The following papers have been accepted for publication in future issues.
Liquidity Dynamics and Cross-Autocorrelations
Tarun Chordia, Asani Sarkar, and Avanidhar Subrahmanyam
This paper examines the relation between information transmission and cross-autocorrelations. We present a simple model where informed trading is transmitted from large to small stocks with a lag. In equilibrium, large stock illiquidity induced by informed trading portends stronger cross-autocorrelations. Empirically, we find that the lead-lag relation increases with lagged large stock illiquidity. Further, the lead from large stock order flows to small stock returns is stronger when large stock spreads are higher. In addition, this lead-lag relation is stronger before macro announcements (when information-based trading is more likely) and weaker afterwards (when information asymmetries are lower).
Analysts’ Incentives to Produce Industry-Level versus Firm-Specific
Information
Mark H. Liu
Using stock returns around recommendation changes to measure the information produced by analysts, I find that analysts produce more firm-specific than industry information. Analysts produce more firm-specific information on stocks with higher idiosyncratic return volatilities. The amount of industry information produced by analysts increases with the absolute value of the stock’s industry beta and decreases with the stock’s idiosyncratic volatility. Other stocks in the industry also respond to the recommendation change, and the magnitude of the response increases with the absolute value of the industry beta of the recommended stock and that of other stocks in the industry. I also offer results on how investors may use analyst research more effectively and potentially improve their investment performance.
The Influence of Affect on Beliefs,
Preferences and Financial Decisions
Camelia M. Kuhnen and Brian Knutson
Neuroeconomics research shows that brain areas that generate emotional states also process information about risk, rewards, and punishments, suggesting that emotions influence financial decisions in a predictable and parsimonious way. We find that positive emotional states such as excitement induce people to take risk and to be confident in their ability to evaluate investment options, while negative emotions such as anxiety have the opposite effects. Beliefs are updated such as to maintain a positive emotional state by ignoring information that contradicts individuals’ prior choices. Marketplace features or outcomes of past choices may change emotions and thus influence future financial decisions.
The Role of Commonality between CEO and Divisional Managers in Internal Capital Markets
José-Miguel Gaspar and Massimo Massa
We study the role played by the informal links, or “connections,” between the CEO and the divisional managers of conglomerate organizations. Using data on a large sample of multi-segment US corporations from 1996 to 2004, we show that segments run by connected managers receive more investment and exhibit lower sensitivity to cash flow short-falls (and exhibit higher sensitivity to other segments’ cashflow). At the firm-level, having more connected managers presiding over high Q segments improves resource allocation and increases firm value. These findings are consistent with the hypothesis that the mutual trust associated with connections reduces the need for wasteful reallocation of resources across divisions of conglomerate firms.
IPO First-Day Return and Ex Ante Equity Premium
Hui Guo
This paper proposes a measure of ex ante equity premium, IPOFDR, which is the average difference between the IPO offer price and first-trading-day close price. I test the idea in three ways. First, there is a positive relation between IPOFDR and future market returns. Second, changes in IPOFDR help explain the cross-section of stock returns. Third, the predictive power of IPOFDR for stock returns reflects mainly its close relation with market variance and average idiosyncratic variance—arguably measures of systematic risk. These results cast doubt on the notion that the IPO first-day return is a measure of investor sentiment.
Negative Hedging: Performance Sensitive Debt and CEOs’ Equity Incentives
Alexei Tchistyi, David Yermack, and Hayong Yun
We examine the relation between CEOs’ equity incentives and their use of performance-sensitive debt contracts. These contracts require higher or lower interest payments when the borrower's performance deteriorates or improves, thereby increasing expected costs of financial distress while making a firm riskier to the benefit of option holders. We find that managers whose compensation is more sensitive to stock volatility choose steeper and more convex performance pricing schedules, while those with high delta incentives choose flatter, less convex pricing schedules. Performance pricing contracts therefore seem to provide a channel for managers to increase firms’ financial risk to gain private benefits.
VC Funds: Aging Brings Myopia
Eugene Kandel, Dima Leshchinskii, and Harry Yuklea
We study the conflict of interests between the limited partners (LPs) and the general partner (GP) in a typical VC fund with a limited life span. LPs commit money to investments in risky projects, while the GP selects projects and provides unobservable monitoring effort. Midway into the project, the GP privately observes the project’s quality and the estimated time to exit and decides whether to continue investing and monitoring. The limited time horizon of the fund forces the GP to dispose of any unfinished projects when the fund is dissolved. This, combined with the informational advantage of the GP, leads to two types of inefficient decisions during the intermediate investment stages. First, we show that when unfinished projects are fairly priced by the uninformed investors, bad projects are likely to be continued. At the same time, the GP may frequently choose to stop monitoring good but delay prone projects, which effectively discontinues them. We provide empirical predictions and illustrative evidence suggesting that these inefficiencies became a serious concern for VC funds after the 2000 crash. Finally, we discuss several contractual amendments to alleviate the problem, and link them to recent developments in this market.
Holdings Data, Security Returns, and the Selection of
Superior Mutual Funds
Edwin J. Elton, Martin J. Gruber, and Christopher R. Blake
In this paper, we show that selecting mutual funds using alpha computed from a fund’s holdings and security betas produces better future alphas than selecting funds using alpha computed from a time-series regression on fund returns. This is true whether future alphas are computed using holdings and security betas or a time series regression on fund returns. Furthermore, we show that the more frequently the holdings data are available, the greater the benefit. This has major implications for the SEC’s recent ruling on the frequency of holdings disclosure and the information plan sponsors should collect from portfolio managers. We also explore the effect of conditioning betas on macro variables as suggested by Ferson and Schadt (1996) to identify superior performing mutual funds as well as the alternative way of employing holdings data proposed by Grinblatt and Titman (1993).
Shareholders’ Say on Pay: Does It Create Value?
Jie Cai and Ralph A. Walkling
Congress and activists recently proposed giving shareholders a say (vote) on executive pay. We find that when the House passed the Say-on-Pay bill, the market reaction was significantly positive for firms with high abnormal CEO compensation, with low pay-for-performance sensitivity, and responsive to shareholder pressure. However, activist sponsored Say-on-Pay proposals target large firms, not those with excessive CEO pay, poor governance, or poor performance. The market reacts negatively to labor sponsored proposal announcements and positively when these proposals are defeated. Our findings suggest that Say-on-Pay creates value for companies with inefficient compensation, but can destroy value for others.
Renewing Assets with Uncertain Revenues and Operating Costs
Roger Adkins and Dean Paxson
We study optimal replacement and abandonment decisions for real assets, when both revenues and costs are uncertain and deteriorate with age. We develop an implicit representation of the renewal boundary as the solution to a set of simultaneous equations. This quasi-analytical method has the merit of computational ease and transparency. We show that the correlation between revenues and operating costs has a significant influence on the renewal boundary, and that the increase in revenue immediately following a renewal has a greater relative influence on the boundary than either operating cost or renewal cost. The quasi-analytical method is sufficiently flexible to deal with other real option models involving two variables.
The Term Structure of Lease Rates with Endogenous Default Triggers and Tenant Capital Structure: Theory and Evidence
Sumit Agarwal, Brent W. Ambrose,
Hongming Huang, and Yildiray Yildirim
This paper focuses on the defaultable lease rate term structure with endogenous default. We combine the competitive lease market argument proposed by Grenadier (1996) and the endogenous default structural model proposed by Leland and Toft (1996) to examine the interaction between a lessee's capital structure and the equilibrium lease rate. Under this framework, determining the lease rate is a simultaneous equation problem that captures the tradeoff between debt and lease financing. Using data on 2,482 real estate lease transactions, we empirically confirm the predictions derived from the numerical analysis of the model.
Venture Capital Conflicts of Interest: Evidence from Acquisitions of Venture Backed Firms
Ronald W. Masulis and Rajarishi Nahata
We analyze the effects of venture capital (VC) backing on the profitability of private firm acquisitions. We find VC backing leads to significantly higher acquirer announcement returns, averaging 3 percent, even after controlling for deal characteristics and endogeneity in venture funding. This leads us to investigate whether some VCs have interests which conflict with other investors. We show that such conflicts arise from VCs having financial relationships with both acquirers and targets, corporate VCs having a dominant strategic focus, and VC funds nearing maturity experiencing pressure to liquidate. Our conclusions follow from examinations of target takeover premia and acquirer announcement returns.
