JFQA Forthcoming Articles

The following papers have been accepted for publication in future issues.

Does Competition Matter for Corporate Governance? The Role of Country Characteristics
Jean-Claude Cosset, Hyacinthe Y. Somé, and Pascale Valéry

We investigate the role of country characteristics on the competition-governance relation. We find that competition is associated with higher ratings in corporate governance, but only in developing countries. Further, corporate governance is associated with greater firm value, but only in less competitive industries from developed countries. For developing countries, the evidence suggests that corporate governance is valuable mostly in competitive industries. Additional tests show that corporate governance increases labor productivity and cost efficiency, mostly in less competitive industries in both developed and developing countries. Furthermore in developing countries, corporate governance increases investment in capital, but primarily in competitive industries.

Urban Agglomeration and CEO Compensation
Bill Francis, Iftekhar Hasan, Kose John, and Maya Waisman

We examine the relationship between the agglomeration of firms around big cities and CEO compensation. We find a positive relationship between a firm's headquarters metropolitan size, the total and equity portion of its CEO's pay, and the quality of CEO educational attainment. We also find that CEOs gradually increase their human capital in major metropolitans and are rewarded for this upon relocation to smaller cities. Taken together, the results suggest that urban agglomeration reflects local network spillovers and faster learning of skilled individuals, for which firms are willing to pay a premium and are therefore important factors in CEO compensation.

Labor Income, Relative Wealth Concerns, and the Cross-Section of Stock Returns
Juan-Pedro Gómez, Richard Priestley, and Fernando Zapatero

The finance literature documents a relation between labor income and the cross-section of stock returns. One possible explanation for this is the hedging decisions of investors with relative wealth concerns. This implies a negative risk premium associated with stock returns correlated with local undiversifiable wealth, since investors are willing to pay more for stocks that help their hedging goals. We find evidence that is consistent with these regularities. In addition, we show that the effect varies across geographic areas depending on the size and variability of undiversifiable wealth, proxied by labor income.

On the Style-Based Feedback Trading of Mutual Fund Managers
Bart Frijns, Aaron Gilbert, and Remco C. J. Zwinkels

This paper examines the style-based feedback trading behavior of US mutual fund managers. We provide an empirical version of the model for style-switching behavior of Barberis and Shleifer (2003). We find style-based feedback trading for 77% of the funds, half of which is positive (negative) feedback trading. There is evidence for “twin style” switching, where capital is channeled between value and growth, and between large- and small-cap. Growth (value) funds apply more positive (negative) feedback trading. Funds that switch more aggressively are younger and have higher expense ratios. Finally, we find that positive (negative) feedback trading yields positive (negative) alpha.

The Price of Street Friends: Social Networks, Informed Trading, and Shareholder Costs
Jie Cai, Ralph A. Walkling, and Ke Yang

Recent studies suggest the transfer of privileged information via social ties but do not explicitly examine the cost of these ties to shareholders. We document a significant, positive relation between stock transaction costs and a company’s social ties to the investment community. Social ties based on education and leisure activities, stronger ties, and ties to individuals responsible for trading have greater effects. Using investment connection deaths as natural experiments, we document that exogenous severance of ties reduces trading costs and trading activities by connected parties. Our evidence illustrates an important and previously undocumented consequence of social ties.

Does Common Analyst Coverage Explain Excess Comovement?
Ryan D. Israelsen

This paper shows that correlated errors in news about fundamentals are an important, rational determinant of excess comovement. Individual analysts' forecast errors tend to be correlated across stocks. Using a proxy for correlated forecast errors based on analyst coverage, I find that stocks with similar sets of analysts exhibit more excess comovement, controlling for industry and other variables. Exogenous changes in commonality in analyst coverage around (1) brokerage firm mergers and (2) additions to an index lead to changes in excess comovement. This information channel explains 10% to 25% of the increase in comovement around additions to the S&P500 index.

The Effects of Government Interventions in the Financial Sector on Banking Competition and the Evolution of Zombie Banks
Cesar Calderon and Klaus Schaeck

We investigate how government interventions such as blanket guarantees, liquidity support, recapitalizations, and nationalizations affect banking competition. This issue is critical for stability, access to finance, and economic growth. Exploiting cross-country and cross-time variation in the timing of interventions and accounting for their nonrandomness, we document that liquidity support, recapitalizations, and nationalizations trigger large increases in competition. We also find some more nuanced evidence that zombie banks’ market shares in crisis countries evolve together with interventions. A higher frequency of interventions coincides with greater zombie bank presence, and increases in competition are larger when zombie banks occupy bigger market shares.

Liquidity Risk and the Credit Crunch of 2007-2008: Evidence from Micro-Level Data on Mortgage Loan Applications
Adonis Antoniades

Recent empirical studies have shown that during the financial crisis of 2007-2008 banks that were more heavily exposed to liquidity risk contracted their supply of credit more sharply. I contribute to the identification of this effect by relying on the use of micro-level data on US mortgage loan applications, which allows me to identify liquidity risk as an important determinant of the contraction of credit in the mortgage market, but as separate from the precipitous fall in credit demand, disruptions in the securitization and subprime markets, shifts in asset risk, and changing risk-aversion among loan oficers.

Investment and Cash Flow: New Evidence
Jonathan Lewellen and Katharina Lewellen

We study the investment-cash flow sensitivities of U.S. firms from 1971–2009. Our tests extend the literature in several key ways and provide strong evidence that cash flow explains investment beyond its correlation with q. A dollar of current- and prior-year cash flow is associated with $0.32 of additional investment for firms that are the least likely to be constrained and $0.63 of additional investment for firms that are the most likely to be constrained, even after correcting for measurement error in q. Our results suggest that financing constraints and free cash flow problems are important for investment decisions.

Risk, Uncertainty, and Expected Returns
Turan G. Bali and Hao Zhou

A conditional asset pricing model with risk and uncertainty implies that the time-varying exposures of equity portfolios to the market and uncertainty factors carry positive risk premiums. The empirical results from the size, book-to-market, momentum, and industry portfolios indicate that the conditional covariances of equity portfolios with market and uncertainty predict the time-series and cross-sectional variation in stock returns. We find that equity portfolios that are highly correlated with economic uncertainty proxied by the variance risk premium (VRP) carry a significant, annualized 8 percent premium relative to portfolios that are minimally correlated with VRP.

Corporate Boards and SEOs: The Effect of Certification and Monitoring
Miguel Ferreira and Paul Laux

In a sample of underwritten seasoned equity offerings (SEOs), issuers with boards dominated by independent directors experience higher abnormal announcement returns than issuers with boards dominated by insiders. Firm size, transparency, and other governance characteristics do not explain the effect of board independence. The positive relation between board independence and SEO returns is more pronounced for firms with lower monitoring costs and more severe financial constraints. The evidence suggests that independent directors have a positive effect because of both their role in controlling shareholder-manager conflicts (monitoring the use of funds) and current-new shareholder conflicts (certification of the issue's value).

Ambiguity Aversion and Underdiversication
Massimo Guidolin and Hening Liu

We examine asset allocation decisions under smooth ambiguity aversion when an investor has a prior degree of belief in an asset pricing model (e.g., the domestic CAPM). Different from a Bayesian approach, the investor separately relies on the conditional distribution of returns and on the posterior over parameters to make decisions, rather than on the predictive distribution of returns that integrates priors and likelihood information. We find that in the perspective of US investors, ambiguity aversion generates strong home bias in equity holdings, regardless of beliefs in the CAPM or risk aversion. Results become stronger under regime-switching investment opportunities.

Are Ex-Ante CEO Severance Pay Contracts Consistent with Efficient Contracting?
Brian D. Cadman, John L. Campbell, and Sandy Klasa

Efficient contracting predicts that ex-ante severance pay contracts are offered to CEOs as protection against downside risk and to encourage investment in risky positive net-present-value projects. Consistent with this prediction, we find that ex-ante contracted severance pay is positively associated with proxies for a CEO’s risk of dismissal and costs the CEO would incur from dismissal. Additionally, we show that the contracted severance payment amount is positively associated with CEO risk-taking and the extent to which a CEO invests in projects that have a positive net-present-value. Overall, our findings imply that ex-ante severance pay contracts are consistent with efficient contracting.

Did TARP Banks Get Competitive Advantages?
Allen N. Berger and Raluca A. Roman

We investigate whether the Troubled Assets Relief Program (TARP) gave recipients competitive advantages. Using a difference-in-difference (DID) approach, we find that: 1) TARP recipients received competitive advantages and increased both their market shares and market power; 2) results may be driven primarily by the safety channel (TARP banks may be perceived as safer), which is partially offset by the cost disadvantage channel (TARP funds may be relatively expensive); and 3) these competitive advantages are primarily or entirely due to TARP banks that repaid early. These results may help explain other findings in the literature and yield important policy implications.

Option Valuation with Macro-Finance Variables
Christian Dorion

I propose a model in which the price of an option is partly determined by macro-finance variables. In an application using an index of current business conditions, the new model outperforms existing benchmarks in fitting underlying asset returns and in pricing options. The model performs particularly well when business conditions are deteriorating. Using the recent financial crisis as an out-of-sample experiment, the new model has option-pricing errors that are 18% below those of a nested two-component volatility benchmark. Results are robust to using alternative business conditions proxies and comparing to different benchmark models.

