JFQA Forthcoming Articles

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

Expected Business Conditions and Bond Risk Premia
Jonas Nygaard Eriksen

This paper studies the predictability of bond risk premia by means of expectations to future business conditions using survey forecasts from the Survey of Professional Forecasters. We show that expected business conditions consistently affect excess bond returns and that the inclusion of expected business conditions in standard predictive regressions improve forecast performance relative to models using information derived from the current term structure or macroeconomic variables. The results are confirmed in a real-time out-of-sample exercise, where the predictive accuracy of the models is evaluated both statistically and from the perspective of a mean-variance investor that trades in the bond market.

DRIPs and the Dividend Pay Date Effect
Henk Berkman and Paul D. Koch

On the day that dividends are paid we find a significant positive mean abnormal return that is completely reversed over the following days. This dividend pay date effect has strengthened since the 1970s, and is consistent with the temporary price pressure hypothesis. The pay date effect is concentrated among stocks with dividend reinvestment plans (DRIPs), and is larger for stocks with a higher dividend yield, greater DRIP participation, and greater limits to arbitrage. Over time, profits from a trading strategy that exploits this behavior are positively related to the dividend yield and spread, and negatively associated with aggregate liquidity.

Payout Yields and Stock Return Predictability: How Important Is the Measure of Cash Flow?
Gregory W. Eaton and Bradley S. Paye

We compare the stock return forecasting performance of alternative payout yields. The net payout yield produces more accurate forecasts relative to alternatives, including the traditional dividend yield. This remains true even after excluding several years during the Great Depression when issuance was unusually high. The measure of cash flow used to form the yield matters economically. Long-term investors' hedging demand for stock is considerably reduced when net payout, rather than dividends, serves as the cash flow measure. An agent relying on an incorrect payout measure is willing to pay an economically significant `management fee' to switch to the optimal policy.

Gender Differences in Executives’ Access to Information
A. Can Inci, M. P. Narayanan, and H. Nejat Seyhun

We provide novel evidence on gender differences in insider trading behavior and profitability of senior corporate executives. On average, both female and male executives make positive profits from insider trading. Males, however, earn significantly more than females in equivalent positions and also trade more than females. These gender differences disappear when we limit the sample to firms in which female trading is relatively high. Collectively these results suggest that female executives have a disadvantage relative to males in access to inside information even if they have equal formal status and informal networks may play an important role attenuating this disadvantage.

Investment Cash Flow Sensitivity: Fact or Fiction?
Şenay Ağca and Abon Mozumdar

We examine whether internal funds matter for investment when the measurement error in q is addressed. By carefully employing methodologies that tackle the measurement error in q, we show that cash flow is a significant determinant of investment. We also find that an analyst forecast based q measure is not superior to a stock market based one. We further propose an approach that uses two alternative proxies of q as instruments for addressing measurement error. Our evidence indicates that instrumental variables type GMM estimators yield empirically well specified models.

Bid Resistance by Takeover Targets: Managerial Bargaining or Bad Faith?
Thomas W. Bates and David A. Becher

This paper examines management’s motives for rejecting takeover bids and the associated shareholder wealth effects. We develop several measures of initial bid quality and find a significant negative correlation between contested offers and bid quality. The likelihood of higher follow-on offers decreases in bid quality and is greater when targets have classified boards and CEOs have significant personal wealth tied to the transaction. Moreover, CEOs who fail to close high quality offers experience a significant rate of forced turnover. Overall, the results support a price improvement motive for contested bids.

Dynamic Portfolio Choice with Linear Rebalancing Rules
Ciamac C. Moallemi and Mehmet Sağlam

We consider a broad class of dynamic portfolio optimization problems that allow for complex models of return predictability, transaction costs, trading constraints, and risk considerations. Determining an optimal policy in this general setting is almost always intractable. We propose a class of linear rebalancing rules and describe an efficient computational procedure to optimize with this class. We illustrate this method in the context of portfolio execution and show that it achieves near optimal performance. We consider another numerical example involving dynamic trading with mean–variance preferences and demonstrate that our method can result in economically large benefits.