Information Shocks, Liquidity Shocks, Jumps, and Price Discovery: Evidence from the U.S. Treasury Market
George J. Jiang, Ingrid Lo, and Adrien Verdelhan
In this paper, we identify jumps in U.S. Treasury bond prices and investigate what causes such unexpected large price changes. In particular, we examine the relative importance of macroeconomic news announcements versus variation in market liquidity in explaining the observed jumps in the U.S. Treasury market. We show that while jumps occur mostly at pre-scheduled macroeconomic announcement times, announcement surprises have limited power in explaining bond price jumps. Our analysis further shows that pre-announcement liquidity shocks, such as changes in the bid-ask spread and market depth, have significant predictive power for jumps. The predictive power is significant even after controlling for information shocks. Finally, we present evidence that post-jump order flow is less informative relative to the case where there is no jump at announcement.
The Price Pressure of Aggregate Mutual Fund Flows
Azi Ben-Rephael, Shmuel Kandel, and Avi Wohl
Using a unique database of aggregate daily flows to equity mutual funds in Israel, we find strong support for the "temporary price pressure hypothesis" regarding mutual fund flows: Mutual fund flows create temporary price pressure that is subsequently corrected. We find that flows are positively auto-correlated, and are correlated with market returns (R2 of 20%). Our main finding is that approximately one-half of the price change is reversed within ten trading days. This support for the "temporary price pressure hypothesis" complements microstructure research concerning price impact and price noises in stocks by indicating price noise at the aggregate market level.
Lemons or Cherries? Growth Opportunities and Market Temptations in Going Public and Private
Hadiye Aslan and Praveen Kumar
Is the decision to go public or private a stock market driven “side-show” or does it have significant effects on investment and profitability? We address this issue using a comprehensive dataset of private and public companies in the UK during 1996-2006. Firms with high investment-financing needs, lower information production costs, and high industry market-to-book ratios are more likely to go public. In contrast to the literature, we find that capital investment and profitability increase substantially after the IPO. Consistent with the agency cost based theories of going private, firms decrease investment but increase profits after going private, especially firms bought out by private equity investors. By directly comparing ex ante characteristics of firms going public and private during the market bubble of 1996-2000 versus those doing so during 2001-2006, we highlight the importance of market conditions on the ownership structure decision.
Stale Prices and the Performance Evaluation of Mutual Funds
Meijun Qian
Staleness in measured prices imparts a positive statistical bias and a negative dilution effect on mutual fund performance. First, evaluating performance with nonsynchronous data generates a spurious component of alpha. Second, stale prices create arbitrage opportunities for high-frequency traders whose trades dilute the portfolio returns and hence fund performance. This paper introduces a model that evaluates fund performance while controlling directly for these biases. Empirical tests of the model show that alpha net of these biases is on average positive although not significant and about 40 basis points higher than alpha measured without controlling for the impacts of stale pricing. The difference between the net alpha and the measured alpha consists of three components: a statistical bias, the dilution effect of long-term fund flows, and the dilution effect of arbitrage flows. Whereas the two former are small, the latter is large and widespread in the fund industry.
Patterns in the Timing of Corporate Event Waves
P. Raghavendra Rau and Aris Stouraitis
Corporate events happen in waves. In this paper, we examine the timing patterns of five different types of corporate event waves (new stock and seasoned equity issues, stock and cash-financed acquisitions, and stock repurchases) using a comprehensive dataset of more than 151,000 corporate transactions over the 25-year period 1980-2004. We document a distinctive pattern, previously undocumented in the literature, in the way stock-related waves form. Corporate waves seem to start with new issue waves (SEO preceding IPO waves), followed by stock-financed merger waves, followed in turn by repurchase waves. Our results hold over separate decades and across industries. Our results seem consistent with both the neoclassical efficiency hypothesis and the misvaluation hypothesis, and there are distinct periods when one or the other appears dominant.
Investing in Talents: Manager Characteristics and Hedge Fund Performances
Haitao Li, Xiaoyan Zhang, and Rui Zhao
Using a large sample of hedge fund manager characteristics, we provide one of the first comprehensive studies on the impact of manager characteristics, such as education and career concern, on hedge fund performances. We document differential ability among hedge fund managers in either generating risk-adjusted returns or running hedge fund as a business. In particular, we find that managers from higher-SAT undergraduate institutes tend to have higher raw and risk-adjusted returns, more inflows, and take less risks. Unlike mutual funds, we find a rather symmetric relation between hedge fund flows and past performance, and that hedge fund flows do not have a significant negative impact on future performance.
Managing Underwriters and the Marketing of Seasoned Equity Offerings
Rongbing Huang and Donghang Zhang
Using a sample of 2,281 SEOs from 1995-2004, we show that the marketing of securities is important to issuers. The number of managing underwriters for an SEO is negatively related to the offer price discount, especially when the relative offer size is large and the stock return volatility is high. Larger investor networks of co-managing underwriters also lower offer price discounts. We argue that the evidence is supportive of the marketing hypothesis – the underwriters' marketing efforts can lower the offer price discount by shifting up and flattening the primary market demand curve of an SEO.
Value-Maximizing Managers, Value-Increasing Mergers, and Overbidding
Evrim Akdogu
Some acquisitions can be viewed as the quickest means to obtain a scarce resource required for restructuring in response to an economic shock. Such acquisitions can give the acquirer a competitive edge and hurt its competitors. In this paper, I first show that if a firm will be adversely affected by a competitor's acquisition, then it can rationally “overpay” for the target to avoid this outcome within a value-maximizing framework due to industry equilibrium effects. Next, I show that depending on the level of anticipation by the market, the magnitude of the cost of losing and the competition between bidders, an acquirer can earn negative payoffs at the announcement of such an acquisition. Even though the merger is the best decision given the circumstances, negative returns incorporate the understanding that the target is a necessary resource to survive in this changing environment, losing it to a rival is costly and there is a positive probability that the bidder may not win or win by paying more than the synergy value of the target. Finally, I extend the model to include two targets that become available sequentially to multiple bidders and show that when there are alternatives available for the target's resources, overbidding subsides.
Why Are Derivative Warrants More Expensive than Options? An Empirical Study
Gang Li and Chu Zhang
Derivative warrants typically have higher prices than do otherwise identical options. Using data from the Hong Kong market during 2002-2007, we show that the price difference reflects the liquidity premium of derivative warrants over options. Newly issued derivative warrants are much more liquid than are options with similar terms. As a result, long-term derivative warrants are preferred by traders who trade frequently. In spite of their higher prices, short-term returns on long-term derivative warrants are, in fact, higher than the hypothetical short-term returns on options. The differences in price and liquidity measures decline as the contracts get closer to maturity.
The Term Structure of Bond Market Liquidity and its Implications for
Expected Bond Returns
Ruslan Goyenko, Avanidhar Subrahmanyam, and Andrey Ukhov
Previous studies of Treasury market illiquidity span short time-periods and focus on particular maturities. In contrast, we study the time-series of illiquidity for different maturities over an extended period of time. We also compare time series determinants of on-the-run and off-the-run illiquidity. Illiquidity increases and the difference between spreads of long- and short-term bonds significantly widens during recessions, suggesting a “flight to liquidity,” wherein investors shift into the more liquid short-term bonds during economic contractions. Macroeconomic variables such as inflation and Federal Funds rates forecast off-the-run illiquidity significantly but have only modest forecasting ability for on-the-run illiquidity. Bond returns across maturities are forecastable by off-the-run but not on-the-run bond illiquidity. Thus, off-the-run illiquidity, by reflecting macro shocks first, is the primary source of the liquidity premium in the Treasury market.
Corporate Governance and Institutional Ownership
Kee H. Chung and Hao Zhang
In this study we examine the relation between corporate governance and institutional ownership. Our empirical results show that the fraction of a company’s shares that are held by institutional investors increases with the quality of its governance structure. In a similar vein, we show that the proportion of institutions that hold a firm’s shares increases with its governance quality. Our results are robust to different estimation methods and alternative model specifications. These results are consistent with the conjecture that institutional investors gravitate to stocks of companies with good governance structure to meet fiduciary responsibility as well as to minimize monitoring and exit costs.
