The following papers have been accepted for publication in future issues.
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
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
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
Arturo Bris, S. Abraham (Avri) Ravid, Ronald Sverdlove, 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
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.
Where Have All the IPOs Gone?
Xiaohui Gao, Jay R. Ritter, and Zhongyan Zhu
During 1980-2000, an average of 310 companies per year went public in the U.S. Since 2000, the average has been only 99 initial public offerings (IPOs) per year, with the drop especially precipitous among small firms. Many have blamed the Sarbanes-Oxley Act of 2002 and the 2003 Global Settlement’s effects on analyst coverage for the decline in IPO activity. We find very little support for the conventional wisdom, and offer an alternative explanation. Our economies of scope hypothesis posits that the advantages of selling out to a larger organization, which can speed a product to market and realize economies of scope, have increased relative to the benefits of operating as an independent firm.
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
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.
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
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.
Bribe Payments and Innovation in Developing Countries: Are Innovating Firms Disproportionately Affected?
Meghana Ayyagari, Asli Demirgüç-Kunt, and Vojislav Maksimovic
We find that innovating firms pay more bribes than non-innovators across 25,000 firms in 57 countries. The bribe payments by innovators are higher in countries with more bureaucratic regulation and weaker governance. Innovators that pay bribes do not receive better services than innovators that do not bribe. We find no evidence that innovators are more likely to engage in other illegal activities such as private protection payments and tax evasion. We find that innovators are more likely to be victims of corruption than perpetrators. Our findings point to the challenges facing entrepreneurs in developing countries.
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.
Recovering Delisting Returns of Hedge Funds
James E. Hodder, Jens Carsten Jackwerth, and Olga Kolokolova
Numerous hedge funds stop reporting each year to commercial data bases, wreaking havoc with analyzing investment strategies which incur the unobserved delisting return. We use estimated portfolio holdings for funds-of-funds to back out estimated hedge-fund delisting returns. For all exiting funds, the estimated mean delisting return is insignificantly different from the average monthly return for live hedge funds. However, funds with poor prior performance and no clearly stated delisting reason had a significantly negative estimated mean delisting return of -5.97%, suggesting that a shock to their returns “tips them over the edge” and leads to delisting.
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.
Stock Return Predictability and Variance Risk Premia: Statistical Inference and International Evidence
Tim Bollerslev, James Marrone, Lai Xu, and Hao Zhou
Recent empirical evidence suggests that the variance risk premium predicts aggregate stock market returns. We demonstrate that statistical finite sample biases cannot "explain" this apparent predictability. Further corroborating the existing evidence of the U.S., we show that country specific regressions for France, Germany, Japan, Switzerland, the Netherlands, Belgium and the U.K. result in quite similar patterns. Defining a "global" variance risk premium, we uncover even stronger predictability and almost identical cross-country patterns through the use of panel regressions.
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.
The Economic Value of Realized Volatility: Using High-Frequency Returns for Option Valuation
Peter Christoffersen, Bruno Feunou, Kris Jacobs, and Nour Meddahi
Many studies have documented that daily realized volatility estimates based on intraday returns provide volatility forecasts that are superior to forecasts constructed from daily returns only. We investigate whether these forecasting improvements translate into economic value added. To do so we develop a new class of affine discrete-time option valuation models that use daily returns as well as realized volatility. We derive convenient closed-form option valuation formulas and we assess the option valuation properties using S&P500 return and option data. We find that realized volatility reduces the pricing errors of the benchmark model significantly across moneyness, maturity and volatility levels.
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.
Transparency and Financing Choices of Family Firms
Tai-Yuan Chen, Sudipto Dasgupta, and Yangxin Yu
While recent literature has documented that U.S. family firms differ markedly from their non-family counterparts, there is a paucity of evidence on how these firms differ in terms of their cost of capital or financial structure. In this paper, we show that family and nonfamily firms differ in their debt maturity and leverage ratios in a manner consistent with the higher expropriation potential of family firms. Moreover, while more transparency causes both family and non-family firms to increase the maturity structure of their debt and reduce leverage ratios, the effects are stronger for family firms.
