamma hedges do not increase the reliability of the test.
The Impact of Commercial Banks on Underwriting Spreads: Evidence From Three Decades
Dongcheol Kim, Darius Palia, and Anthony Saunders
This paper examines the effect of commercial bank entry on underwriting spreads for IPOs, SEOs and debt issues using a long time series that spans 30 years from 1975 to 2004. We find that on average commercial banks charge lower spreads of approximately 72 basis points for IPOs, 43 basis points for SEOs, and 14 basis points for debt over the entire sample period. The economic impact of commercial banks on lowering underwriting spreads is most significant when commercial banks were allowed to enter via Section 20 subsidiaries but persists beyond. Commercial bank entry into underwriting appears to have a pro-competitive effect that lasts many years after their initial entry.
Blockholder Scarcity, Takeovers, and Ownership Structures
Gary Gorton and Matthias Kahl
Agency problems in firms are prevalent because of a scarcity of wealthy principals with corporate governance ability, whom we call "restructuring specialists" We investigate how this scarce resource, "agency cost-free capital," is allocated. We show that the restructuring specialists may acquire blocks only in those states of the world in which they can increase firm value the most, which corresponds to a takeover. Firms with dispersed ownership and firms with a financial intermediary as a blockholder can coexist, although they are otherwise identical. The model can explain differences in corporate ownership structures and restructuring mechanisms across economies.
The Costs of Owning Employer Stocks: Lessons from Taiwan
Yi-Tsung Lee, Yu-Jane Liu, and Ning Zhu
Using data on all employees at listed companies in Taiwan, we find that the bias toward employer stocks is generic to individual investor decision-making, but not limited to retirement plans. 71 percent of sample employees invest in employer stocks and the employer stocks make up on average 47 percent of employee equity portfolios. The under-diversification resulting from the bias toward employer stocks is highly costly. Holding current portfolio risk constant, employees forego 4.89 percent per annum in raw returns by investing in employer stocks, which represents 39.74 percent of their average 1998 salary income. Our findings have important implications for social security reform and retirement account management.
Recovering Risk Neutral Densities from Option Prices: A New Approach
Leonidas S. Rompolis and Elias Tzavalis
In this paper we present a new method of approximating the risk neutral density (RND) from option prices based on the C-type Gram-Charlier series expansion (GCSE) of a probability density function. The exponential form of this type of GCSE guarantees that it will always give positive values of the risk neutral probabilities and it can allow for stronger deviations from normality, which are two drawbacks of the A-type GCSE used in practice. To evaluate the performance of the suggested expansion of the RND, the paper presents simulation and empirical evidence.
New Evidence of Asymmetric Dependence Structures in International Equity Markets
Tatsuyoshi Okimoto
A number of recent studies found two asymmetries in dependence structures in international equity markets; specifically, dependence tends to be high in (1) highly volatile markets and (2) bear markets. In this paper, a further investigation on asymmetric dependence structures in international equity markets is performed under the use of the Markov switching model and copula theory. Combining these two theories enables us to model dependence structures with sufficient flexibility. Using this flexible framework we indeed found that there are two distinct regimes in the US-UK market. We also showed that, for the US-UK market, the bear regime is better described by an asymmetric copula with lower tail dependence with clear rejection of the Markov switching multivariate Normal model. In addition, we showed ignorance of this further asymmetry in bear markets is very costly for risk management. Lastly, we conducted similar analysis for other G7 countries, where we found other cases where the use of a Markov switching multivariate Normal model would be inappropriate.
Home Biased Analysts in Emerging Markets
Sandy Lai and Melvyn Teo
We find that local analyst recommendations are systematically more optimistic than foreign analyst recommendations in emerging markets. The effects of this novel "home bias" among local analysts overwhelm any information asymmetry between foreign and local analysts. Consequently, local analyst upgrades underperform foreign analyst upgrades, while local analyst downgrades outperform foreign analyst downgrades. Neither foreign investors, local institutions, nor retail investors appear to be fully cognizant of this bias. Trade reactions suggest that foreign investors overestimate the bias in foreign analyst recommendations while local institutions underestimate the bias in local analyst recommendations. These results are pervasive across countries, time periods, and stock groupings, and can be traced to investment banking pressure.