The Sensitivity of American Options to Suboptimal Exercise Strategies
Alfredo Ibáñez and Ioannis Paraskevopoulos
The value of American options depends on the exercise policy followed by option holders. Market frictions, risk aversion, or a misspecified model, e.g., can result in suboptimal behavior. We study the sensitivity of American options to suboptimal exercise strategies. We show that this measure is given by the Gamma of the American option at the optimal exercise boundary. More precisely, “if B is the optimal exercise price, but exercise is either brought forward when or delayed until a price B˜has been reached, the cost of suboptimal exercise is given by ½ × G(B) × (B – B˜)2, where G(B) denotes the American option Gamma.” Therefore, the cost of suboptimal exercise is second-order in the bias of the exercise policy and depends on Gamma. This result provides new insights on American options.
Why Do Firms With Diversification Discounts Have Higher Expected Returns?
Todd Mitton and Keith Vorkink
A diversified firm can trade at a discount to a matched portfolio of single-segment firms if the diversified firm has either lower expected cash flows or higher expected returns than the single-segment firms. We study whether firms with diversification discounts have higher expected returns in order to compensate investors for offering less upside potential (or skewness exposure) than focused firms. Our empirical tests support this hypothesis. First, we find that focused firms offer greater skewness exposure than diversified firms. Second, we find that diversified firms have significantly larger discounts when the diversified firm offers less skewness than matched single-segment firms. Finally, we find that up to 53% of the excess returns received on diversification-discount firms relative to diversification-premium firms can be explained by differences in exposure to skewness.
Information Quality and Stock Returns Revisited
Frode Brevik and Stefano d'Addona
This paper investigates the relation between information on the state of the economy and equity risk premium. We use a setup where investors have Epstein-Zin preferences and the economy randomly switches between booms and recessions. We are able to establish two key results: First, investors with high elasticity of in- tertemporal substitution will require lower excess returns for holding stocks if they are provided with better information on the state of the economy. Second, we find this also holds for investors with moderate elasticity of intertemporal substitution if they are sufficiently risk averse.
Market Dynamics and Momentum Profits
Ebenezer Asem and Gloria Y. Tian
Recent evidence indicates that momentum profits are sensitive to market conditions. We find that the profits are higher when the markets continue in the same state than when they transition to a different state. These findings support Daniel, Hirshleifer, and Subrahmanyam (1998), who suggest that investor overconfidence is higher when the markets continue in the same state (UP or DOWN) than when they reverse, predicting higher momentum profits in the former. In contrast, our evidence following DOWN markets is not consistent with the other competing models for the market-state conditional momentum profits.
Has the Propensity to Pay Out Declined?
Gustavo Grullon, Bradley Paye, Shane Underwood, and James P. Weston
Recent studies document both a significant decline in firms’ propensity to pay dividends and a significant increase in firms’ propensity to repurchase shares and issue equity over the past 30 years. In this paper we test whether firms’ net cash disbursements to equity-holders have declined in a pattern similar to firms’ propensity to pay dividends. Contrary to the evidence using dividends, we find no evidence that the conditional propensity to distribute net cash to equity holders has declined over the past three decades. Surprisingly, we find that, conditional on firm characteristics, net payout yields have been increasing over time.
Trading Volume in Dealer Markets
Katya Malinova and Andreas Park
We develop a financial market trading model in the tradition of Glosten and Milgrom (1985) that allows us to incorporate non-trivial volume. We observe that in this model price volatility is positively related to the trading volume and to the absolute value of the net order flow, i.e. the order imbalance. Moreover, higher volume leads to higher order imbalances. These findings are consistent with well-established empirical findings. Our model further predicts that higher trader participation and systematic improvements in the quality of traders’ information lead to higher volume, larger order imbalances, lower market depth, shorter duration, and higher price volatility.
Labor Unions, Operating Flexibility, and the Cost of Equity
Huafeng (Jason) Chen, Marcin Kacperczyk, and Hernán Ortiz-Molina
We study whether the constraints on firms’ operations imposed by labor unions affect firms’ costs of equity. The cost of equity is significantly higher for firms in more unionized industries. This effect holds after controlling for several industry and firm characteristics, is robust to endogeneity concerns, and is not driven by omitted variables. Moreover, the unionization premium is stronger when unions face a more favorable bargaining environment and is highly countercyclical. Unionization is also positively related to various measures of operating leverage. Our findings suggest that labor unions increase firms’ costs of equity by decreasing firms’ operating flexibility.
The Economic Role of Jumps and Recovery Rates in the Market for Corporate Default Risk
Paul Schneider, Leopold Sogner, and Tanja Veza
Using an extensive cross-section of US corporate CDS this paper offers an economic understanding of implied loss given default (LGD) and jumps in default risk. We formulate and underpin empirical stylized facts about CDS spreads, which are then reproduced in our affine intensitybased jump-diffusion model. Implied LGD is well identified, with obligors possessing substantial tangible assets expected to recover more. Sudden increases in the default risk of investment-grade obligors are higher relative to speculative grade. The probability of structural migration to default is low for investment-grade and heavily regulated obligors because investors fear distress rather through rare but devastating events.
Agency Costs of Free Cash Flow and the Effect of Shareholder Rights on the Implied Cost of Equity Capital
Kevin C. W. Chen, Zhihong Chen, and K. C. John Wei
In this paper, we examine the effect of shareholder rights on reducing the cost of equity and the impact of agency problems from free cash flow on this effect. We find that firms with strong shareholder rights have a significantly lower implied cost of equity after controlling for risk factors, price momentum, analysts’ forecast biases, and industry effects than do firms with weak shareholder rights. Further analysis shows that the effect of shareholder rights on reducing the cost of equity is significantly stronger for firms with more severe agency problems from free cash flows.
Political Connections and Minority-Shareholder Protection: Evidence from Securities-Market Regulation in China
Henk Berkman, Rebel A. Cole, and Lawrence J. Fu
We examine the wealth effects of three regulatory changes designed to improve minorityshareholder protection in the Chinese stock markets. Using the value of a firm’s related-party transactions as an inverse proxy for the quality of corporate governance, we find that firms with weaker governance experienced significantly larger abnormal returns around announcements of the new regulations than did firms with stronger governance. We also find that firms with strong ties to the government did not benefit from the regulations, suggesting that minority shareholders did not expect regulators to enforce the new rules on firms where block holders have strong political connections.
Transparency, Price Informativeness, Stock Return
Synchronicity: Theory and Evidence
Sudipto Dasgupta, Jie Gan, and Ning Gao
This paper argues that, contrary to the conventional wisdom, stock return synchronicity (or R2) can increase when transparency improves. In a simple model, we show that, in more transparent environments, stock prices should be more informative about future events. Consequently, when the events actually happen in the future, there should be less “surprise”, i.e., there is less new information impounded into the stock price. Thus a more informative stock price today means higher return synchronicity in the future. We find empirical support for our theoretical predictions in three settings, namely firm age, seasoned equity issues, and listing of ADRs.
What Drove the Increase in Idiosyncratic Volatility During the Internet Boom?
Jason Fink, Kristin E. Fink, Gustavo Grullon, and James P. Weston
Aggregate idiosyncratic volatility spiked nearly five-fold during the internet boom of the late 1990s, dwarfing in magnitude a moderately increasing trend. While some researchers argue that this rise in idiosyncratic risk was the result of changes in the characteristics of public firms, others argue that it was driven by the changing sentiment of irrational traders. We present evidence that the market-wide decline in maturity of the typical public firm can explain most of the increase in firm-specific risk during the internet boom. Controlling for firm maturity, we find no evidence that investor sentiment drives idiosyncratic risk throughout the internet boom.
Debt Capacity and Tests of Capital Structure Theories
Michael L. Lemmon and Jaime F. Zender
We examine the impact of explicitly incorporating a measure of debt capacity in recent tests of competing theories of capital structure. Our main results are that if external funds are required, in the absence of debt capacity concerns, debt appears to be preferred to equity. Concerns over debt capacity largely explain the use of new external equity financing by publicly traded firms. Finally, we present evidence that reconciles the frequent equity issues by small, high-growth firms with the pecking order. After accounting for debt capacity, the pecking order appears to be a good description of financing behavior for a large sample of firms examined over an extended time period.