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.
Solvency Constraint, Underdiversification, and Idiosyncratic Risks
Contrary to the prediction of the standard portfolio diversification theory, many investors place a large fraction of their stock investment in a small number of stocks. We show that underdiversification may be caused by solvency requirement. Our model predicts that underdiversification decreases in the remaining wealth after committed consumption and variance and higher moments do not affect stock selection for quite general preferences and return distributions. In addition, a less diversified stock portfolio has a higher expected return, a higher volatility, and a higher skewness and idiosyncratic risks are priced. Many predictions of our model are consistent with empirical findings.
Trading in the Options Market around Financial Analysts' Consensus Revisions
Darren K. Hayunga and Peter P. Lung
This article investigates the options market around a revision in the financial analysts' consensus recommendation. The results demonstrate that options investors trade in the correct direction of the upcoming revision approximately three days prior to the announcement. We find this behavior in options-implied prices, implied volatilities, and options trading volume. Tests confirm that the options market leads the stock market before the financial analysts' revision. Moreover, using all firms with outstanding options, an out-of-sample analysis produces a profitable zero-cost trading strategy net of transaction costs based on the relative valuations between the synthetic and the underlying equity security.
Individual Investors and Broker Types
Kingsley Y. L. Fong, David R. Gallagher, and Adrian D. Lee
We study the informativeness of trades via discount and full-service retail brokers. We find that trades via full-service retail brokers are statistically and economically more informative than are trades via discount retail brokers. This finding holds in every year over the twelve-year sample period and in various subsamples. We also find that past returns, volatility, and news announcements positively relate to the net volume of discount retail brokers but these variables are unrelated to the net volume of full-service retail brokers. Our results suggest that broker type selection bias is an important consideration in studying individual investors' trades.
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.
The Strategic Listing Decisions of Hedge Funds
Philippe Jorion and Christopher Schwarz
The voluntary nature of hedge fund database reporting creates strategic listing opportunities for hedge funds. However, little is known about how managers list funds across multiple databases or whether investors are fooled by funds' listing decisions. In this paper, we find that hedge funds strategically list their small, best performing funds in multiple outlets immediately while preserving the option to list their other funds in additional databases later. We generally find that investors react rationally to these fund listings based on the predictability of performance. Finally, our results lead to specific guidelines on handling backfilled returns to minimize biases.
Managerial Incentives, Risk Aversion, and Debt
Andreas Milidonis and Konstantinos Stathopoulos
We investigate the risk choices of risk averse CEOs. Following recent theoretical work, we expect CEO risk aversion to be more pronounced in firms with high leverage, or high default probability. We find that the CEOs of these firms reduce firm risk, even in the presence of strong risk taking incentives. Our results are robust to controls for the sensitivity of CEO wealth to stock price changes, firm risk determinants, the endogenous feedback effects of firm risk on CEO incentives, unobserved firm and market effects, and debt governance. The impact of CEO risk aversion is economically significant.
Spillover Effects among Financial Institutions: A State-
Dependent Sensitivity Value-at-Risk (SDSVaR) Approach
Zeno Adams, Roland Füss, and Reint Gropp
In this paper, we develop a state-dependent sensitivity value-at-risk (SDSVaR) approach that enables us to quantify the direction, size, and duration of risk spillovers among financial institutions. We show that while small during normal times, equivalent shocks lead to considerable spillover effects in volatile market periods. Commercial banks and, especially, hedge funds appear to play a major role in the transmission of shocks to other financial institutions. Using daily data, we can trace out the spillover effects over time in a set of impulse response functions and find that they reach their peak after 10 to 15 days.