The Valuation of Hedge Funds' Equity Positions
Gjergji Cici, Alexander Kempf, and Alexander Puetz

We provide evidence on the valuation of equity positions by hedge funds. Reported valuations deviate from standard valuations based on closing prices from CRSP for roughly seven percent of the positions. These equity valuation deviations are positively related to illiquidity and price volatility of the underlying stocks. They respond to past performance and intensify after an adviser starts reporting to a commercial database. Furthermore, advisers with more valuation deviations show a stronger discontinuity in their reported returns around zero, manage a higher fraction of potentially fraudulent funds, report smoother returns, and exhibit an upward spike in their December reported returns.

What Is the Nature of Hedge Fund Manager Skills? Evidence from the Risk Arbitrage Strategy
Charles Cao, Bradley A. Goldie, Bing Liang, and Lubomir Petrasek

To understand the nature of hedge fund managers’ skills, we study the implementation of risk arbitrage by hedge funds using their portfolio holdings and comparing them with those of other institutional arbitrageurs. We find that hedge funds significantly outperform a naive risk arbitrage portfolio by 3.7% annually on a risk-adjusted basis, while non-hedge fund arbitrageurs fail to outperform the benchmark. Our analysis reveals that hedge funds’ superior performance does not reflect fund managers’ ability to predict or affect the outcome of merger and acquisition deals; rather, hedge fund managers’ superior performance is attributed to their ability to manage downside risk.

Understanding Portfolio Efficiency with Conditioning Information
Francisco Peñaranda

I develop two new types of portfolio efficiency when returns are predictable. The first type maximizes the unconditional Sharpe ratio of excess returns and differs from unconditional efficiency unless the safe asset return is constant over time. The second type maximizes conditional mean-variance preferences and differs from unconditional efficiency unless, additionally, the maximum conditional Sharpe ratio is constant. Using stock data, I quantify and test their performance differences with respect to unconditionally and fixed-weight efficient returns. I also show the relevance of the two new portfolio strategies to test conditional asset pricing models.

Making Waves: To Innovate or be a Fast Second?
Chris Yung

Internal finance leads to a stalemate in innovation games; each firm wants to free-ride on the others' costly experimentation. When instead innovation is financed externally (e.g., with venture capital or in IPOs) there is an endogenous cost to delay. Waiting to make risky irreversible investment conveys pessimistic information. I characterize the relative sizes of waves of leaders and followers in innovation cycles, and the endogenous, intertemporal distribution of quality as each wave builds and crashes. Finally, old waves leave an adverse selection "hangover" so that too much early innovation can cause the market for future innovation to break down.

The Role of Mutual Funds in Corporate Governance: Evidence from Mutual Funds’ Proxy Voting and Trading Behavior
Ying Duan and Yawen Jiao

This paper examines mutual fund families’ proxy voting records to analyze their choices between voting against management (“voice”) and voting with their feet (“exit”). Even though proxy voting is particularly conducive to governance through voice rather than exit, we provide evidence that both exit and voice are important governance mechanisms when Institutional Shareholder Services recommends voting against management. Funds with smaller ownership blocks and shorter investment horizons are more likely to exit, and funds are more likely to exit small, liquid firms with greater insider ownership.

Time-Varying Margin Requirements and Optimal Portfolio Choice
Oleg Rytchkov

This paper studies the optimal consumption and portfolio problem of an investor with recursive preferences who is subject to time-varying margin requirements. The level of the requirements at each moment is determined by contemporaneous volatility of returns, which is stochastic and may have jumps. I show that nonstandard hedging demand produced by margin requirements increases with their persistence and volatility. However, for realistic values of parameters the hedging demand is small even in the presence of jumps and contemporaneous jumps in prices have a much stronger effect on optimal portfolio than jumps in constraints.

Portfolio Diversification and International Corporate Bonds
Edith X. Liu

This paper examines the benefits of corporate bond diversification for US investors. Analysis of a newly compiled bond-level dataset for 2000-2010 finds that diversification with corporate bonds can significantly reduce volatility and increase risk-adjusted returns for US investors. Unlike diversification with equities, corporate bonds offer significant out-of-sample risk reduction, particularly during the recent financial crisis. Risk reduction gains are large even when the benchmark includes international equities or when longer samples of equities and sovereign bonds are used to inform corporate bond returns. Finally, significant risk reduction gains remain after accounting for bond characteristics, liquidity, and informational costs.

Human Capital, Management Quality, and the Exit Decisions of Entrepreneurial Firms
Shan He and C. Wei Li

We model the employee incentive problem jointly with a firm’s exit decision. Our model predicts that firms in industries where human capital is important are more likely to go public and use high-powered stock-based compensation. We also show that the higher the management quality, the more likely a firm is to go public than to be acquired. Lifecycle-wise, a firm with high capital intensity and/or high management quality will choose to go public at a younger age.

Capital Market Efficiency and Arbitrage Efficacy
Ferhat Akbas, Will J. Armstrong, Sorin Sorescu, and Avanidhar Subrahmanyam

Efficiency in the capital markets requires that capital flows are sufficient to arbitrage anomalies away. We examine the relationship between flows to a "quant" strategy that is based on capital market anomalies, and the subsequent performance of this strategy. When these flows are high, quant funds are able to implement arbitrage strategies more effectively, which, in turn, leads to lower profitability of market anomalies in the future, and vice versa. Thus, the degree of cross-sectional equity market efficiency varies across time with the availability of arbitrage capital.

Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility Around the World
Yufeng Han, Ting Hu, and David A. Lesmond

This paper examines data from 45 world markets and shows that the previouslydocumented relation between mean returns and idiosyncratic volatility arises because of biases in volatility estimates that we can attribute to the bid-ask bounce in trade prices. We show that no significant relation exists between mean returns and idiosyncratic volatility estimated from quote-midpoint returns. Further, there is no significant relation between mean returns and the portion of transaction-price based idiosyncratic volatility that is orthogonal to bid-ask spreads. The pricing of idiosyncratic volatility is due to the negative pricing of the bid-ask spread.

Bank Skin in the Game and Loan Contract Design: Evidence from Covenant-Lite Loans
Matthew T. Billett, Redouane Elkamhi, Latchezar Popov, and Raunaq S. Pungaliya

In a model of dual agency problems where borrower-lender and bank-nonbank incentives may conflict, we predict a hockey stick relation between bank skin in the game and covenant tightness. As bank participation declines covenant tightness increases until reaching a low threshold, at which point the relation sharply reverses and covenant protection is removed with a commensurate increase in spread. We find support for the hockey stick relation with bank’s stake in covenant-lite loans averaging 8% (0% median). We also find that covenant-lite loans are more likely when borrower moral hazard is less severe and when bank relationship rents are high.

A Rent Protection Explanation for SEO Flotation Method Choice
Xueping Wu, Zheng Wang, and Jun Yao

We model how a rent-protection motive drives the choice of flotation method in new equity issuance between two polar cases: rights issues and cash offers. Unexpected new blockholders would emerge in control-diluting cash offers and share in jealously guarded control benefits. But rights issues help the incumbent controlling shareholders avoid control dilution and safeguard their private benefits. Under asymmetric information about private benefits, the choice of flotation method can convey information about hidden private benefits and hence firm value. Our model can explain even a negative announcement effect of rights issues, and supports not just one but three important equilibriums.

New Evidence on the Forward Premium Puzzle
Jacob Boudoukh, Matthew Richardson, and Robert F. Whitelaw

The forward premium anomaly—exchange rate changes are negatively related to interest rate differentials—is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of lagged forward interest rate differentials, documenting a reversal of the anomalous sign on the coefficient in the traditional specification. We show that this novel evidence is consistent with recent empirical models of exchange rates which imply exchange rate changes depend on two key variables—the interest rate differential and the magnitude of the deviation of the current exchange rate from that implied by purchasing power parity.

Benchmarking and Currency Risk
Massimo Massa, Yanbo Wang, and Hong Zhang

We show that the currency risk embedded in the benchmarks of international mutual funds negatively affects fund performance. More specifically, a high benchmark-implied currency risk induces funds to invest in markets with less volatile currencies, leading to a higher degree of currency concentration in portfolio holdings. This currency concentration, however, departs from the optimal equity allocation strategy across countries and reduces fund performance. We document that funds resorting to high currency concentrations underperform funds with low currency concentrations by as much as 1% to 2% per year.

Does Information Processing Cost Affect Firm-Specific Information Acquisition? Evidence from XBRL Adoption
Yi Dong, Oliver Zhen Li, Yupeng Lin, and Chenkai Ni

We examine how information processing cost affects investors’ acquisition of firm-specific information using a natural experiment resulting from a recent mandate that US firms be required to adopt the eXtensible Business Reporting Language (XBRL) when submitting filings to the SEC. XBRL filings make financial data standardized, tagged, and machine-readable. We find that XBRL adoption reduces firms’ stock return synchronicity. The reduction in synchronicity mainly applies to filings under the mandatory program as opposed to the voluntary program. Further, such an effect is more pronounced for opaque and complex firms. Finally, we find that XBRL adoption also reduces price delay.