Affine Models of the Joint Dynamics of Exchange Rates and Interest Rates
Bing Anderson, Peter J. Hammond, and Cyrus A. Ramezani
This paper extends the affine class of term structure models to describe the joint dynamics of exchange rates and interest rates. In particular, the issue of how to reconcile the low volatility of interest rates with the high volatility of exchange rates is addressed. The incomplete market approach of introducing exchange rate volatility that is orthogonal to both interest rates and the pricing kernels is shown to be infeasible in the affine setting. Models in which excess exchange rate volatility is orthogonal to interest rates but not orthogonal to the pricing kernels are proposed, and validated via Kalman filter estimation of maximal five-factor models for six country pairs.
Information, Expected Utility, and Portfolio Choice
Jun Liu, Ehud Peleg, and Avanidhar Subrahmanyam
We study the consumption-investment problem of an agent with a constant relative risk aversion preference function, who possesses noisy information about the future prospects of a stock. We also solve for the value of information to the agent in closed-form. We find that information can significantly alter consumption and asset allocation decisions. For reasonable parameter ranges, information increases consumption in the vicinity of 25%. Information can shift the portfolio weight on a stock from zero to around 70%. Thus, depending on the stock beta, the weight on the market portfolio can be considerably reduced with information, causing the appearance of under-diversification. The model indicates that stock holdings of informed agents are positively related to wealth, unrelated to systematic risk, and negatively related to idiosyncratic uncertainty. We also show that the dollar value of information to the agent depends linearly on his wealth and decreases with both the propensity to intermediate consumption and risk aversion.
Seasonality in the Cross-Section of Stock Returns: The International Evidence
Steven L. Heston and Ronnie Sadka
This paper studies seasonal predictability in the cross-section of international stock returns. Stocks that outperform the domestic market in a particular month continue to outperform the domestic market in that same calendar month for up to five years. The pattern appears in Canada, Japan, and twelve European countries. Global trading strategies based on seasonal predictability outperform similar non-seasonal strategies by over 1% per month. Abnormal seasonal returns remain after controlling for size, beta, and value, using global or local risk factors. In addition, the strategies are not highly correlated across countries. This suggests they do not reflect return premiums for systematic global risk.
Heterogeneity and Volatility Puzzles in International Finance
Tao Li and Mark L. Muzere
We develop an equilibrium model in a two-country, two-good, pure exchange economy in which investors with logarithmic utility functions have heterogeneous beliefs about exogenously given output or endowment processes. We obtain closed-form representations of real exchange rate and of stock prices. We show that heterogeneous beliefs, together with heterogeneous preferences make the volatility of real exchange rates and of stocks exhibit some properties that have been well documented in the empirical literature. These properties include the high volatility of both real exchange rates and stocks compared with that of economic fundamentals, the high correlation of stocks during periods of volatile markets. The model can also generate the clustering of the volatility of foreign exchange rate and stocks if the differences of beliefs are clustering.
Level Dependent Annuities: Defaults of Multiple Degrees
Aksel Mjøs and Svein-Arne Persson
Motivated by the effect on valuation of stopped or reduced debt coupon payments from a company in financial distress, we value a level dependent annuity contract where the annuity rate depends on the value of an underlying asset-process. The range of possible values of this asset is divided into a finite number of regions, with constant annuity rates within each region. We present closed-form formulas for the market value of level dependent annuities contracts when the market value of the underlying asset is assumed to follow a geometric Brownian motion. Such annuities occur naturally in models of debt with credit risk in financial economics. Our results are applied for valuing both corporate debt with suspended interest payments under the US Chapter 11 provisions and loans with contractual level dependent interest rates.
Can Mutual Fund Managers Pick Stocks? Evidence From Their Trades Prior to Earnings Announcements
Malcolm Baker, Lubomir Litov, Jessica A. Wachter, and Jeffrey Wurgler
Recent research finds that the stocks that mutual fund managers buy outperform the stocks that they sell (e.g., Chen, Jegadeesh, and Wermers (2000)). We study the nature of this stock-picking ability. We construct measures of trading skill based on how the stocks held and traded by fund managers perform at subsequent corporate earnings announcements. This approach increases power to detect skilled trading and sheds light on its source. We find that the average fund’s recent buys significantly outperform its recent sells around the next earnings announcement, and that this accounts for a disproportionate fraction of the total abnormal returns to fund trades estimated in prior work. We find that mutual fund trades also forecast earnings surprises. We conclude that mutual fund managers are able to trade profitably in part because they are able to forecast earnings-related fundamentals.
The Term Structure of Variance Swap Rates and Optimal Variance Swap Investments
Daniel Egloff, Markus Leippold, and Liuren Wu
This paper performs specification analysis on the term structure of variance swap rates on the S&P 500 index and studies the optimal investment decision on the variance swaps and the stock index. The analysis identifies two stochastic variance risk factors, which govern the short and long end of the variance swap term structure variation, respectively. The highly negative estimate for the market price of variance risk makes it optimal for an investor to take short positions in a short-term variance swap contract, long positions in a long-term variance swap contract, and short positions in the stock index.
Behavioral and Rational Explanations of Stock Price Performance around SEOs: Evidence from a Decomposition of Market-to-Book Ratios
Michael G. Hertzel and Zhi Li
We examine the extent to which investment opportunities and/or mispricing motivates equity issuance and contributes to post-issue stock underperformance. We decompose market-to-book ratios into misvaluation and growth option components and find that issuing firms are both overvalued and have greater growth opportunities relative to non-issuers. Firms with greater growth opportunities invest more in capital expenditures and R&D after issuance, but do not experience lower post-issue stock returns. In contrast, issuing firms with greater mispricing tend to decrease long-term debt and/or increase cash holdings, and do earn lower returns. Our findings are consistent with behavioral explanations for post-issue stock price underperformance.
Longer-Term Time Series Volatility Forecasts
Louis H. Ederington and Wei Guan
Option pricing models and longer-term VaR models typically require volatility forecasts over horizons considerably longer than the data frequency. The typical recursive procedure for generating longer-term forecasts keeps the relative weights of recent and older observations the same for all forecast horizons. In contrast, we find that older observations are relatively more important in forecasting at longer horizons. We find that the Ederington and Guan (2005) model and a modified EGARCH model in which parameter values vary with the forecast horizon forecast better out-of-sample than GARCH, EGARCH, and GJR across a wide variety of markets and forecast horizons.
Incorporating Economic Objectives into Bayesian Priors: Portfolio Choice under Parameter Uncertainty
Jun Tu and Guofu Zhou
Economic objectives are often ignored when estimating parameters, though the loss of doing so can be substantial. This paper proposes a way to allow Bayesian priors to reflect the objectives. Using monthly returns on the Fama-French 25 size and book-to-market portfolios and their three factors from January 1965 to December 2004, we find that investment performances under the objective-based priors can be significantly different from those under alternative priors, with differences in terms of annual certainty-equivalent returns greater than 10% in many cases. In terms of an out-of-sample loss function measure, portfolio strategies based on the objective-based priors can substantially outperform both strategies under alternative priors and some of the best strategies developed in the classical framework.
Idiosyncratic Risk, Long-Term Reversal, and Momentum
R. David McLean
I test whether the persistence of the momentum and reversal effects is the result of idiosyncratic risk limiting arbitrage. Idiosyncratic risk deters arbitrage, regardless of the arbitrageur’s diversification. Reversal is prevalent only in high idiosyncratic risk stocks, suggesting that idiosyncratic risk limits arbitrage in reversal mispricing. This finding is robust to controls for transaction costs, informed trading, and systematic relations between idiosyncratic risk and subsequent returns. Momentum is not related to idiosyncratic risk. Momentum generates a smaller aggregate return than reversal, so the findings along with those in related studies suggest that transaction costs are sufficient to prevent arbitrageurs from eliminating momentum mispricing.