Financial Expertise of the Board, Risk Taking and Performance: Evidence from Bank Holding Companies
Bernadette A. Minton, Jérôme P. Taillard, and Rohan Williamson
Financial expertise among independent directors of U.S. banks is positively associated with balance-sheet and market-based measures of risk in the run-up to the 2007-2008 financial crisis. While financial expertise is weakly associated with better performance before the crisis, it is strongly related to lower performance during the crisis. Overall, the results are consistent with independent directors with financial expertise supporting increased risk-taking prior to the crisis. Despite being consistent with shareholder value maximization ex ante, these actions became detrimental during the crisis. These results are not driven by powerful CEOs who select independent experts to rubber stamp strategies that satisfy their risk appetite.
Leaders, Followers, and Risk Dynamics in Industry Equilibrium
Murray Carlson, Engelbert J. Dockner, Adlai Fisher, and Ron Giammarino
We study the distinct impacts of own and rival actions on risk and return when firms strategically compete in the product market. Contrary to simple intuition, a competitor's options to adjust capacity reduce own-firm risk. For example, if a rival possesses a growth option, an increase in industry demand directly enhances profits but also encourages value- reducing competitor expansion. The rival option thus acts as a natural hedge. Within the industry, we obtain endogenous differences in expected returns. In a leader-follower equilibrium, own-firm and competitor risks and required returns move together through contractions and oppositely during expansions, providing testable new predictions.
Asset Specificity, Industry Driven Recovery Risk and Loan Pricing
Christopher James and Atay Kizilaslan
This paper examines the relationship between a firm's exposure to industry downturns what we call industry risk and bank loan pricing. We measure industry risk based on the relationship between a firm's stock returns and industry returns conditional on an industry downturn. We find industry risk is significantly related to the recovery rates in bankruptcy and likelihood of the firm experiencing financial distress when its peers are also in distress. More importantly, we find that the spreads on unsecured bank loans are positively related to industry risk measures. These relationships are stronger for firms with more industry specific assets.
The Stock-Bond Return Relation, the Term-Structure's Slope, and Asset-Class Risk Dynamics
Naresh Bansal, Robert A. Connolly, and Chris Stivers
We study whether asset-class risk dynamics can help understand the predominantly negative stock-bond return relation and movements in the term-structure’s slope over 1997-2011. Using option-derived implied volatilities to measure risk, we find: (1) the negative stock-bond return relation largely disappears when controlling for risk movements, at both monthly and weekly horizons; (2) the partial relation between equity-risk changes and 10-year T-bond excess returns (term-slope movements) is reliably positive (negative); and (3) a stronger link between equity risk and stock returns implies a more negative stock-bond return correlation. Our results suggest a flight-to-quality influence between equity-risk dynamics and longer-term Treasury pricing.
Interest Rate Risk and the Cross-Section of Stock Returns
Abraham Lioui and Paulo Maio
We derive a macroeconomic asset pricing model in which the key factor is the opportunity cost of money. The results show that the model explains well the cross-section of stock returns in addition to the excess market return. The interest rate factor is priced and seems to drive most of the explanatory power of the model. In this model, both value stocks and past long-term losers enjoy higher average (excess) returns because they have greater interest rate risk than growth/past winner stocks. The model significantly outperforms the nested models (Consumption-CAPM and CAPM) and compares favorably with alternative macroeconomic models.
Who Gains From Buying Bad Bidders?
David Offenberg, Miroslava Straska, and Gregory Waller
We study the value gains from takeovers of firms with poor acquisition histories. We document that the premium received by target shareholders is higher when the value loss from the targets’ prior acquisitions is larger. However, the gains to target shareholders seem to be offset by losses to acquiring shareholders. The average announcement return to acquiring shareholders is negative and decreasing in the value loss from the targets’ prior acquisitions. Additionally, the combined acquirer-target value created in these takeovers is insignificant. These results suggest that the value lost from targets’ prior acquisitions is not recovered through changes in corporate control.