Irreversible Investment, Financing, and Bankruptcy Decisions in an Oligopoly
Jyh-bang Jou and Tan Lee
This paper examines a firm's debt level, investment timing, and investment scale choices in a continuous-time model where the output price of a good that the firm produces depends on a stochastic demand-shift variable and the total industry supply of the good. Using the simple symmetric Cournot-Nash equilibrium assumption that all firms are identical and therefore follow the same financing and investment strategies, we show that competition decreases the output price and hence encourages a firm to wait for a higher demand level before it is profitable to invest. We also demonstrate how uncertainty, bankruptcy costs, and corporate taxation affect the firm's financing and investment decisions.
The Cost to Firms of Cooking the Books
Jonathan M. Karpoff, D. Scott Lee, and Gerald S. Martin
We examine the penalties imposed on all 585 firms that were targeted by SEC enforcement actions for financial misrepresentation from 1978–2002, which we track through November 15, 2005. The penalties imposed on firms through the legal system average only $23.5 million per firm. The penalties imposed by the market, in contrast, are huge. Our point estimate of the reputational penalty—which we define as the expected loss in the present value of future cash flows due to lower sales and higher contracting and financing costs—is over 7.5 times the sum of all penalties imposed through the legal and regulatory system. For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08. Of this additional loss, $0.36 is due to expected legal penalties and $2.71 is due to lost reputation. In firms that survive the enforcement process, lost reputation is even greater at $3.83. In the cross-section, the reputational penalty is positively related to measures of the firm's reliance on implicit contracts. This evidence belies a widespread belief that financial misrepresentation is disciplined lightly. To the contrary, reputation losses impose substantial penalties for cooking the books.
Pseudo Market Timing: A Reappraisal
Magnus Dahlquist and Frank de Jong
The average firm going public or issuing new equity underperforms the market in the long run. This underperformance could be related to the endogeneity of the number of new issues, if new issues cluster after periods of high abnormal returns on new issues. In such a case, ex-post measures of new issue abnormal returns may be negative on average, despite the absence of ex-ante abnormal returns. We evaluate this endogeneity problem in event studies of long-run performance. We argue that it is unlikely that the endogeneity of the number of new issues explains the long-run underperformance of equity issues.
Aggregate Earnings, Firm-Level Earnings, and Expected Stock Returns
Turan G. Bali, K. Ozgur Demirtas, and Hassan Tehranian
This paper provides an analysis of the predictability of stock returns using market, industry, and firm-level earnings. Contrary to Lamont (1998), we find that neither dividend payout ratio nor the level of aggregate earnings can forecast the excess market return. We show that these variables do not have robust predictive power across different stock portfolios and sample periods. In contrast to the aggregate-level findings, earnings yield has significant explanatory power for the time-series and cross-sectional variation in firmlevel stock returns and 48-industry portfolio returns. It is the mean-reversion of stock prices as well as the earnings' correlation with expected stock returns that are responsible for the forecasting power of earnings yield. These results are robust after controlling for book-to-market, size, price momentum and post-earnings announcement drift. At the aggregate-level, the information content of firm-level earnings about future cash flows is diversified away and higher aggregate earnings do not forecast higher returns.
Liquidity, Investment Style, and the Relation Between Fund Size and Fund Performance
Xuemin (Sterling) Yan
Using stock transactions data along with detailed stockholdings for a comprehensive sample of U.S. actively-managed equity mutual funds from 1993 to 2002, this paper empirically examines the effect of liquidity and investment style on the relation between fund size and fund performance. Consistent with Chen, Hong, Huang, and Kubik (2004), I find a significant inverse relation between fund size and fund performance. Further, this inverse relation is stronger among funds that hold less liquid portfolios. The inverse relation between fund size and fund performance is also more pronounced among growth and high-turnover funds which tend to have high demands for immediacy. Overall, this paper's findings suggest that liquidity is an important reason why fund size erodes performance.