Cross-Sectional Return Dispersion and Time-Variation in Value and Momentum Premia
Chris Stivers and Licheng Sun
We study the intertemporal relation between the cross-sectional dispersion in stock returns and subsequent value and momentum premia. The market's recent return dispersion (RD) is found to be positively related to subsequent value payoffs and negatively related to subsequent momentum payoffs, both relative to the unconditional premia and relative to payoffs in the recent past. The partial relation between RD and the subsequent value and momentum premia remains strong when controlling for lagged macroeconomic state variables suggested by the literature. Our findings are consistent with recent theoretical insights and empirical evidence which suggest that the momentum premium is procyclical and that the value premium and the market's RD are countercyclical. Our evidence also suggests that the market's RD serves as a leading countercyclical state variable.
Multiple Risky Assets, Transaction Costs and Return Predictability: Allocation Rules and Implications for U.S. Investors
Anthony W. Lynch and Sinan Tan
Our paper contributes to the dynamic portfolio choice and transaction cost literatures by considering and numerically solving the decision problem of a multiperiod CRRA individual who faces transaction costs and has access to two risky assets, both with predictable returns. With proportional transaction costs and i.i.d. returns, we numerically find the rebalancing rule to be a no-trade region for the portfolio weights with rebalancing to the boundary. The shape of the no-trade region depends on the correlation between the two risky assets. With predictable returns, there is instead a no-trade region for each state. Moreover, our numerical results strongly suggest that the no-trade region’s shape in a given state is determined by the conditional return correlation over the agent’s likely holding period till her next trade. We also use our framework to examine a number of important economic questions. The utility cost of not being able to buy on margin is zero for relative risk aversions (RRAs) greater than 4 but can be greater than 5% for RRA of 2 even with a realistic wedge between the borrowing and lending rates. Incorporating the “specialness” of stocks, the utility cost of not being able to short stock is as much as 0.73% when RRA is 2 and as much as 1.54% when RRA is 6. Our comparison of the various investment vehicles indicates that using individual stocks for the high and low B-M portfolios and ETFs for the market portfolio usually does better than using ETFs alone or Vanguard.
Stock Returns and the Volatility of Liquidity
Joao Pedro Pereira and Harold H. Zhang
This paper offers a rational explanation for the puzzling empirical fact that stock returns decrease in the volatility of liquidity. We model liquidity as a stochastic price impact process and define the liquidity premium as the additional return necessary to compensate a multi-period investor for the adverse price impact of trading. The model demonstrates that a fully rational, utility maximizing, risk averse investor can take advantage of time-varying liquidity by adapting his trades to the state of liquidity. We provide new empirical evidence supportive of the model.
Estimating the Equity Premium
R. Glen Donaldson, Mark J. Kamstra, and Lisa A. Kramer
Existing empirical research investigating the size of the equity premium has largely consisted of a series of innovations around a common theme: producing a better estimate of the equity premium by using better data or a better estimation technique. The equity premium estimate that emerges from most of this work matches one moment of the data alone: the mean difference between an estimate of the return to holding equity and a risk free rate. We instead match multiple moments of US market data, exploiting the joint distribution of the dividend yield, return volatility and realized excess returns, and find that the equity premium lies within 50 basis points of 3.5%, a range much narrower than achieved in previous studies. Additionally, statistical tests based on the joint distribution of these moments reveal that only those models of the conditional equity premium that embed time variation, breaks, and/or trends are supported by the data. In order to develop the joint distribution of the dividend yield, return volatility and excess returns, we need a model of price and return fundamentals. We document that even recently developed analytically tractable models which permit autocorrelated dividend growth rates and discount rates impose restrictions that are rejected by the data. We therefore turn to a wider range of models, requiring numerical solution methods and parameter estimation by Simulated Method of Moments.
Rational Cross-Sectional Differences in Market Efficiency: Evidence from Mutual Fund Returns
Paul Schultz
Markets should be inefficient enough to allow returns to security analysis to adequately compensate the marginal analyst for his efforts. Cross-sectional differences in the costs of analysis therefore imply cross-sectional differences in market efficiency and in before-cost returns to smart investors. Small growth stocks are difficult to analyze and costly to trade. I find that the abnormal returns of mutual fund investments in small growth stocks over 1980–2006 averaged 0.76% per month. Large value stocks are easier to analyze and cheaper to trade. Mutual funds earned average monthly abnormal returns of only 0.05% in these stocks.
Arbitrage Risk and Stock Mispricing
John A. Doukas, Chansog (Francis) Kim, and Christos Pantzalis
In this paper we examine the relation between equity mispricing and arbitrage risk, and find that stocks with high arbitrage risk have higher estimated mispricing than stocks with low arbitrage risk. These results are not limited to high book-to-market or small capitalization stocks, and they are not sensitive to transaction and short selling costs. In addition, they remain robust to alternative multifactor return generating specification models and mispricing measures. Overall, our empirical results are consistent with the conjecture that mispricing is a manifestation of the inability of arbitrageurs to hedge idiosyncratic risk, a major deterrent to arbitrage activity.
Friend or Foe? The Role of State and Mutual Fund Ownership in the Split Share Structure Reform in China
Michael Firth, Chen Lin, and Hong Zou
The recent split share structure reform in China involves the non-tradable shareholders proposing a compensation package to the tradable shareholders in exchange for the listing rights of their shares. We find that state ownership (the major owners of non-tradable shares) has a positive effect on the final compensation ratio. In contrast, mutual fund ownership (the major institutional owner of tradable shares) has a negative effect on the compensation ratio and especially in state owned firms. The evidence is consistent with our predictions that state shareholders have incentives to complete the reform quickly and exert political pressure on mutual funds to accept the terms without a fight.
A Re-Examination of the Causes of Time-Varying Stock Return Volatilities
Chu Zhang
The decline of average stock return volatility in the 2001–2006 period provides an opportunity to test various theories on why the average return volatility increased in the pre-2000 period. This paper compares fundamentals-based theories with trading volume-based theories. While both fundamentals-based theories and trading volumebased theories explain the upward trend in the average volatility in U.S. stocks from 1976 to 2000 and international stocks from 1990 to 2000, only the fundamentals-based theories explain the volatility pattern for 2001–2006. Much of the variation in the stock return volatilities can be explained by the variation in the earnings volatilities and proxies for growth options, but not by trading-related variables. Evidence also shows that the explanatory power of the fundamentals variables is time-varying.
Disagreement, Portfolio Optimization, and Excess Volatility
Ran Duchin and Moshe Levy
Disagreement is a key factor inducing trading, which has been receiving ever-increasing attention in recent years. Most research has focused on disagreement about the expected returns. Several authors have shown that if the average belief coincides with the true expected return, in the portfolio context prices are unaffected by disagreement. In this paper we study the pricing effects of disagreement regarding return variances. We show that 1) disagreement about variances has systematic and significant pricing effects—more disagreement leads to higher prices, and 2) prices are very sensitive to the degree of disagreement: even if the average belief about the variance is constant, tiny fluctuations in the disagreement about the variance lead to substantial price fluctuations. This second result may offer an explanation for the excess volatility puzzle: when small changes in the degree of disagreement occur, they induce relatively large price changes. Yet, the changes in disagreement may be hard to directly detect empirically, leading to apparent “excess volatility.”
The Response of Corporate Financing and Investment to Changes in the Supply of Credit
Michael Lemmon, Michael R. Roberts
We examine how shocks to the supply of credit impact corporate financing and investment using the collapse of Drexel Burnham Lambert, Inc., the passage of the Financial Institutions Reform, Recovery, and Enforcement Act, and regulatory changes in the insurance industry as an exogenous contraction in the supply of below-investmentgrade credit after 1989. A difference-in-differences empirical strategy reveals that substitution to bank debt and alternative sources of capital (e.g., equity, cash balances, trade credit) was limited, leading to an almost one-for-one decline in net investment with the decline in net debt issuances. Despite this sharp change in behavior, corporate leverage ratios remained relatively stable, a result of the contemporaneous decline in debt issuances and investment. Overall, our findings highlight how even large firms with access to public credit markets are susceptible to fluctuations in the supply of capital.