Systematic Tail Risk
Maarten R. C. van Oordt and Chen Zhou

We test for the presence of a systematic tail risk premium in the cross-section of expected returns by applying a measure on the sensitivity of assets to extreme market downturns, the tail beta. Empirically, historical tail betas help to predict the future performance of stocks in extreme market downturns. During a market crash, stocks with historically high tail betas suffer losses that are approximately 2 to 3 times larger than their low tail beta counterparts. However, we find no evidence of a premium associated with tail betas. The theoretically additive and empirically persistent tail betas can help to assess portfolio tail risks.

Gambling Preferences, Options Markets, and Volatility
Benjamin M. Blau, T. Boone Bowles, and Ryan J. Whitby

This study examines whether the gambling behavior of investors affects volume and volatility in financial markets. Focusing on the options market, we find that the ratio of call option volume relative to total option volume is greatest for stocks with return distributions that resemble lotteries. Consistent with theoretical predictions in Stein (1987), we demonstrate that gambling-motivated trading in the options market influences future spot price volatility. These results not only identify a link between lottery preferences in the stock market and the options market, but they also suggest that lottery preferences can lead to destabilized stock prices.

Real Economic Shocks and Sovereign Credit Risk
Patrick Augustin and Roméo Tédongap

We provide new empirical evidence that U.S. expected growth and consumption volatility are closely related to the strong co-movement in sovereign spreads. We rationalize these findings in an equilibrium model with recursive utility for CDS spreads. The framework nests a reduced-form default process with country-specific sensitivity to expected growth and macroeconomic uncertainty. Exploiting the high-frequency information in the CDS term structure across 38 countries, we estimate the model and find parameters consistent with preference for early resolution of uncertainty. Our results confirm the existence of time-varying risk premia in sovereign spreads as compensation for exposure to common U.S. macroeconomic risk.

Differential Access to Price Information in Financial Markets
David Easley, Maureen O'Hara, and Liyan Yang

Recently exchanges have been directly selling market data. We analyze how this practice affects price discovery, the cost of capital, return volatility, market liquidity, information production and trader welfare. We show that selling price data increases the cost of capital and volatility, worsens market efficiency and liquidity, and discourages the production of fundamental information relative to a world in which all traders observe prices. Generally allowing exchanges to sell price information benefits exchanges and harms liquidity traders. Overall, our results suggest that regulations on selling market data can play an important role in improving market quality and trader welfare.

Cross-Listing Waves
Sergei Sarkissian and Michael J. Schill

Using a 57-year global foreign listing sample, we identify cross-listing waves at the host market, home market, and industry levels. Waves in host markets are often due to cross-listing waves in proximate home markets. Consistent with gravity model implications and economic synergy arguments of cross-listing decisions, cross-listing waves in a given host country coincide with the outperformance of host and proximate home country’s economies and financial markets. The valuation gains from listings associated with cross-listing waves are transitory, supporting the market timing component in these decisions. Our results provide novel evidence of nonmonotonic market development across countries and over time.

The Politics of Related Lending
Michael Halling, Pegaret Pichler, and Alex Stomper

We analyze the profitability of government-owned banks’ lending to their owners, using a unique data set of relatively homogeneous government-owned banks; the banks are all owned by similarly structured local governments in a single country. Making use of a natural experiment that altered the regulatory and competitive environment, we find evidence that such lending was used to transfer revenues from the banks to the governments. Some of the evidence is particularly pronounced in localities where the incumbent politicians face significant competition for reelection.

Analyst Coverage and Real Earnings Management: Quasi-Experimental Evidence
Rustom M. Irani and David Oesch

We study how securities analysts influence managers' use of different types of earnings management. To isolate causality, we employ a quasi-experiment that exploits exogenous reductions in analyst following resulting from brokerage house mergers. We find that managers respond to the coverage loss by decreasing real earnings management, while increasing accrual manipulation. These effects are significantly stronger among firms with less coverage and for firms close to the zero-earnings threshold. Our causal evidence suggests that managers use real earnings management to enhance short-term performance in response to analyst pressure, effects that are not uncovered when focusing solely on accrual-based methods.

Business Microloans for U.S. Subprime Borrowers
Cesare Fracassi, Mark J. Garmaise, Shimon Kogan, and Gabriel Natividad

We show that business microloans to U.S. subprime borrowers have a very large impact on subsequent firm success. Using data on startup loan applicants from a lender that employed an automated algorithm in its application review, we implement a regression discontinuity design assessing the causal impact of receiving a loan on firms. Startups receiving funding are dramatically more likely to survive, enjoy higher revenues and create more jobs. Loans are more consequential for survival among subprime business owners with more education and less managerial experience.

Heterogeneity in Beliefs and Volatility Tail Behavior
Gurdip Bakshi, Dilip Madan, and George Panayotov

We propose a model of volatility tail behavior, in which investors display aversion to both low volatility and high volatility states, and, hence, the derived pricing kernel exhibits an increasing and decreasing region in the volatility dimension. The model features investors who have heterogeneity in beliefs about volatility outcomes, and maximize their utility by choosing volatility-contingent cash flows. Our empirical examination suggests that the model is better suited to reproduce data features in the left tail of the volatility distribution, both qualitatively and quantitatively.

Who Moves Markets in a Sudden Market-Wide Crisis? Evidence from Nine-Eleven
Timothy R. Burch, Douglas R. Emery, and Michael E. Fuerst

We compare reactions in the prices and trading patterns of common stocks and closed-end funds (CEFs), which have substantially different investor clienteles, to the September 11, 2001 terrorist attacks. When the market reopened six days later, retail investors sold and there were sharp price declines---even in assets with net institutional buying. In the subsequent two weeks, price reversals were substantially security-specific and thus not simply due to improved systematic sentiment. Consistent with microstructure theory, comparisons between CEFs and common stocks show the speed of these reversals depended significantly on the relative quality and availability of information about fundamental values.

Bank Competition and Financial Stability: Evidence from the Financial Crisis
Brian Akins, Lynn Li, Jeffrey Ng, and Tjomme O. Rusticus

We examine the link between bank competition and financial stability using the recent financial crisis as the setting. We utilize variation in banking competition at the state level and find that banks facing less competition are more likely to engage in risky activities, more likely to face regulatory intervention, and more likely to fail. Focusing on the real estate market, we find that states with less competition had higher rates of mortgage approval, experienced greater housing price inflation before the crisis, and a steeper housing price decline during it. Overall, our study is consistent with greater competition increasing financial stability.

Inside Debt and Bank Risk
Sjoerd Van Bekkum

Inside debt compensation held by top ocers of U.S. banks is negatively re- lated to risk and risk-taking. The evidence reveals a robust and strongly negative relation between end-of-2006 inside debt and 2007-2009 bank-specic risk expo- sures in terms of lost stock market value, volatility, tail risk, and the probability of nancial distress. Banks with managers having large inside debt holdings are also characterized by better-quality assets, more conservative balance sheet man- agement, and a stronger tendency towards traditional banking activities. The results suggest that debt-based compensation limits bank risk and risk-taking by encouraging more conservative decision-making.

Local Business Cycles and Local Liquidity
Gennaro Bernile, George Korniotis, Alok Kumar, and Qin Wang

This study examines whether state-level economic conditions affect the liquidity of local firms. We find that liquidity levels of local stocks are higher (lower) when the local economy has performed well (poorly). This relation is stronger when local financing constraints are more binding, the local information environment is more opaque, and local institutional ownership levels and trading intensity are higher. Overall the evidence supports the notion that the geographical segmentation of U.S. capital markets generates predictable patterns in local liquidity.

Hedge Fund Performance Evaluation Under the Stochastic Discount Factor Framework
Haitao Li, Yuewu Xu, and Xiaoyan Zhang

We study hedge fund performance evaluation under the stochastic discount factor framework of Farnsworth, Ferson, Jackson, and Todd (2002). To accommodate dynamic trading strategies and derivatives used by hedge funds, we extend their approach by considering models with option and time-averaged risk factors and incorporating option returns in model estimation. A wide range of models yield similar conclusions on the performance of simulated long/short equity hedge funds. We apply these models to 2,315 actual long/short equity funds from TASS and find that a small portion of these funds can outperform the market.

Financial Weakness and Product Market Performance: Internal Capital Market Evidence
Ryoonhee Kim

Using a data set of Korean business groups in the period 1999–2006, just after the Asian Financial Crisis, this study shows how business groups’ financial leverage can lead group-affiliated firms to lose market share to industry rivals. This analysis reveals that the negative effect of group leverage is greater when an affiliated firm is financially weak. Additionally, high group leverage is more detrimental to firms operating in fast-growing industries, discouraging affiliated firms from investing while encouraging their rivals. The results suggest that groups’ financial positions encompass a substantial strategic dimension of group-affiliated firms.

Private Equity Firms’ Reputational Concerns and the Costs of Debt Financing
Rongbing Huang, Jay R. Ritter, and Donghang Zhang

A popular view is that private equity (PE) firms tend to expropriate other stakeholders of their portfolio companies. Bonds offered during 1992–2011 by companies after their initial public offerings (IPOs) do not reflect this view. We find that yield spreads on bonds offered by PE-backed companies are on average 70 basis points lower, holding other things constant. We also find that PE-backed companies have more conservative investment and dividend policies after bond offerings compared to non-PE-backed companies. These results suggest that PE firms’ reputational concerns dominate their wealth expropriation incentives and help their portfolio companies reduce the costs of debt.