Does the Disposition Effect Matter in Corporate Takeovers? Evidence from Institutional Investors of Target Companies
This paper examines whether one of the most important participants in the takeover market, the institutional investors of target companies, suffers from the disposition effect; and if so, how this selling bias influences the takeover outcomes. I report robust evidence that target institutional investors are reluctant to realize losses. This bias further allows their sunk cost to affect both the takeover price and the deal success. My results are explained by neither the undervalued targets, nor the 52-week high price effect. They are most pronounced among targets whose investors have a strong propensity to hold on to loser stocks.
Momentum Effect as Part of a Market Equilibrium
Seung Mo Choi and Hwagyun Kim
Does the momentum effect arise naturally from the determination of asset prices in market equilibrium? We calibrate a standard endowment model of multiple assets under recursive preferences. The momentum effect partly comes from investors.aversion to consumption risks. An unexpected dividend increase generates a positive return and increases the asset's proportion of consumption, raising the correlation between its future dividend growth and consumption growth. This is compensated by a higher expected return, generating the momentum effect. The cross-sectional di¤erence in expected returns is also a key contributor. The quantified model produces sizable momentum profits, often close to the observed profits.
How Does the Market Value Toxic Assets?
Francis A. Longstaff and Brett W. Myers
How does the market value “toxic” structured-credit securities? We study the valuation of what is possibly the most toxic of all toxic assets: the equity tranche of a CDO. In theory, CDO equity should be similar in nature to bank stock since both represent residual claims on a portfolio of loans. We find that CDO equity returns are much more related to stock returns than to fixed income returns. CDO equity returns track the returns of financial stocks much more closely than any other industry. Nearly two-thirds of the variation in CDO returns can be explained by fundamentals.
Real Asset Illiquidity and the Cost of Capital
Hernán Ortiz-Molina and Gordon M. Phillips
We show that firms with more illiquid real assets have a higher cost of capital. This effect is stronger when real illiquidity arises from lower within-industry acquisition activity. Real asset illiquidity increases the cost of capital more for firms that face more competition, have less access to external capital or are closer to default, and for those facing negative demand shocks. The effect of real asset illiquidity is distinct from that of firms’ stock illiquidity or systematic liquidity risk. These results suggest that real asset illiquidity reduces firms’ operating flexibility and through this channel its cost of capital.
Does the Location of Directors Matter?
Information Acquisition and Board Decisions
Zinat S. Alam, Mark A. Chen, Conrad S. Ciccotello, and Harley E. Ryan, Jr.
Using data on over 4,000 individual residential addresses, we find that geographic distance between directors and corporate headquarters is related to information acquisition and board decisions. The fraction of a board’s unaffiliated directors who live near headquarters is higher when information-gathering needs are greater. When the fraction of unaffiliated directors living near headquarters is lower, non-routine CEO turnover is more sensitive to stock performance. Also, the level, intensity, and sensitivity of CEO equity-based pay increase with board distance. Overall, our results suggest that geographic location is an important dimension of board structure that influences directors’ costs of gathering information.
Investing in the ‘New Economy’: Mutual Fund Performance and the Nature of the Firm
Although stock returns of intangibles-intensive firms tend to exceed physical assets-intensive firms, risk-adjusted returns of actively managed mutual funds significantly decrease (increase) with their portfolios’ exposure to intangibles-intensive (physical assets-intensive) firms. Fund managers tend to exhibit skill when they focus on difficult-to-value (e.g. small) firms, except when the firms are intangibles-intensive. In sum, the worst-performing funds are in areas of the market which seem to offer ample opportunities for professional investors due to exacerbated mispricing. The negative impact of investments in intangibles-intensive firms on fund performance appears to be driven by extrapolation bias and decreases with learning from experience.