Market Feedback and Equity Issuance: Evidence from Repeat Equity Issues
Armen Hovakimian and Irena Hutton
Higher first-year post-issue returns are associated with a significantly higher probability of follow-on equity issuance over the next five years. This result holds when we control for pre-issue returns and other factors known to affect the probability of equity issuance. The result is most consistent with the market feedback hypothesis that a high post-issue return encourages managers to increase the firm’s investment because it implies that, in the market’s view, the marginal return to the project is high.
Financing Frictions and the Substitution Between Internal and External Funds
Heitor Almeida and Murillo Campello
Ample evidence points to a negative relation between internal funds (profitability) and the demand for external funds (debt issuance). This relation has been interpreted as evidence supporting the pecking order theory. We show, however, that the negative effect of internal funds on the demand for external financing is concentrated among firms that are least likely to face high external financing costs (firms that distribute large amounts of dividends, that are large, and whose debt is rated). For firms in the other end of the spectrum (low payout, small, and unrated), external financing is insensitive to internal funds. These crossfirm differences hold separately for debt and equity, and are magnified in the aftermath of macroeconomic movements that tighten financing constraints. We argue that the greater complementarity between internal funds and external finance for constrained firms is a consequence of the interdependence of their financing and investment decisions.
Dynamic Factors and Asset Pricing
Zhongzhi (Lawrence) He, Sahn-Wook Huh, and Bong-Soo Lee
This study develops an econometric model that incorporates features of price dynamics across assets as well as through time. With the dynamic factors extracted via the Kalman filter, we formulate an asset-pricing model, termed as the dynamic factor pricing model (DFPM). We then conduct asset-pricing tests in the in-sample and out-of-sample contexts. Our analyses show that the ex ante factors are a key component in asset pricing and forecasting. By using the ex ante factors, the DFPM improves upon the explanatory and predictive power of other competing models, including unconditional and conditional versions of the Fama and French (1993) three-factor model. In particular, the DFPM can explain and better forecast the momentum portfolio returns, which are mostly missed by other alternative models.
What Does the Individual Option Volatility Smirk Tell Us About Future Equity
Returns?
Yuhang Xing, Xiaoyan Zhang, and Rui Zhao
The shape of the volatility smirk has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by 10.9% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with the steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to trade out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.
Prospect Theory and the Disposition Effect
Markku Kaustia
This paper shows that prospect theory is unlikely to explain the disposition effect. Prospect theory predicts that the propensity to sell a stock declines as its price moves away from the purchase price in either direction. Trading data, on the other hand, show that the propensity to sell jumps at zero return, but it is approximately constant over a wide range of losses, and increasing or constant over a wide range of gains. Further, the pattern of realized returns does not seem to stem from optimal after-tax portfolio rebalancing, a belief in mean-reverting returns, or investors acting on target prices.
A Longer Look at the Asymmetric Dependence between Hedge Funds and the Equity Market
Byoung Uk Kang, Francis In, Gunky Kim, and Tong Suk Kim
This paper re-examines, at a range of investment horizons, the asymmetric dependence between hedge fund returns and market returns. Given the current availability of hedge fund data, the joint distribution of longer-horizon returns is extracted from the dynamics of monthly returns using the filtered historical simulation; we then apply the method based on copula theory to uncover the dependence structure therein. While the direction of asymmetry remains unchanged, the magnitude of asymmetry is attenuated considerably as the investment horizon increases. Similar horizon effects also occur on the tail dependence. Our findings suggest that nonlinearity in hedge fund exposure to market risk is more short-term in nature, and that hedge funds provide higher benefits of diversification, the longer the horizon.
Forecasting Volatility Using Long Memory and Comovements: An
Application to Option Valuation under SFAS 123R
George J. Jiang and Yisong S. Tian
Horizon-matched historical volatility is commonly used to forecast future volatility for option valuation under the Statement of Financial Accounting Standards 123R. In this paper, we empirically investigate the performance of using historical volatility to forecast long-term stock return volatility in comparison with a number of alternative forecasting methods. Analyzing forecasting errors and their impact on reported income due to option expensing, we find that historical volatility is a poor forecast for long-term volatility and shrinkage adjustment towards comparable-firm volatility only slightly improves its performance. Forecasting performance can be improved substantially by incorporating both long memory and comovements with common market factors. We also experiment with a simple mixed-horizon realized volatility model and find its long-term forecasting performance to be more accurate than historical forecasts but less accurate than long-memory forecasts.
Exploitable Predictable Irrationality: The FIFA World
Cup Effect on the U.S. Stock Market
Guy Kaplanski and Haim Levy
In a recently published paper, Edmans, García, and Norli (2007) reveal a strong association between results of soccer games and local stock returns. Inspired by their work, we propose a novel approach to exploit this effect on the aggregate international level with the following three unique features: (i) The aggregate effect does not depend on the games results; hence, the effect is an exploitable predictable effect. (ii) The aggregate effect is based on many games; hence, it is very large and highly significant. We find that the average return on the U.S. market over the World Cup's effect period is -2.58%, compared to +1.21% for alldays average returns over the same period length. (iii) Exploiting the aggregate effect is involved with trading in a single index for a relatively long period.
Informational Efficiency and Liquidity Premium as the Determinants of Capital Structure
Chun Chang and Xiaoyun Yu
This paper investigates how a firm’s capital structure choice affects the informational efficiency of its security prices in the secondary markets. We identify two new determinants of a firm’s capital structure policy: liquidity (adverse selection) premium due to investors’ anticipated losses to informed trading, and operating efficiency improvement due to information revelation from the firm’s security prices. We show that capital structure decision affects traders’ incentives to acquire information and subsequently, the distribution of informed traders across debt and equity claims. When information is less imperative for improving its operating decisions, a firm issues zero or negative debt (i.e., holding excess cash reserves) in order to reduce socially wasteful information acquisition and the liquidity premium associated with it. When information is crucial for a firm’s operating decisions, the optimal debt level is one which achieves maximum information revelation at the lowest possible liquidity cost. Our model can explain why many firms consistently hold no debt. It also provides new implications for financial system design and for the relationship among leverage, liquidity premium, profitability, and the cost of information acquisition.
Factoring Information into Returns
David Easley, Soeren Hvidkjaer, and Maureen O’Hara
We examine the potential profits of trading on a measure of private information (PIN) in a stock. A zero-investment portfolio which is size neutral, but long in high PIN stocks and short in low PIN stocks earns a significant abnormal return. The Fama-French, momentum and liquidity factors do not explain this return. However, significant covariation in returns exists among high PIN stocks and among low PIN stocks, suggesting that PIN might proxy for an underlying factor. We create a PIN factor as the monthly return on the zero-investment portfolio above and show that it is successful in explaining returns to independent PIN-size portfolios. We also show that it is robust to inclusion of the Pastor-Stambaugh liquidity factor and the Amihud illiquidity factor. We argue that information remains an important determinant of asset returns even in the presence of these additional factors.
Dynamic General Equilibrium and T-Period Fund Separation
Anke Gerber, Thorsten Hens, and Peter Woehrmann
In a dynamic general equilibrium model, we derive conditions for a mutual fund separation property by which the savings decision is separated from the asset allocation decision. With logarithmic utility functions, this separation holds for any heterogeneity in discount factors, while the generalization to constant relative risk aversion holds only for homogeneous discount factors but allows for any heterogeneity in endowments. The logarithmic case provides a general equilibrium foundation for the growth optimal portfolio literature. Both cases yield equilibrium asset pricing formulas that allow for investor heterogeneity, in which the return process is endogenous and asset prices are determined by expected discounted relative dividends. Our results have simple asset pricing implications for the time series as well as the cross section of relative asset prices. It is found that on data from the Dow Jones Industrial Average, a risk aversion smaller than in the logarithmic case fits best.
How Syndicate Short Sales Affect the Informational Efficiency of IPO Prices and
Underpricing
Bjorn Bartling and Andreas Park
When a company goes public, it is standard practice that the underwriting syndicate allocates more shares than issued. The underwriter thus holds a short position that it commonly fills by aftermarket trading when market prices fall or, when prices rise, by executing the so-called overallotment option. This option is a standard feature of IPO arrangements that allows the underwriter to purchase more shares from the issuer at the original offer price. We propose a theoretical model to study the implications of this combination of short-position and overallotment option on the pricing of the IPO. Maximizing the sum of both the profits from its share of the offer revenue and the potential profits from aftermarket trading, we show that underwriters strategically distort the offer price. This results either in exacerbated underpricing when favorably informed underwriters lower prices to secure a signaling benefit, or in informationally inefficient offer prices when underwriters pool in offer prices irrespective of their information.