Portfolio Concentration and the Performance of Individual Investors
Zoran Ivkovich, Clemens Sialm, and Scott Weisbenner
This paper tests whether information advantages help explain why some individual investors concentrate their stock portfolios in a few stocks. Stock investments made by households that choose to concentrate their brokerage accounts in a few stocks outperform those made by households with more diversified accounts (especially among those with large portfolios). Excess returns of concentrated relative to diversified portfolios are stronger for stocks not included in the S&P 500 index and local stocks, potentially reflecting concentrated investors' successful exploitation of information asymmetries. Controlling for households' average investment abilities, their trades and holdings perform better when their portfolios include fewer stocks.
Asset Pricing Models with Conditional Betas and Alphas: The Effects of Data Snooping and Spurious Regression
Wayne E. Ferson, Sergei Sarkissian, and Timothy Simin
This paper studies the estimation of asset pricing model regressions with conditional alphas and betas, focusing on the joint effects of data snooping and spurious regression. We find that the regressions are reasonably well specified for conditional betas, even in settings where simple predictive regressions are severely biased. However, there are biases in estimates of the conditional alphas. When time-varying alphas are suppressed and only time-varying betas are considered, the betas become baised. Previous studies overstate the significance of time-varying alphas.
Macroeconomic News, Order Flows, and Exchange Rates
Ryan Love and Richard Payne
In textbook models of exchange rate determination, the news contained in public information announcements is directly impounded into prices with there being no role for trading in this process of information assimilation. This paper directly tests this theoretical result using transaction level exchange rate return and trading data and a sample of scheduled macroeconomic announcements. The main result of the paper is that even information that is publicly and simultaneously released to all market participants is partially impounded into prices via the key micro-level price determinant—order flow. We quantify the role that order flow plays and find that approximately one third of price relevant information is incorporated via the trading process.
Conditional Return Smoothing in the Hedge Fund Industry
Nicolas P.B. Bollen and Veronika K. Pool
We show that if true returns are independently distributed, and a manager
fully reports gains but delays reporting losses, then reported returns will
feature conditional serial correlation. We use conditional serial correlation
as a measure of conditional return smoothing. We estimate conditional
serial correlation in a large sample of hedge funds. We find that the
probability of observing conditional serial correlation is related to the
volatility and magnitude of investor cash flows, consistent with
conditional return smoothing in response to the risk of capital flight. We
also present evidence that conditional serial correlation is a leading
indicator of fraud.
Corporate Governance, Shareholder Rights, and Shareholder Rights Plans:
Poison, Placebo, or Prescription?
Gary L. Caton and Jeremy Goh
We examine the effect of poison pill adoptions on firm value, controlling for the adopting firm's pre-existing corporate governance structure. We find that only companies with the most democratic governance structures, defined as those with the fewest pre-existing protective governance provisions, experience significantly positive abnormal stock returns and significantly positive abnormal revisions in five-year earnings growth rate forecasts. Moreover, regression results indicate that abnormal returns and forecast revisions are significantly related to governance structure and not to board composition or subsequent merger activity.
Second Order Stochastic Dominance, Reward-Risk Portfolio Selection, and the CAPM
Enrico De Giorgi and Thierry Post
Starting from the reward-risk model for portfolio selection introduced in De Giorgi (2005), we derive
the reward-risk Capital Asset Pricing Model (CAPM) analogously to the classical mean-variance CAPM. In contrast to the mean-variance model, reward-risk
portfolio selection arises from an axiomatic definition of reward and risk measures based on few
basic principles, including consistency with second order stochastic dominance.