Parameter Uncertainty in Multiperiod Portfolio Optimization with Transaction Costs
Victor DeMiguel, Alberto Martín-Utrera, and Francisco J. Nogales

We study the impact of parameter uncertainty on the expected utility of a multiperiod investor subject to quadratic transaction costs. We characterize the utility loss associated with ignoring parameter uncertainty, and show that it is equal to the product between the single-period utility loss and another term that captures the effects of the multiperiod mean-variance utility and transaction cost losses. To mitigate the impact of parameter uncertainty, we propose two multiperiod shrinkage portfolios and demonstrate with simulated and empirical datasets that they substantially outperform portfolios that ignore parameter uncertainty, transaction costs, or both.

CEO Personal Risk-Taking and Corporate Policies
Matthew D. Cain and Stephen B. McKeon

This study analyzes the relation between CEO personal risk-taking, corporate risk-taking and total firm risk. We find evidence that CEOs who possess private pilot’s licenses, our proxy for personal risk-taking, are associated with riskier firms. Firms led by pilot CEOs have higher equity return volatility, beyond the amount explained by compensation components that financially reward risk-taking. We trace the source of the elevated firm risk to specific corporate policies including leverage and acquisition activity. Our results suggest that non-pecuniary risk preferences revealed outside the scope of the firm have implications for project selection and various corporate policies.

CEO Narcissism and the Takeover Process: From Private Initiation to Deal Completion
Nihat Aktas, Eric de Bodt, Helen Bollaert, and Richard Roll

CEO narcissism affects the takeover process. Acquirer shareholders react less favorably to a takeover announcement when the target CEO is more narcissistic. Narcissistic acquiring CEOs negotiate faster. They are also marginally more likely to initiate deals. Acquirer and target CEO narcissism are associated with a lower probability of deal completion and reduce the likelihood that the target CEO will be employed by the merged firm. Our findings highlight the importance of both acquirer and target CEO psychological characteristics throughout the takeover process.

Strategic Default, Debt Structure, and Stock Returns
Philip Valta

This paper theoretically and empirically investigates how the debt structure and the strategic interaction between shareholders and debt holders in the event of default affect expected stock returns. The model predicts that expected stock returns are higher for firms that face high debt renegotiation difficulties and that have a large fraction of secured or convertible debt. Using a large sample of publicly traded US firms between 1985 and 2012, the paper presents new evidence on the link between debt structure and stock returns that is supportive of the model’s predictions.

Skin in the Game versus Skimming the Game: Governance, Share Restrictions, and Insider Flows
Gideon Ozik and Ronnie Sadka

This paper advances that share restrictions engender potential conflict of interest between fund managers and investors. Fund flows predict future fund returns for share-restricted funds, especially among funds with low levels of governance and funds managing insiders’ wealth, providing managers incentive to trade in advance of their clients. Some direct evidence for such managerial action are presented, using proprietary data on managerial investment in own funds. The evidence suggests that private information about a fund, not necessarily its holdings, may constitute material information, with implications for proper fund governance and disclosure policy concerning managerial actions.

Flashes of Trading Intent at the NASDAQ
Johannes A. Skjeltorp, Elvira Sojli, and Wing Wah Tham

We use the introduction and subsequent removal of the flash order functionality from NASDAQ as a natural experiment to investigate the impact of voluntary disclosure of trading intent on market quality. We find that flash orders significantly improve liquidity in NASDAQ. Furthermore, overall market quality improves (deteriorates) when the flash functionality is introduced (removed). This result can be attributed to increased competition among liquidity suppliers across competing trading venues. Alternatively, flash orders attract responses from reactive traders immediately after the announcement, attracting more “hidden liquidity" and lowering risk-bearing costs for the overall market.

Is Momentum an Echo?
Amit Goyal and Sunil Wahal

In the U.S., momentum portfolios formed from 12 to seven months prior to the current month deliver higher future returns than momentum portfolios formed from six to two months prior, suggesting an “echo” in returns (Novy-Marx (2012)). In 37 countries excluding the U.S., there is no robust evidence of such an echo. In portfolios that combine securities in developed and emerging markets, or across three major geographic regions (Americas ex-U.S., Asia and Europe), there is also no evidence of an echo. Any echo in the U.S. appears to be driven largely by a carryover of short-term reversals from month –2.

Trading Patterns and Market Integration in Overlapping Experimental Asset Markets
Patricia Chelley-Steeley, Brian Kluger, James Steeley, and Paul Adams

This paper examines trading patterns and market integration using laboratory asset markets. Our markets are designed to approximately correspond to the trading day for stocks cross-listed in markets in Europe and North America. Some of our markets feature timing restrictions so that participants cannot trade across markets except during a fully integrated overlap period. Comparison of markets with and without timing restrictions shows that restrictions reduce trading activity and shift transactions to the overlap period. When asset values are extreme, price discovery can be impeded when trading restrictions exist. The measurement of liquidity suggests that trading restrictions increase overall spreads.

Gambling and Comovement
Alok Kumar, Jeremy K. Page, and Oliver G. Spalt

This study shows that correlated trading by gambling-motivated investors generates excess return comovement among stocks with lottery features. Lottery-like stocks comove strongly with one another and this return comovement is strongest among lottery stocks located in regions where investors exhibit stronger gambling propensity. Looking directly at investor trades, we find that investors with a greater propensity to gamble trade lottery-like stocks more actively and that those trades are more strongly correlated. Finally, we demonstrate that time variation in general gambling enthusiasm and income shocks from fluctuating economic conditions induce a systematic component in investors’ demand for lottery-like stocks.

On Bank Credit Risk: Systemic or Bank-Specific? Evidence from the US and UK
Junye Li and Gabriele Zinna

We develop a multivariate credit risk model that accounts for joint defaults of banks and allows us to disentangle how much of banks’ credit risk is systemic. We find that the US and UK differ not only in the evolution of systemic risk, but in particular in their banks’ systemic exposures. In both countries, however, systemic credit risk varies substantially, represents about half of total bank credit risk on average, and induces high risk premia. The results suggest that sovereign and bank systemic risk are particularly interlinked in the UK.

Sophistication, Sentiment, and Misreaction
Chuang-Chang Chang, Pei-Fang Hsieh, and Yaw-Huei Wang

This study investigates whether the existence or strength of any misreaction in the options market is affected by investor sophistication and investor sentiment. Based on a unique data set of the complete history of all transactions in the Taiwan options market, we find that individual investors exhibit significant misreaction to information and that this misreaction becomes stronger during periods of high investor sentiment. In addition, more active or aggressive individual investors always exhibit misreaction and do not learn from their past mistakes. Our empirical results are robust to alternative measures of investor sentiment and definitions of long- and short-term horizons.

Lending Relationships and the Effect of Bank Distress: Evidence from the 2007-2009 Financial Crisis
Daniel Carvalho, Miguel A. Ferreira, and Pedro Matos

We study the transmission of bank distress to nonfinancial firms from 34 countries during the 2007-2009 financial crisis using systemic and bank-specific shocks. We find that bank distress is associated with equity valuation losses and investment cuts to borrower firms with the strongest lending relationships with banks. The losses are not offset by borrowers’ access to public debt markets and are concentrated in firms with the greatest information asymmetry problems and with the weakest financial positions. Our findings suggest that public debt markets do not mitigate the effects of relationship bank distress during financial crises.

Conflicts in Bankruptcy and the Sequence of Debt Issues
S. Abraham (Avri) Ravid, Ronald Sverdlove, Arturo Bris, and Gabriela Coiculescu

This paper investigates the optimal sequencing of debt issues. Our theoretical model suggests that once firms issue debt with one level of seniority, they may have an incentive to alternate seniorities, because of priced APR violations. When we introduce explicit costs of class conflict, the model yields cases of alternating seniorities and other cases where firms issue only one class of debt. The implications of the model are consistent with the observed regularities in a large data base of debt issues. We test several other implications of our model as well.

Anticipating the 2007-2008 Financial Crisis: Who Knew What and When Did They Know It?
Paul Brockman, Biljana Nikolic, and Xuemin (Sterling) Yan

We examine the ability of three groups of informed market participants to anticipate the 2007–2008 financial crisis. Institutional investors and financial analysts exhibit some awareness of the impending crisis in their preference for non-financial stocks over financial stocks. In contrast, corporate insiders of financial firms appear to be completely unaware of the timing and extent of the financial crisis. Net purchases by managers of financial firms exceed those by managers of non-financial firms over the entire 2006–2008 period. Our results add considerable weight to the argument that the financial crisis was more a case of flawed judgment than flawed incentives.