Portfolio Optimization with Mental Accounts
Sanjiv Das, Harry Markowitz, and Meir Statman
We integrate appealing features of Markowitz's mean-variance portfolio theory (MVT) and Shefrin and Statman's behavioral portfolio theory (BPT) into a new mental accounting (MA) framework. Features of the MA framework include a mental accounting structure of portfolios, a definition of risk as the probability of failing to reach the threshold level in each mental account, and attitudes toward risk that vary by account. We demonstrate a mathematical equivalence between MVT, MA and risk management using VaR. The aggregate allocation across MA sub-portfolios is mean-variance efficient with short-selling. Short-selling constraints on mental accounts impose very minor reductions in certainty equivalents, only if binding for the aggregate portfolio, offsetting utility losses from errors in specifying risk aversion coefficients in MVT applications. These generalizations of MVT and BPT via a unified MA framework result in a fruitful connection between investor consumption goals and portfolio production.
The Impact of the Euro on Equity Markets
Lorenzo Cappiello, Arjan Kadareja, and Simone Manganelli
This paper investigates whether comovements between euro area equity returns at national and industry level have changed after the introduction of the euro. By adopting a regression quantile-based methodology, we find that after 1999 the degree of comovements among euro area national equity markets has augmented. By explicitly controlling for the impact of global factors, we show that this result cannot be explained away by recent world-wide trends. A more refined analysis based on an industry breakdown suggests that the increase in national index comovements is mainly driven by financial, industrials and consumer services sectors.
Deviations from Put-Call Parity and Stock Return Predictability
Martijn Cremers and David Weinbaum
Deviations from put-call parity contain information about future stock returns. Using the difference in implied volatility between pairs of call and put options to measure these deviations we find that stocks with relatively expensive calls outperform stocks with relatively expensive puts by 50 basis points per week. We find both positive abnormal performance in stocks with relatively expensive calls and negative abnormal performance in stocks with relatively expensive puts, which cannot be explained by short sales constraints. Rebate rates from the stock lending market confirm directly that our findings are not driven by stocks that are hard to borrow. The degree of predictability is larger when option liquidity is high and stock liquidity low, while there is little predictability when the opposite is true. Controlling for size, option prices are more likely to deviate from strict put-call parity when underlying stocks face more information risk. The degree of predictability decreases over the sample period. Our results are consistent with mispricing during the earlier years of the study, with a gradual reduction of the mispricing over time.
Corporate Governance and Liquidity
Kee H. Chung, John Elder, and Jang-Chul Kim
We investigate the empirical relation between corporate governance and stock market liquidity. We find that firms with better corporate governance have narrower spreads, higher market quality index, smaller price impact of trades, and lower probability of information-based trading. In addition, we show that changes in our liquidity measures are significantly related to changes in the governance index over time. These results suggest that firms may alleviate information-based trading and improve stock market liquidity by adopting corporate governance standards that mitigate informational asymmetries. Our results are remarkably robust to alternative model specifications, across exchanges, and different measures of liquidity.
Clientele Change, Liquidity Shock, and the Return on Financially Distressed Stocks
Zhi Da and Pengjie Gao
We show that the abnormal returns on high-default risk stocks documented by Vassalou and Xing (2004) are driven by short-term return reversals rather than systematic default risk. These abnormal returns occur only during the month after portfolio formation and are concentrated in a small subset of stocks that had recently experienced large negative returns. Empirical evidence supports the view that the short-term return reversal arises from a liquidity shock triggered by a clientele change.
Investor Protection, Equity Returns, and Financial Globalization
Mariassunta Giannetti and Yrjö Koskinen
We study the effects of investor protection on stock returns and portfolio allocation decisions. In our theoretical model, if investor protection is weak, wealthy investors have an incentive to become controlling shareholders. In equilibrium, the stock price reflects the demand from both controlling shareholders and portfolio investors. Due to the high demand from controlling shareholders, the price of weak corporate governance stocks is not low enough to fully discount the extraction of private benefits. Thus, stocks have lower expected returns when investor protection is weak. This has implications for domestic and foreign investors' stockholdings. In particular, we show that portfolio investors' participation in the domestic stock market and home equity bias are positively related to investor protection and provide original evidence in their support.
Predicting Global Stock Returns
Erik Hjalmarsson
I test for stock return predictability in the largest and most comprehensive data set analyzed so far, using four common forecasting variables: the dividend- and earnings-price ratios, the short interest rate, and the term spread. The data contain over 20,000 monthly observations from 40 international markets, including 24 developed and 16 emerging economies. In addition, I develop new methods for predictive regressions with panel data. Inference based on the standard fixed effects estimator is shown to suffer from severe size distortions in the typical stock return regression, and an alternative robust estimator is proposed. The empirical results indicate that the short interest rate and the term spread are fairly robust predictors of stock returns in developed markets. In contrast, no strong or consistent evidence of predictability is found when considering the earnings- and dividend-price ratios as predictors.
Pharmaceutical R&D Spending and Threats of Price Regulation
Joseph Golec, Shantaram Hegde, and John Vernon
Do threats of pharmaceutical price regulation affect subsequent R&D spending? This study uses the Clinton Administration’s Health Security Act (HSA) of 1993 as a natural experiment to study this issue. We link events surrounding the HSA to pharmaceutical stock price changes and then examine the cross-sectional relation between firms’ stock price changes and their subsequent unexpected R&D spending changes. Results show that the HSA had significant negative effects on stock prices and firm-level R&D spending. Conservatively, the HSA reduced R&D spending by about $1 billion, even though it never became law.
How Does Liquidity Affect Government Bond Yields?
Carlo Favero, Marco Pagano, and Ernst-Ludwig von Thadden
The paper explores the determinants of yield differentials between sovereign bonds, using Euro area data. There is a common trend in yield differentials, which is correlated with a measure of aggregate risk. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We propose a simple model with endogenous liquidity demand, where a bond’s liquidity premium depends both on its transaction cost and on investment opportunities. The model predicts that yield differentials should increase in both liquidity and risk, with an interaction term of the opposite sign. Testing these predictions on daily data, we find that the aggregate risk factor is consistently priced, liquidity differentials are priced for a subset of countries, and their interaction with the risk factor is in line with the model’s prediction and crucial to detect their effect.
The Signaling Hypothesis Revisited: Evidence from Foreign IPOs
Bill B. Francis, Iftekhar Hasan, James R. Lothian, and Xian Sun
While the signaling hypothesis has played a prominent role as the economic rationale associated with the initial public offering (IPO) underpricing puzzle (Welch, 1989), the empirical evidence on it has been mixed at best (Jegadeesh, Weinstein and Welch, 1993; Michaely and Shaw, 1994). This paper revisits the issue from the vantage point of close to two decades of additional experience by examining a sample of foreign IPOs—firms from both financially integrated and segmented markets—in U.S. markets. The evidence indicates that signaling does matter in determining IPO underpricing, especially for firms domiciled in countries with segmented markets, which as a result face higher information asymmetry and lack access to external capital markets. We find a significant positive and robust relationship between the degree of IPO underpricing and segmented-market firms’ seasoned equity offering activities. For firms from integrated markets, in contrast, the analyst-coverage-purchase hypothesis appears to matter more in explaining IPO underpricing and the aftermarket price appreciation explains these firms’ seasoned equity offering activities. The evidence, therefore, clearly supports the notion that some firms are willing to leave money on the table voluntarily to get a more favorable price at seasoned offerings when they are substantially wealth constrained, a prediction embedded in the signaling hypothesis.
An Epidemic Model of Investor Behavior
Sophie Shive
I test whether social influence affects individual investors’ trading and stock returns. In each of the 20 most active stocks in Finland over nine years, the number of owners in a municipality multiplied by the number of investors who do not own a stock, a measure of the rate of transmission of diseases and rumors through social contact, predicts individual investor trading. I control for known determinants of trade including daily news and show that competing explanations for the relation are unlikely. Socially motivated trades predict stock returns and the effects are not reversed, suggesting that individuals share useful information. Individuals’ susceptibility to social influence has declined during the period, but the opportunities for social influence have increased.