With complete markets, we show that at any financial market
equilibrium, reward-risk investors' optimal allocations are
comonotonic and therefore our model reduces to a representative
investor model. Moreover, the pricing kernel is an explicitly
given, non-increasing function of the market portfolio
return, reflecting the representative investor's risk attitude. Finally, an empirical application shows that the reward-risk CAPM better captures the cross-section of US stock returns than the mean-variance CAPM does.
International Diversification with Large- and Small-Cap Stocks
Cheol S. Eun, Wei Huang, and Sandy Lai
To the extent that investors diversify internationally, large-cap stocks receive the
dominant share of fund allocation. Increasingly, however, returns to large-cap stocks or stock
market indices tend to co-move, mitigating the benefits from international diversification. In
contrast, stocks of locally oriented, small companies do not exhibit the same tendency. In this
paper, we assess the potential of small-cap stocks as a vehicle for international portfolio
diversification during the period 1980-1999. We show that the extra gains from the augmented
diversification with small-cap funds are statistically significant for both in-sample and out-ofsample
periods and remain robust to the consideration of market frictions.
Investment and Competition
Evrim Akdoğu and Peter MacKay
This paper examines how industry structure affects corporate investment patterns.
Real-options theory shows that deferring irreversible investment in the face of
uncertainty is valuable. Theory also shows that the value of waiting to invest falls if
investment opportunities are contestable. Consistent with these theories, we find that
firms in monopolistic industries exhibit lower investment-q sensitivity and are slower to
invest than firms in competitive industries. However, we find that investment-q
sensitivity and investment speed are highest in oligopolistic industries, suggesting that
the value of investing strategically can outweigh the value of waiting. Indeed,
oligopolistic industries experience less entry and more exit than other industries.
The (Poor) Predictive Performance of Asset Pricing Models
Timothy Simin
This paper examines time-series forecast errors of expected returns from conditional and
unconditional asset pricing models for portfolio and individual firm equity returns. A new
result concerning model specification and forecasting that increases predictive precision
is introduced. Conditional versions of the models generally produce higher mean squared
errors than unconditional versions for step-ahead prediction. This holds for individual
firm data when the instruments are firm specific. Mean square forecast error
decompositions indicate that the asset pricing models produce relatively unbiased
predictions, but the variance is severe enough to ruin the step ahead predictive ability
beyond that of a constant benchmark.
Debt Capacity, Cost of Debt, and Corporate Insurance
Hong Zou and Mike B. Adams
Using a unique insurance dataset for a sample of Chinese publicly listed companies
for the period 1997 through 2003, this study tests the simultaneous linkages between
debt capacity, cost of debt and corporate property insurance. Our results suggest that
on the one hand, a higher cost of debt appears to motivate the use of more property
insurance, but high leverage alone does not lead to the purchase of more property
insurance. The latter finding might reflect the unique institutional setting of China, for
example, the low chance of legally enforced company liquidation. Also, there is
evidence that leverage and tangible assets intensity can interact and exert a positive
conjoint effect on the corporate purchase of property insurance. On the other hand, we
find evidence supporting that property insurance helps expand insuring firms' debt
capacity and lower their borrowing costs. However, the moderate evidence on the
cost-reduction effect suggests that lowering the borrowing cost is likely to be a
concern secondary to facilitating corporate borrowings and thereby expanding debt
capacity in corporate property insurance decisions in China. Overall, we conclude that
debt capacity, cost of debt and corporate insurance appear to be simultaneously
related.
Are Household Portfolios Efficient? An Analysis Conditional on Housing
Loriana Pelizzon and Guglielmo Weber
Standard tests of portfolio efficiency neglect the existence of illiquid wealth. The most
important illiquid asset in household portfolios is housing: if housing stock adjustments are
infrequent, optimal portfolios in periods of no adjustment are affected by housing price risk through
a hedge term and tests for portfolio efficiency of financial assets must be run conditionally upon
housing wealth. We use Italian household portfolio data and time series on financial assets and
housing stock returns to assess whether actual portfolios are efficient. We find that housing wealth
plays a key role in determining whether portfolios chosen by home-owners are efficient.
Last updated February 27, 2008.