The Impact of Investability on Asset Valuation
Vihang Errunza and Hai Ta

We develop an international asset pricing model to measure the impact of investability constraints on asset pricing. For a sample of 18 emerging markets, we use Standard & Poor's investable weight factor (IWF) to show a 26.33% reduction in the cost of equity capital when non-investable firms become partially investable, with a further 12.51% reduction when partially investable firms become unrestricted. We demonstrate the generality and usefulness of the IWF by examining stocks with global/American depository receipts and foreign institutional holdings as alternate investability proxies. Our results provide strong evidence of the economic benefits of market liberalization policies.

Mean Variance Portfolio Optimization with Sparse Inverse Covariance Matrix
Shingo Goto and Yan Xu

In portfolio risk minimization, the inverse covariance matrix prescribes the hedge trades in which a stock is hedged by all the other stocks in the portfolio. In practice with finite samples, however, multicollinearity makes the hedge trades too unstable and unreliable. By shrinking trade sizes and reducing the number of stocks in each hedge trade, we propose a "sparse" estimator of the inverse covariance matrix. Comparing favorably with other methods (equal weighting, shrunk covariance matrix, industry factor model, non-negativity constraints), a portfolio formed on the proposed estimator achieves significant out-of-sample risk reduction and improves certainty equivalent returns after transaction costs.

Industry Expertise of Independent Directors and Board Monitoring?
Cong Wang, Fei Xie, and Min Zhu

We examine whether industry expertise of independent directors affects board monitoring effectiveness. We find that the presence of independent directors with industry experience on a firm's audit committee significantly curtails firms' earnings management. In addition, a greater representation of independent directors with industry expertise on a firm's compensation committee reduces CEO excess compensation and a greater presence of such directors on the full board increases the CEO turnover-performance sensitivity and improves acquirer returns from diversifying acquisitions. Overall, the evidence is consistent with the hypothesis that having relevant industry expertise enhances independent directors' ability to perform their monitoring function.

The Role of Activist Hedge Funds in Financially Distressed Firms
Jongha Lim

This paper investigates the role of activist hedge funds in the restructuring of a sample of 469 firms that attempted to resolve distress either out-of-court, in conventional Chapter 11, or via prepackaged restructuring. Activist hedge funds strategically gain a position of influence in the restructuring of economically viable firms with contracting problems that prevent efficient restructuring without outside intervention. I find that hedge fund involvement is associated with a higher probability of completing prepackaged restructurings, faster restructurings, and greater debt reduction. Overall, the evidence in this paper suggests that activist hedge funds can create value by enabling more efficient contracting.

Giants at the Gate: Investment Returns and Diseconomies of Scale in Private Equity
Florencio Lopez-de-Silanes, Ludovic Phalippou, and Oliver Gottschalg

We document the wide dispersion of private equity investment returns and examine performance determinants using a newly constructed database of 7,500 investments worldwide. One in ten investments does not return any money, whereas one in four has an IRR above 50%. Quick flips are associated with some of the highest returns. Performance does not appear scalable: Investments held by private equity firms in periods with a high number of simultaneous investments underperform substantially. Results are consistent with the theoretical literature on organizational diseconomies linked to firm structure. Private equity firms’ actions do not appear to be mechanical or easily scalable.

A Synthesis of Two Factor Estimation Methods
Gregory Connor, Robert A. Korajczyk, and Robert T. Uhlaner

Two-pass cross sectional regression (TPCSR) is frequently used in estimating factor risk premiums. Recent papers argue that the common practice of grouping assets into portfolios to reduce the errors-in-variables (EIV) problem leads to loss of efficiency and masks potential deviations from asset pricing models. One solution that allows the use of individual assets while overcoming the EIV problem is iterated TPCSR (ITPCSR). ITSCSR converges to a fixed point regardless of the initial factors chosen. ITPCSR is intimately linked to the asymptotic principal components (APC) method of estimating factors since the ITPCSR estimates are the APC estimates, up to a rotation.

Dynamic Capital Structure Adjustment and the Impact of Fractional Dependent Variables
Ralf Elsas and David Florysiak

Researchers in empirical corporate finance often use bounded ratios (e.g. debt ratios) as dependent variables in their regressions. Using the example of estimating the speed of adjustment toward target leverage, we show by Monte Carlo and resampling experiments that commonly applied estimators yield severely biased estimates, as they ignore that debt ratios are fractional, i.e. bounded between 0 and 1. We propose a new unbiased estimator for adjustment speed in the presence of fractional dependent variables that also controls for unobserved heterogeneity and unbalanced panel data. This new estimator is suitable for corporate finance applications beyond capital structure research.

Beyond the Carry Trade: Optimal Currency Portfolios
Pedro Barroso and Pedro Santa-Clara

We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum and value reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio produces out-of-sample returns that are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that besides risk, currency returns reflect the scarcity of speculative capital.

Managerial Entrenchment and Firm Value: A Dynamic Perspective
Xin Chang and Hong Feng Zhang

We examine the impact of managerial entrenchment on firm value using a dynamic model with firm fixed effects. To estimate the model, we employ the long difference technique, which is shown by our simulation to deliver the least biased estimates. Based on a large sample of U.S. companies, we document a significantly negative and causal effect of managerial entrenchment on firm value after taking into account omitted variables, reverse causality, and highly persistent endogenous variables. Additional analysis suggests that the causality running from managerial entrenchment to firm value is more pronounced than reverse causality.

Informational Content of Options Trading on Acquirer Announcement Return
Konan Chan, Li Ge, and Tse-Chun Lin

This study examines the informational content of options trading on acquirer announcement returns. We show that implied volatility spread predicts positively on the cumulative abnormal return (CAR), and implied volatility skew predicts negatively on the CAR. The predictability is much stronger around actual merger and acquisition (M&A) announcement days, compared with pseudo-event days. The prediction is weaker if pre-M&A stock price has incorporated part of the information, but stronger if acquirer’s options trading is more liquid. Finally, we find that higher relative trading volume of options to stock predicts higher absolute CARs. The relation also exists among the target firms.

Investor Sentiment and Mutual Fund Strategies
Massimo Massa and Vijay Yadav

We show that mutual funds employ portfolio strategies based on market sentiment. We build a proxy for the degree of a fund’s sentiment beta (or FSB). The low FSB funds outperform high FSB funds, even after controlling for standard risk factors and fund characteristics. This effect is sizable and delivers a net-of-risk performance of 3.8% per year. Funds with lower FSB follow more idiosyncratic strategies, suggesting that FSB is deliberate active choice of the fund manager. A sentiment contrarian strategy leads to high flows due to its superior performance, whereas a sentiment catering strategy fails to attract significant investor flows.

The Dynamics of Sovereign Credit Risk
Alexandre Jeanneret

This paper proposes a structural model for sovereign credit risk with endogenous sovereign debt and default policies. A maximum-likelihood estimation of the model with local stock market prices generates daily model-implied sovereign spreads. This approach explains two-thirds of the daily variation in observed sovereign spreads for emerging and European economies over the 2000-2011 period. Global factors help to further explain the time variation in sovereign credit risk. In particular, sovereign spreads in emerging markets vary with U.S. market uncertainty, while European spreads depend on Euro zone bond factors.

Does Increased Competition Affect Credit Ratings? A Reexamination of the Effect of Fitch’s Market Share on Credit Ratings in the Corporate Bond Market
Kee-Hong Bae, Jun-Koo Kang, and Jin Wang

We examine two competing views regarding the impact of competition among credit rating agencies on rating quality: the view that rating agencies do not sacrifice their reputation by inflating firm ratings and the view that competition among rating agencies arising from the conflict of interest inherent in an ‘issuer pay’ model creates pressure to inflate ratings. Using Fitch’s market share as a measure of competition among rating agencies and controlling for the endogeneity problem caused by unobservable industry effects, we find no relation between Fitch’s market share and ratings, suggesting that competition does not lead to rating inflation.

Social Influence in the Housing Market
Carrie H. Pan and Christo A. Pirinsky

We utilize the decennial U.S. Census to study social effects in housing consumption across 4 million households from 126 ethnic groups and 2,071 geographic locations in the U.S. We find that the homeownership decisions within ethnic groups are locally correlated, after controlling for the homeownership rates within the group and the region. Social influence is stronger for younger, less educated, and lower-income individuals; immigrants; and Americans with ancestors from more unequal, uncertainty-avoiding, and collectivistic cultures. Our results suggest that both status and information considerations play an important role in the social comparison process in capital markets.

The Role of Government in the Labor-Creditor Relationship: Evidence from the Chrysler Bankruptcy
Bradley Blaylock, Alexander Edwards, and Jared Stanfield

We examine the role of government in the labor-creditor relationship using the case of the Chrysler bankruptcy. As a result of the government intervention, firms in more unionized industries experienced lower event-window abnormal bond returns, higher abnormal bond yields, and lower cumulative abnormal bond returns. The results are stronger for firms closer to distress. We also observe the effect in firms in which labor bargaining power is stronger and those with larger pension liabilities. Overall, the results underline the importance of government as a significant force in shaping the agency conflict between creditors and workers.

Bonus-Driven Repurchases
Yingmei Cheng, Jarrad Harford, and Tianming (Tim) Zhang

Utilizing a large hand-collected database of CEO bonus structures, we find that when a CEO’s bonus is directly tied to EPS, his company is more likely to conduct a buyback. This effect is especially pronounced when a company’s EPS is right below the threshold for a bonus award. Share repurchasing increases the probability the CEO receives a bonus and the magnitude of that bonus, but only when bonus pay is EPS-based. Bonus-driven repurchasing firms do not exhibit positive long-run abnormal returns.