Is There Shareholder Expropriation in the United States? An Analysis of Publicly-Traded Subsidiaries
Vladimir Atanasov, Audra Boone, and David Haushalter
This paper examines the relation between the performance and valuations of publicly-traded subsidiaries in the United States and the ownership stake of their parent companies. Crosssectional and time-series tests demonstrate that subsidiaries in which the parent owns a substantial minority stake exhibit negative peer-adjusted operating performance and are valued at a 23% median discount relative to peers. Performance is poorest among minority-owned subsidiaries with executive officers that are also affiliated with the parent, while majority-owned and fully divested subsidiaries show no abnormal performance. The results of our study indicate that the association between parent ownership and subsidiary performance is nonlinear and that some parents do, in fact, behave opportunistically toward their publicly traded subsidiaries.
Fund Flow Volatility and Performance
David Rakowski
This paper provides a detailed analysis of the impact of daily mutual fund flow volatility on fund performance. I document a significant negative relationship between the volatility of daily fund flows and cross-sectional differences in risk-adjusted performance. This relationship is driven by domestic equity funds, as well as small funds, well-performing funds, and funds that experience inflows over the sample period. My results are consistent with performance differences arising from the transaction costs of non-discretionary trading driven by daily fund flows, but not with performance differences arising from the suboptimal cash holdings that arise from fund flows.
Predicting Hedge Fund Failure: A Comparison of Risk Measures
Bing Liang and Hyuna Park
This paper compares downside risk measures that incorporate higher return moments with traditional risk measures such as standard deviation in predicting hedge fund failure. When controlling for styles, performance, fund age, size, lockup, high-water mark, and leverage, we find that funds with larger downside risk have a higher hazard rate. However, standard deviation loses the explanatory power once the other explanatory variables are included in the hazard model. Further, we find liquidation does not necessarily mean failure in the hedge fund industry. By reexamining the attrition rate, we show that the real failure rate of 3.1% is lower than the attrition rate of 8.7% on an annual basis from the period of 1995-2004.
Stock Option Repricing and its Alternatives: An Empirical Examination
Swaminathan Kalpathy
In this paper I examine the likelihood of CEO stock option repricing and its alternatives, namely option grant, stock grant, and “do nothing.” Multinomial logit results suggest that firms reprice options to increase sensitivity of pay to stock price and to temper down sensitivity of pay to volatility. Moreover, repricing firms are younger and concentrated more in industries where human capital is important. Finally, I find no evidence that internal governance or executive conflicts of interest are relevant in explaining repricing. My results indicate that repricing is motivated by incentive alignment and retention, and not by agency cost considerations.
Paying for Market Quality
Amber Anand, Carsten Tanggaard, and Daniel G. Weaver
Many financial markets, including electronic limit order markets, assign designated liquidity providers (LPs). We study the experience of the Stockholm Stock Exchange, where listed firms contract directly with LPs. Our analysis offers insights regarding situations where designated liquidity provision may be beneficial, and relating to the form of liquidity provision contracts, including the affirmative obligations required of the LP and compensation for LP services. We find that low current trading activity, wide spreads and higher information asymmetry increase the attractiveness of contracted liquidity provision. The evidence indicates that liquidity providers trade against market movements, and in times of wide spreads. On balance, firms contracting with LPs experience a decreased cost of capital, and significant improvements in market quality and price discovery.
Organization and Financing of Innovation, and the Choice between Corporate and Independent Venture Capital
Paolo Fulghieri and Merih Sevilir
This paper examines the impact of competition on the optimal organization and financing structures used in innovation intensive industries. We show that, as an optimal response to competition, firms choose external organization structures established in collaboration with specialized start-ups where they provide financing for the start-ups from their own resources. As the intensity of the competition to innovate increases, firms move away from internal to external organization of projects to increase the speed of product innovation and to obtain a competitive advantage with respect to rival firms in their industry. We also show that as the level of competition becomes greater, firms provide a higher level of financing for externally organized projects in the form of corporate venture capital. Hence, at high levels of competition, external organization structures combined with corporate venture capital financing become the optimal organization and financing structure of innovation. Our results help explain the emergence of organization and financing arrangements such as corporate venture capital and strategic alliances, where large established firms organize their projects in collaboration with external specialized firms, and provide financing for the externally organized projects from their own internal resources.
Do Firms Target Credit Ratings or Leverage Levels?
Darren J. Kisgen
Firms reduce leverage following credit rating downgrades. In the year following a downgrade, downgraded firms issue approximately 1.5-2.0% less net debt relative to net equity as a percentage of assets compared to other firms. This relationship persists within an empirical model of target leverage behavior. The effect of a downgrade is larger at downgrades to a speculative grade rating and if commercial paper access is affected. In particular, firms downgraded to speculative are about twice as likely to reduce debt as other firms. Rating upgrades do not affect subsequent capital structure activity, suggesting that firms target minimum rating levels.
Hard-to-Value Stocks, Behavioral Biases, and Informed Trading
Alok Kumar
This paper uses investor-level data to provide direct evidence for an intuitive but surprisingly untested proposition that investors make larger investment mistakes when valuation uncertainty is higher and stocks are more difficult to value. Using multiple measures of valuation uncertainty and multiple behavioral bias proxies, I show that individual investors exhibit stronger behavioral biases when stocks are harder-to-value and when market-level uncertainty is higher. I also find that informed trading intensity is higher among stocks where individual investors exhibit stronger behavioral biases. Collectively, these results indicate that uncertainty at both stock and market levels amplifies individual investors’ behavioral biases and that relatively better informed investors attempt to exploit those biases.
On the Volatility and Comovement of U.S. Financial Markets Around Macroeconomic News Announcements
Menachem Brenner, Paolo Pasquariello, and Marti Subrahmanyam
The objective of this paper is to provide a deeper insight into the links between financial markets and the real economy. To that end, we study the short-term anticipation and response of U.S. stock, Treasury, and corporate bond markets to the first release of surprise U.S. macroeconomic information. Specifically, we focus on the impact of these announcements not only on the level, but also on the volatility and comovement of those assets’ returns. We do so by estimating several extensions of the parsimonious multivariate GARCH-DCC model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that both the process of price formation in each of those financial markets and their interaction appear to be driven by fundamentals. Yet, our analysis reveals a statistically and economically significant dichotomy between the reaction of the stock and bond markets to the arrival of unexpected fundamental information. We also show that the conditional mean, volatility, and comovement among stock, Treasury, and corporate bond returns react asymmetrically to the information content of these surprise announcements. Overall, the above results shed new light on the mechanisms by which new information is incorporated into prices within and across U.S. financial markets.
Block Ownership, Trading Activity, and Market Liquidity
Paul Brockman, Dennis Y. Chung, and Xuemin (Sterling) Yan
We examine the impact of block ownership on the firm’s trading activity and secondary-market liquidity. Our empirical results show that block ownership takes potential trading activity off the table relative to a diffuse ownership structure and impairs the firm’s market liquidity. These adverse liquidity effects disappear, however, once we control for trading activity. Our findings suggest that block ownership is detrimental to the firm’s market liquidity because of its adverse impact on trading activity—a real friction effect. After controlling for this real friction effect, we find little evidence that block ownership has a negative impact on informational friction. Our results suggest that the relative lack of trading, and not the threat of informed trading, explains the inverse relation between block ownership and market liquidity.
Does Skin in the Game Matter? Director Incentives and Governance in the Mutual Fund Industry
Martijn Cremers, Joost Driessen, Pascal Maenhout, and David Weinbaum
We use a unique database on ownership stakes of equity mutual fund directors to analyze whether the directors’ incentive structure is related to fund performance. Ownership of both independent and non-independent directors plays an economically and statistically significant role. Funds in which directors have low ownership, or “skin in the game,” significantly underperform. We posit two economic mechanisms to explain this relation. First, lack of ownership could indicate a director’s lack of alignment with fund shareholder interests. Second, directors may have superior private information on future performance. We find evidence in support of the first and against the second mechanism.
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.
Last updated November 24, 2009.