A Servant to Many Masters: Competing Shareholder Preferences and Limits to Catering
Alberto Manconi and Massimo Massa
We study what determines catering through the payout policy, and how catering affects firm value. We create a catering index, measuring how the firm caters to its investors' payout preferences. The index is based on the revealed payout preferences of mutual funds holding the firm's stocks. Catering is constrained by market segmentation and dispersion in investor payout preferences. It is also associated with positive value effects: Firms increasing their catering index also experience an increase in value. Furthermore, greater catering ability is associated with a more positive market reaction to corporate announcements of equity issues and dividend payouts.
Analyst Disagreement and Aggregate Volatility Risk
The paper explains why firms with high dispersion of analyst forecasts earn low future returns. These firms beat the CAPM in periods of increasing aggregate volatility and thereby provide a hedge against aggregate volatility risk. The aggregate volatility risk factor can explain the abnormal return differential between high and low disagreement firms. This return differential is higher for firms with abundant real options, and this fact can be explained by aggregate volatility risk. Aggregate volatility risk can also explain why the link between analyst disagreement and future returns is stronger for firms with high short-sale constraints.
Volume and Volatility in a Common Factor Mixture of Distributions Model
Xiaojun He and Raja Velu
This paper develops a multi-asset mixture distribution hypothesis model to investigate commonality in stock returns and trading volume. The model makes two main predictions: first, the factor structures of returns and trading volume are independent although they stem from the same valuation fundamentals and jointly depend on a latent information flow; second, crosssectional positive volatility-volume relations arise solely from the dynamic features of the information flow. Empirical analyses at the market level support these predictions. Furthermore, the results indicate that removing the information flow significantly reduces the return volatility persistence and the extent of the reduction exhibits a size pattern.
The Cross-Section of Recovery Rates and Default Probabilities Implied by Credit Default Swap Spreads
Redouane Elkamhi, Kris Jacobs, and Xuhui Pan
Rather than assuming a fixed recovery rate in estimation, we estimate recovery rates from CDS spreads, using three years of daily data on 152 corporates. We use a quadratic pricing model which ensures nonnegative default probabilities and recovery rates. The estimated cross-section of recovery rates is plausible, with an average recovery rate of 54%, and substantial cross-sectional variation. Estimated five-year default probabilities are on average 67% higher than default probabilities obtained using the standard 40% recovery assumption. This finding critically impacts the valuation of structured credit products. Larger firms and firms with more tangible assets have higher recovery rates.
The Sarbanes-Oxley Act, Earnings Management, and Post-Buyback Performance of Open-Market Repurchasing Firms
Sheng-Syan Chen and Chia-Wei Huang
We examine how the Sarbanes-Oxley Act (SOX) affects pre-repurchase earnings management and its association with post-repurchase firm performance. Unlike prior pre-SOX studies, our post-SOX results indicate that open-market repurchasers do not engage in pre-buyback downward accrual-based earnings management. Audit committee independence, reforms in corporate governance structures, and changes in executives’ equity holdings prompted by SOX may explain the findings. Post-SOX, the significant negative association between pre-repurchase abnormal accruals and post-repurchase performance disappears, the market reaction to repurchase announcements becomes significantly less favorable, and there is no evidence of any shift away from accrual-based to real earnings management.
On the Importance of Golden Parachutes
Eliezer M. Fich, Anh L. Tran, and Ralph A. Walkling
In acquisitions, target CEOs face a moral hazard: any personal gain from the deal could be offset by the loss of the future compensation stream associated with their jobs. Larger, more important, parachutes provide greater relief for these losses. To explicitly measure the moral hazard target CEOs face, we standardize the parachute payment by the expected value of their acquisition-induced lost compensation. We examine 851 acquisitions from 1999-2007, finding that more important parachutes benefit target shareholders through higher completion probabilities. Conversely, as parachute importance increases, target shareholders receive lower takeover premia while acquirer shareholders capture additional rents from target shareholders.