How Important Is Financial Risk?
Söhnke M. Bartram, Gregory W. Brown, and William Waller

We explore the determinants of equity price risk of non-financial corporations. Operating and asset characteristics are by far the most important determinants of risk. For the median firm, financial risk accounts for only 15% of observed stock price volatility. Furthermore, financial risk has declined over the last three decades indicating that any upward trend in equity volatility was driven entirely by economic risk factors. This explains why financial distress (as opposed to economic distress) was surprisingly uncommon in the nonfinancial sector during the recent crisis even as measures of equity volatility reached unprecedented highs.

The Enterprise Multiple Investment Strategy: International Evidence
Christian Walkshäusl and Sebastian Lobe

The enterprise multiple (EM) predicts the cross-section of international returns. The return predictability of EM is similarly pronounced in developed and emerging markets and likewise strong among small and large firms. An international portfolio of low EM firms outperforms a portfolio of high EM firms by about 1% per month. The EM value premium is individually significant for the majority of countries, remains largely unexplained by existing asset pricing models, is robust after controlling for co-movement with the respective U.S. premium, and is highly persistent for up to five years after portfolio formation, making it a promising strategy for investors.

Suitability Checks and Household Investments in Structured Products
Eric C. Chang, Dragon Yongjun Tang, and Miao (Ben) Zhang

The suitability of complex financial products for household investors is an important issue in light of consumer financial protection. The U.S. Dodd-Frank Act, for instance, mandates that distributors check suitability when selling structured products to retail investors. However, little empirical evidence exists on such transactions. Using data from Hong Kong, we find that investors purchase 8% more structured products, on average, when the suitability is not checked. The effect of suitability checks is more pronounced for less financially literate investors. Moreover, investors tend to buy products with lower risk-adjusted returns when product suitability is not checked.

Future Lending Income and Security Value
Melissa Porras Prado

I test the Duffie, Gârleanu, and Pedersen (2002) hypothesis that security prices incorporate expected future securities lending income. To determine whether institutional investors anticipate gains from future lending of securities, I examine their trading behavior around loan fee increases. The evidence suggests that institutions buy shares in response to an increase in lending fees and that this could explain the premium associated with high lending fee stocks. Expected future lending income affects stock prices, although the effect seems to be attenuated by the negative information that arises from short selling.

Related Securities and Equity Market Quality: The Case of CDS
Ekkehart Boehmer, Sudheer Chava, and Heather E. Tookes

We document that equity markets become less liquid and equity prices become less effcient when markets for single-name credit default swap (CDS) contracts emerge. This finding is robust across a variety of market quality measures. We analyze the potential mechanisms driving this result and find evidence consistent with negative trader-driven information spillovers that result from the introduction of CDS. These spillovers greatly outweigh the potentially positive effects associated with completing markets (e.g., CDS markets increase hedging opportunities) when firms and their equity markets are in "bad" states. In "good" states, we find some evidence that CDS markets can be beneficial.

Director Histories and the Pattern of Acquisitions
Peter L. Rousseau and Caleb Stroup

We trace directors through time and across firms to study whether acquirers’ access to non-public information about potential targets via their directors’ past board service histories affects the market for corporate control. In a sample of publicly-traded U.S. firms, we find acquirers about 4.5 times more likely to buy firms where their directors once served. Effects are stronger when the acquirer has better corporate governance, the interlocked director has a larger ownership stake at the acquirer, or the director played an important role during past service. The findings are robust to endogeneity of board composition and controls for contemporaneous inter-firm interlocks.

Keynes the Stock Market Investor: A Quantitative Analysis
David Chambers, Elroy Dimson, and Justin Foo

The consensus view of the influential economist John Maynard Keynes is that he was a stellar investor. We provide an extensive quantitative appraisal of his performance over a quarter-century in both calendar and event time, and present detailed empirical analysis of his archived trading records. His top-down approach generated disappointing returns in the 1920s and we find no evidence of any market-timing ability. However, from the early 1930s his performance improved as he evolved into a bottom-up stock-picker with high tracking error, substantial active risk, and pronounced size and value tilts. Our careful reconstruction of Keynes’ stock trading provides a unique record of realized performance and sheds light on how equity focussed investing developed historically.

Taxes and Capital Structure
Mara Faccio and Jin Xu

We use nearly 500 shifts in statutory corporate and personal income tax rates as natural experiments to assess the effect of corporate and personal taxes on capital structure. We find both corporate and personal income taxes to be significant determinants of capital structure. Based on ex-post observed summary statistics, across OECD countries, taxes appear to be as important as other traditional variables in explaining capital structure choices. The results are stronger among corporate tax payers, dividend payers, and companies that are more likely to have an individual as the marginal investor.

Are Credit Default Swaps a Sideshow? Evidence That Information Flows from Equity to CDS Markets
Jens Hilscher, Joshua M. Pollet, and Mungo Wilson

In this paper we provide evidence that equity returns lead credit protection returns at daily and weekly frequencies, while credit protection returns do not lead equity returns. Our results indicate that informed traders are primarily active in the equity market rather than the CDS market. These findings are consistent with standard theories of market selection by informed traders in which market selection is determined partially by transaction costs. We also find that credit protection returns respond more quickly during salient news events (earnings announcement days) compared to days with similar equity returns and turnover. This evidence regarding the response of credit protection returns to news provides support for explanations related to investor inattention.

The Post-Acquisition Returns of Stock Deals: Evidence of the Pervasiveness of the Asset Growth Effect
Sandra Mortal and Michael J. Schill

A growing literature finds that firm asset growth rates are negatively correlated subsequent stock returns. We show that the poor post-deal returns that have been documented for stock acquisitions are more precisely explained by the return effects associated with systematically larger asset growth rates for stock deals. We find a similar result for other cross-sectional and time-series acquisition effects, including poor returns for glamour deals, weakly monitored deals, and deals done during high valuation periods. We suggest that the distinguishing characteristic associated with poor performing acquisitions is simply their tendency to grow assets.

Changing the Nexus: The Evolution and Renegotiation of Venture Capital Contracts
Ola Bengtsson and Berk A. Sensoy

We study the evolution and renegotiation of the cash flow rights that venture capitalists (VCs) obtain in their portfolio companies. When company performance between financing rounds is poor, subsequent contracts contain stronger VC cash flow rights, and existing VCs tend to either give new VCs senior claims or forfeit their existing rights altogether. These results are consistent with the importance of financing problems between different VCs, and with theory predicting that financing frictions worsen with poor performance. A consequence is that VC cash flow rights are frequently significantly diluted before exit, implying that VC investments are riskier than previously estimated.

Trust, Investment, and Business Contracting
James S. Ang, Yingmei Cheng, and Chaopeng Wu

How does trust affect business contracting at the firm level? We analyze the case of foreign high-tech companies investing in China where the risk of expropriation of their intellectual property is high. We find that firms mitigate this type of risk by taking local trustworthiness into account when making investment decisions. Firms prefer to invest in regions where local partners and employees are considered more trustworthy; they are also more likely to establish joint ventures and to make greater R&D investments. We employ instrumental variable regressions and dynamic panel GMM estimators to alleviate endogeneity concerns and control for time-invariant heterogeneity.

You’re Fired! New Evidence on Portfolio Manager Turnover and Performance
Leonard Kostovetsky and Jerold B. Warner

We study managerial turnover for both internally managed mutual funds and those managed externally by subadvisors. We argue that turnover of subadvisors provides sharper tests and helps address several unresolved issues and puzzles from the previous literature. We find dramatically stronger inverse relations between subadvisor departures and lagged returns, and new evidence on how past flow predicts turnover. We find no evidence of improvements in return performance related to departures, but flow improvements are associated with departures of poor past performers. Our findings represent new evidence on how investors, sponsors, and boards learn about and evaluate mutual fund management performance.

The Diminishing Liquidity Premium
Azi Ben-Rephael, Ohad Kadan, and Avi Wohl

Stock liquidity has improved over the recent four decades. This improvement was accompanied by a dramatic increase in trading activity. The net effect on the liquidity premium is ambiguous. We show that the characteristic liquidity premium of U.S. stocks has significantly declined over the past four decades. In recent time periods characteristic liquidity is significantly priced only for the smallest common stocks. This decline stems from an improvement in liquidity, and from a lower sensitivity of expected returns to liquidity. By contrast, systematic liquidity has not been trending down, and is still significantly priced primarily among NASDAQ stocks.

Dividend Yields, Dividend Growth, and Return Predictability in the Cross-Section of Stocks
Paulo Maio and Pedro Santa-Clara

There is a generalized conviction that variation in dividend yields is exclusively related to expected returns and not to expected dividend growth—e.g. Cochrane's presidential address (Cochrane (2011)). We show that this pattern, although valid for the aggregate stock market, is not true for portfolios of small and value stocks, where dividend yields are related mainly to future dividend changes. Thus, the variance decomposition associated with aggregate dividend yield has important heterogeneity in the cross-section of equities. Our results are robust to different forecasting horizons, econometric methodology used (long-horizon regressions or first-order VAR), and an alternative decomposition based on excess returns.

The Effects of Securities Class Action Litigation on Corporate Liquidity and Investment Policy
Matteo Arena and Brandon Julio

The risk of securities class action litigation alters corporate savings and investment policy. Firms with greater exposure to securities litigation hold significantly more cash in anticipation of future settlements and other related costs. The result is due to firms accumulating cash in anticipation of lawsuits and not a consequence of plaintiffs targeting firms with high cash levels. The marginal value of cash is lower for firms exposed to litigation risk. Corporate investment decisions are also affected by litigation risk, as firms reduce capital expenditures in response. Our results are robust to endogeneity concerns and possible spurious temporal effects.

Acquirer Valuation and Acquisition Decisions: Identifying Mispricing Using Short Interest
Itzhak Ben-David, Michael S. Drake, and Darren T. Roulstone

We use short interest as an investor-based measure of over/undervaluation that distinguishes between the misvaluation and Q-theories of mergers. Using this measure, we find that misvaluation is a strong determinant of merger decision making. Firms in the top quintile of short interest are 54% more likely to engage in stock acquisitions and 22% less likely to engage in cash acquisitions. Stock (but not cash) acquirers have higher short interest than their targets. Overall, our results suggest that the previously documented underperformance of stock acquirers and the overperformance of cash acquirers can be explained by misvaluation, as captured by short interest.

Religion and Stock Price Crash Risk
Jeffrey L. Callen and Xiaohua Fang

This study examines whether religiosity at the county level is associated with future stock price crash risk. We find robust evidence that firms headquartered in counties with higher levels of religiosity exhibit lower levels of future stock price crash risk. This finding is consistent with the view that religion, as a set of social norms, helps to curb bad news hoarding activities by managers. Our evidence further shows that the negative relation between religiosity and future crash risk is stronger for riskier firms and for firms with weaker governance mechanisms measured by shareholder takeover rights and dedicated institutional ownership.

Once Burned, Twice Shy: Money Market Fund Responses to a Systemic Liquidity Shock
Philip E. Strahan and Basak Tanyeri

After Lehman’s collapse, investors ran from risky money market funds. In 27 of them, outflows overwhelmed cash inflows, thus forcing asset sales. These funds sold their safest and most liquid holdings. Funds were thus left with riskier and longer maturity assets. Over the subsequent quarter, however, the hard-hit funds reduced risk more than other funds. In contrast, money funds hit by idiosyncratic liquidity shocks before Lehman did not alter portfolio risk. The result suggests that moral hazard concerns with the Treasury Guarantee of investor claims did not increase risk taking. Funds that benefitted most from the government bailout reduced risk.

Do Better-Connected CEOs Innovate More?
Olubunmi Faleye, Tunde Kovacs, and Anand Venkateswaran

We present evidence suggesting that CEO connections facilitate investments in corporate innovation. We find that firms with better-connected CEOs invest more in R&D and receive more and higher quality patents. Further tests suggest that this effect stems from two characteristics of personal networks that alleviate CEO risk aversion in investment decisions. First, personal connections increase the CEO's access to relevant network information, which encourages innovation by helping to identify, evaluate, and exploit innovative ideas. Second, personal connections provide the CEO with labor market insurance that facilitates investments in risky innovation by mitigating the career concerns inherent in such investments.

Corporate Policies of Republican Managers
Irena Hutton, Danling Jiang, and Alok Kumar

We demonstrate that personal political preferences of corporate managers influence corporate policies. Specifically, Republican managers who are likely to have conservative personal ideologies adopt and maintain more conservative corporate policies. Those firms have lower levels of corporate debt, lower capital and R&D expenditures, less risky investments, but higher profitability. Using the 9/11 terrorist attacks and September 2008 Lehman Brothers bankruptcy as natural experiments, we demonstrate that investment policies of Republican managers became more conservative following these exogenous uncertainty increasing events. Further, around CEO turnover, including CEO deaths, firm leverage policy becomes more conservative when managerial conservatism increases.

Firm Mortality and Natal Financial Care
Utpal Bhattacharya, Alexander Borisov, and Xiaoyun Yu

We construct a mortality table for U.S. public companies during 1985–2006. We find that firms’ age-specific mortality rates initially increase, peaking at age three, and then decrease with age, implying that the first three years of public life are critical. Financial intermediaries involved around the public birth of a firm—venture capitalists (VCs) and high-quality underwriters—are associated with lower firm mortality rates, sometimes for up to seven years after the IPO. VCs reduce mortality rates more through natal financial care than through selection, whereas highquality underwriters affect firm mortality more through selection.

Communicating Private Information to the Equity Market before a Dividend Cut: An Empirical Analysis
Thomas J. Chemmanur and Xuan Tian

This paper presents the first empirical analysis of the choice of firms regarding whether or not to release private information (“prepare the market”) in advance of a possible dividend cut, and the consequences of such market preparation. We use a hand-collected data set of dividend cutting firms that allows us to distinguish between prepared and non-prepared dividend cutters and test the implications of two alternative theories: the “signaling through market preparation” theory and the “stock return volatility reduction” theory. We document several important differences between prepared and non-prepared dividend cutters. Overall, our empirical results are consistent with the signaling theory.

Inside Debt and Mergers and Acquisitions
Hieu V. Phan

I empirically investigate the relation between CEO inside debt holdings and mergers and acquisitions (M&As) and find evidence consistent with the agency theory’s prediction of a negative relation between CEO inside debt holdings and corporate risk taking. Further analysis shows that CEO inside debt holdings are positively correlated with M&A announcement abnormal bond returns and long-term operating performance, but negatively correlated with M&A announcement abnormal stock returns. Finally, I find evidence that acquirers restructure the post-merger composition of CEO compensation that mirrors their capital structure in order to alleviate incentives for wealth transfer from shareholders to bondholders or vice versa.

Capital Structure Decisions around the World: Which Factors Are Reliably Important?
Özde Öztekin

This article examines the international determinants of capital structure using a large sample of firms drawn from 37 counties. The reliable determinants for leverage are firm size, tangibility, industry leverage, profits, and inflation. The quality of the countries’ institutions affects leverage and the speed of adjustment toward target leverage in significant ways. High-quality institutions lead to faster leverage adjustments, while laws and traditions that safeguard debt holders relative to stockholders (e.g., more effective bankruptcy procedures and stronger creditor protection) lead to higher leverage.

Detecting Regime Shifts in Credit Spreads
Olfa Maalaoui Chun, Georges Dionne, and Pascal François

Using an innovative random regime shift detection methodology, we identify and confirm two distinct regime types in the dynamics of credit spreads: a level regime and a volatility regime. The level regime is long lived and shown to be linked to Federal Reserve policy and credit market conditions, whereas the volatility regime is short lived and, apart from recessionary periods, detected during major financial crises. Our methodology provides an independent way of supporting structural equilibrium models and points toward monetary and credit supply effects to account for the persistence of credit spreads and their predictive power over the business cycle.

Portfolio Concentration and Firm Performance
Anders Ekholm and Benjamin Maury

This paper investigates the relation between shareholders’ portfolio concentration and firm performance. Using data on more than 1.3 million unique shareholders, we create an index that measures how concentrated shareholder portfolios are in each firm. We posit that portfolio concentration will affect incentives when shareholders are resource constrained. We find that average shareholder portfolio concentration is significantly positively related to future operational performance and valuation. We also find that portfolio concentration is positively correlated with abnormal stock returns. Our findings suggest that shareholders with concentrated portfolios are more informed and play a governance role through the stock market.

Do Happy People Make Optimistic Investors?
Guy Kaplanski, Haim Levy, Chris Veld, and Yulia Veld-Merkoulova

Do happy people predict future risk and return differently from unhappy people, or do individuals rely only on economic facts? We survey investors on their subjective sentiment-creating factors, return and risk expectations, and investment plans. We find that non-economic factors systematically affect return and risk expectations, where the return effect is more profound. Investment plans are also affected by non-economic factors. Sports results and general feelings significantly affect predictions. Sufferers from seasonal affective disorder have lower return expectations in the autumn than in other seasons, supporting the Winter Blues hypothesis.

Shareholder Litigation, Reputational Loss, and Bank Loan Contracting
Saiying Deng, Richard H. Willis, and Li Xu

We examine shareholder litigation and the price and non-price terms of bank loan contracts. After the lawsuit filing, defendant firms pay higher loan spreads, up-front charges, experience more financial covenants, and are more likely to have a collateral requirement. These findings are consistent with reputational losses associated with shareholder litigation. The magnitude of a firm’s lost market value when the lawsuit is filed is positively related to the increase in the firm’s future borrowing costs. We investigate whether the lawsuit allegations and its merit affect future bank loan terms. Our results do not appear to be affected by self-selection.

Corporate Governance and Innovation: Theory and Evidence
Haresh Sapra, Ajay Subramanian, and Krishnamurthy Subramanian

We develop a theory to show how external and internal corporate governance mechanisms affect innovation. We show that there is a U-shaped relation between innovation and external takeover pressure, which arises from the interaction between expected takeover premia and private benefits of control. We show strong empirical support for the predicted relation using ex ante and ex post innovation measures. We exploit the variation in takeover pressure created by the passage of anti-takeover laws across different states. Innovation is fostered either by an unhindered market for corporate control, or by anti-takeover laws that are severe enough to effectively deter takeovers.