Creating Value by Changing the Old Guard: The Impact of Controlling Shareholder Heterogeneity on Firm Performance and Corporate Policies
Hua Deng, Fariborz Moshirian, Peter Kien Pham, and Jason Zein
Theory suggests that controlling shareholders can influence firm value through both shared benefits creation and private benefits consumption. Using negotiated control-block transfers from 31 countries, we look beyond ownership concentration and investigate how controlling shareholder heterogeneity influences the relative importance of these two effects. We document that a control transfer precipitates positive firm outcomes particularly when the vendor has maintained control over an extended period and the acquirer displays a strong incentive to engage in restructuring. In such cases, we observe a sustained positive price reaction, more focused corporate investments, lower leverage, higher operating efficiency, and superior long-term performance.
Improving Portfolio Selection Using Option-Implied Volatility and Skewness
Victor DeMiguel, Yuliya Plyakha, Raman Uppal, and Grigory Vilkov
Our objective in this paper is to examine whether one can use option-implied information to improve the selection of mean-variance portfolios with a large number of stocks, and to document which aspects of option-implied information are most useful to improve their out-of-sample performance. Portfolio performance is measured in terms of volatility, Sharpe ratio, and turnover. Our empirical evidence shows that using option-implied volatility helps to reduce portfolio volatility. Using option-implied correlation does not improve any of the metrics. Using option-implied volatility, risk-premium, and skewness to adjust expected returns leads to a substantial improvement in the Sharpe ratio, even after prohibiting shortsales and accounting for transaction costs.
Investor Horizons and Corporate Policies
François Derrien, Ambrus Kecskés, and David Thesmar
We study the effect of investor horizons on corporate behavior. We argue that longer investor horizons attenuate the effect of stock mispricing on corporate policies. Consistent with our argument, we find that when a firm is undervalued, greater long-term investor ownership is associated with more investment, more equity financing, and less payouts to shareholders. Our results do not appear to be explained by long-term investor self-selection, monitoring (corporate governance), or concentration (blockholdings). Our results are consistent with a version of market timing in which mispriced firms cater to the tastes of their short-term investors rather than their long-term investors.
On the Relation between EGARCH Idiosyncratic Volatility and Expected Stock Returns
Hui Guo, Haimanot (Haim) Kassa, and Michael F. Ferguson
A spurious positive relation between EGARCH estimates of expected month t idiosyncratic volatility and month t stock returns arises when the month t return is included in estimation of model parameters. We illustrate via simulations that this look-ahead bias is problematic for empirically observed degrees of stock return skewness and typical monthly return time series lengths. Moreover, the empirical idiosyncratic risk-return relation becomes negligible when expected month t idiosyncratic volatility is estimated using returns only up to month t – 1.
Hindsight Effects in Dollar-Weighted Returns
A growing number of studies use dollar-weighted returns as evidence that bad timing substantially reduces investor returns, and that consequently the equity risk premium must be considerably lower than previously thought. This paper demonstrates that this method is subject to a hindsight effect (as prior returns influence levels of new investment), and derives a technique which corrects it. The results show that for mainstream U.S. equities dollar-weighted returns are low because of this hindsight effect—bad investor timing had very little impact. Thus low dollarweighted returns should not lead us to adopt correspondingly low estimates of the risk premium.
The Role of Growth Options in Explaining Stock Returns
Lenos Trigeorgis and Neophytos Lambertides
We extend the Fama-French (1992) model by considering growth option (as well as distress/leverage) variables in explaining the cross-section of stock returns. We find that growth option variables, namely growth in capital investment and yet-unexercised growth options (GO), are significantly negatively related to stock returns. Investors may be willing to accept lower average returns from growth stocks in exchange for a more favourable (positively skewed) riskreturn profile. Book-to-market seems to proxy for omitted distress/leverage variables. When these are explicitly accounted for, B/M is not that significant. Our growth options variables have added explanatory power.
Last updated March 16, 2014.