Taking the Twists into Account: Predicting Firm Bankruptcy Risk with Splines of Financial Ratios
Paolo Giordani, Tor Jacobson, Erik von Schedvin, and Mattias Villani

We demonstrate improvements in predictive power when introducing spline functions to take account of highly non-linear relationships between firm failure and leverage, earnings, and liquidity in a logistic bankruptcy model. Our results show that modeling excessive non-linearities yields substantially improved bankruptcy predictions, on the order of 70 to 90 percent, compared with a standard logistic model. The spline model provides several important and surprising insights into non-monotonic bankruptcy relationships. We find that low-leveraged as well as highly profitable firms are riskier than given by a standard model, possibly a manifestation of credit rationing and excess cash-flow volatility.

Managed Distribution Policies in Closed-End Funds and Shareholder Activism
Martin Cherkes, Jacob S. Sagi, and Z. Jay Wang

In closed-end funds, a Managed Distribution Policy (MDP) is a dividend commitment potentially requiring the liquidation of assets. We argue that MDPs lower managerial claims on fund assets and, when the fund is at a discount, increase shareholder value. This transfer of wealth can be rationalized by managers wishing to deter a challenge from activist shareholders through a costly proxy vote. We find strong empirical evidence that managers respond to the presence of activists using MDPs, that MDPs constitute an effective wealth transfer to shareholders, and that activists are less likely to challenge management when an MDP is in place.

Do Hedge Funds Reduce Idiosyncratic Risk?
Namho Kang, Péter Kondor, and Ronnie Sadka

This paper studies the effect of hedge-fund trading on idiosyncratic risk. We hypothesize that while hedge-fund activity would often reduce idiosyncratic risk, high initial levels of idiosyncratic risk might be further amplified due to fund loss limits. Panel-regression analyses provide supporting evidence for this hypothesis. The results are robust to sample selection and are further corroborated by a natural experiment using the Lehman bankruptcy as an exogenous adverse shock to hedge-fund trading. Hedge-fund capital also explains the increased idiosyncratic volatility of high-idiosyncratic-volatility stocks as well as the decreased idiosyncratic volatility of low-idiosyncratic-volatility stocks over the past few decade.

Antitakeover Provisions and Shareholder Wealth: A Survey of the Literature
Miroslava Straska and Gregory Waller

We survey theoretical and empirical research on antitakeover provisions, focusing on the relationship between antitakeover provisions and shareholder value. We divide the empirical studies based upon the evidence that they provide: short-term event studies, studies on performance and policy changes around adopting antitakeover provisions or passing state antitakeover laws, studies on the impact of antitakeover provisions on takeovers, studies on the relation between antitakeover provisions and firm characteristics, and long-term studies on the relation between antitakeover provisions and firm performance or policies. We also discuss the place of antitakeover provisions in the current debate about "good governance" practices.

Debt Maturity Structure and Credit Quality
Radhakrishnan Gopalan, Fenghua Song, and Vijay Yerramilli

We examine whether a firm’s debt maturity structure affects its credit quality. Consistent with theory, we find that firms with greater exposure to rollover risk (measured by the amount of long-term debt payable within a year relative to assets) have lower credit quality; long-term bonds issued by those firms trade at higher yield spreads, indicating that bond market investors are cognizant of rollover risk arising from a firm’s debt maturity structure. These effects are stronger among firms with a speculative grade rating, declining profitability, and during recessions.

Deviations from Norms and Informed Trading
Alok Kumar and Jeremy K. Page

Investment managers are subject to personal and institutional norms which can constrain their investment choices. We conjecture that norm-constrained investors deviate from such norms only when they have compelling information, and predict that deviating investments earn relatively high abnormal returns ex post. Consistent with our conjecture, we find that institutions averse to holding lottery-like stocks or sin stocks earn relatively high abnormal returns when they choose to hold such stocks. We find similar but weaker results for deviations from broader style categories. Overall, our evidence indicates that deviations from established institutional or social norms signal informed investing.

Foreign Currency Returns and Systematic Risks
Victoria Galsband and Thomas Nitschka

We apply an empirical approximation of the intertemporal CAPM to show that cross-sectional dispersion in currency returns can be rationalized by differences in currency excess returns’ sensitivities to the market return’s cash-flow news component. This finding echoes recent explanations of the value and growth stock market anomaly. The distinction between cash-flow news and discount-rate news is key to jointly explain average stock and currency returns. Our analysis reveals the presence of a common source of systematic risk in stock and foreign currency returns that is reflected in the market return’s cash-flow news component.

Dividend Predictability around the World
Jesper Rangvid, Maik Schmeling, and Andreas Schrimpf

We show that dividend growth predictability by the dividend yield is the rule rather than the exception in global equity markets. Dividend predictability is weaker, however, in large and developed markets where dividends are smoothed more, the typical firm is large, and volatility is lower. Our findings suggest that the apparent lack of dividend predictability in the U.S. does not uniformly extend to other countries. Rather, cross-country patterns in dividend predictability are driven by differences in firm characteristics and the extent to which dividends are smoothed.

A Model-Free Measure of Aggregate Idiosyncratic Volatility and the Prediction of Market Returns
René Garcia, Daniel Mantilla-García, and Lionel Martellini

In this paper, we formally show that the cross-sectional variance of stock returns is a consistent and asymptotically efficient estimator for aggregate idiosyncratic volatility. This measure has two key advantages: it is model-free and observable at any frequency. Previous approaches have used monthly model-based measures constructed from time series of daily returns. The newly proposed cross-sectional volatility measure is a strong predictor for future returns on the aggregate stock market at the daily frequency. Using the cross-section of size and book-to-market portfolios, we show that the portfolios’ exposures to the aggregate idiosyncratic volatility risk predict the cross-section of expected returns.

Aggregate Earnings and Market Returns: International Evidence
Wen He and Maggie (Rong) Hu

Kothari, Lewellen and Warner (2006) document that aggregate earnings changes in the U.S. are negatively related to contemporaneous market returns. In this study we show that this negative aggregate earnings-returns relation is unique to the U.S. In 28 non-U.S. markets market, aggregate earnings changes are positively associated with contemporaneous market returns. Further evidence shows that the aggregate earnings-returns relation becomes less positive in countries with more transparent financial disclosure that helps investors forecast earnings more precisely. Our result supports Sadka and Sadka’s (2009) argument that predictability of aggregate earnings leads to the negative relation between aggregate earnings and market returns in the U.S.

Success in Global Venture Capital Investing: Do Institutional and Cultural Differences Matter?
Rajarishi Nahata, Sonali Hazarika, and Kishore Tandon

We analyze the impact of institutional and cultural differences on success in global venture capital (VC) investing. In both developed and emerging economies, superior legal rights (and enforcement) and better-developed stock markets significantly enhance VC performance. Remarkably, cultural distance between countries of the portfolio company and its lead investor positively affects VC success. Further analysis reveals that cultural differences create incentives for rigorous ex-ante screening, improving VC performance. Finally, local VC participation enhances success and mitigates foreign VCs' "liability of foreignness," albeit only in developed economies. Our findings follow from analyzing VC investments in nearly 10,000 companies across 30 countries.

Industries and Stock Return Reversals
Allaudeen Hameed and G. Mujtaba Mian

This paper documents pervasive evidence of intra-industry reversals in monthly returns. Unlike the conventional reversal strategy based on stock returns relative to the market portfolio, we document intra-industry return reversals that are larger in magnitude, consistently present over time, and prevalent across sub-group of stocks, including large and liquid stocks. These return reversals are driven by order imbalances and non-informational shocks. Consistent with reversals representing compensation for supplying liquidity, intra-industry reversals are stronger following aggregate market declines and volatile times, reflecting binding capital constraints and limited risk bearing capacity of liquidity providers.

Institutional Investors and the Information Production Theory of Stock Splits
Thomas J. Chemmanur, Gang Hu, and Jiekun Huang

We make use of a large sample of transaction-level institutional trading data to test an extended version of Brennan and Hughes' (1991) information production theory of stock splits. We compare brokerage commissions paid by institutional investors before and after a split, assess the private information held by them, and relate the informativeness of their trading to brokerage commissions paid. We show that institutions make abnormal profits net of brokerage commissions by trading in splitting stocks. We also show that the information asymmetry faced by firms goes down after stock splits. Overall, our empirical results support the information production theory.

Treasury Bond Illiquidity and Global Equity Returns
Ruslan Goyenko and Sergei Sarkissian

In this study, using data from 46 markets and a 34-year time period, we examine the impact of the illiquidity of U.S. Treasuries on global asset valuation. We find that it predicts equity returns in both developed and emerging markets. This predictive relation remains intact after controlling for various world and country-level variables. Asset pricing tests further reveal that bond illiquidity is a priced factor even in the presence of other conventional risks. Since the illiquidity of Treasuries is known to reflect monetary and macroeconomic shocks, our results suggest that it can be considered a proxy for aggregate worldwide risks.

Last updated December 7, 2014.