Liquidity Constraints and Credit Card Delinquency: Evidence from Raising Minimum Payments
Philippe d'Astous and Stephen H. Shore

We use credit card data to estimate the impact of increasing minimum payments on delinquency, payments, spending, and write-offs. Our identification strategy exploits an unusual institutional feature: borrowers can use their account to make purchases with both revolving loans (on which minimum payments increased) and term loans (on which there was no change). Payment increases by delinquent borrowers are insufficient to match increasing minimums, resulting in lower cure rates and an increase in write-offs. Affected borrowers migrate away from these accounts by decreasing charges and increasing payments, consequently lowering the interest earned by the bank.

Fortune Favors the Bold
Costanza Meneghetti and Ryan Williams

We investigate whether incentives to join the Fortune 500 affect corporate decisions. Firms closer to the cutoff appear to take actions to join the list by engaging in more M&A activity, bidding for larger targets, and paying higher takeover premia. Further, the relation is stronger for firms with more-entrenched CEOs and the stock market reaction to bids is worse when bidders are close to Fortune’s cutoff. A 1994 methodological change by Fortune acts as an exogenous shock for identification. Our results suggest that firms try to increase revenues to join the Fortune 500 but that such actions adversely affect shareholders.

Hedge Funds: The Good, the Bad, and the Lucky
Yong Chen, Michael Cliff, and Haibei Zhao

We develop an estimation approach based on a modified EM algorithm and a mixture of Normal distributions associated with skill groups to assess performance in hedge funds. By allowing luck to affect both skilled and unskilled funds, we estimate the number of skill groups, the fraction of funds from each group, and the mean and variability of skill within each group. For each individual fund, we propose a performance measure combining the fund’s estimated alpha with the crosssectional distribution of fund skill. In out-of-sample tests, an investment strategy using our performance measure outperforms those using estimated alpha and t-statistic.

CEO Turnover-Performance Sensitivities in Private Firms
Huasheng Gao, Jarrad Harford, and Kai Li

We compare CEO turnover in public and large private firms. Public firms have higher turnover rates and exhibit greater turnover-performance sensitivities than private firms. Controlling for preturnover performance, performance improvements are greater for private firms than for public firms. We investigate whether these differences are due to differences in quality of accounting information, the CEO candidate pool, CEO power, board structure, ownership structure, investor horizon, or some unobservable differences between public and private firms. One factor contributing to public firms’ higher turnover rates and greater turnover-performance sensitivities appears to be investor myopia.

New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods
David Blake, Tristan Caulfield, Christos Ioannidis, and Ian Tonks

We compare two bootstrap methods for assessing mutual fund performance. Kosowski, Timmermann, Wermers and White (2006) produces narrow confidence intervals due to pooling over time, while Fama and French (2010) produces wider confidence intervals because it preserves the cross-correlation of fund returns. We then show that the average UK equity mutual fund manager is unable to deliver outperformance net of fees under either bootstrap. Gross of fees, 95% of fund managers on the basis of the first bootstrap and all fund managers on the basis of the second bootstrap fail to outperform the luck distribution of gross returns.

Social Capital and Debt Contracting: Evidence from Bank Loans and Public Bonds
Iftekhar Hasan, Chun-Keung (Stan) Hoi, Qiang Wu, and Hao Zhang

We find that firms headquartered in US counties with higher levels of social capital incur lower bank loan spreads. This finding is robust to using organ donation as an alternative social-capital measure and incremental to the effects of religiosity, corporate social responsibility, and tax avoidance. We identify the causal relation using companies with a social-capital changing headquarter relocation. We also find that high-social-capital firms face loosened nonprice loan terms, incur lower at-issue bond spreads, and prefer bonds over loans. We conclude that debt holders perceive social capital as providing environmental pressure constraining opportunistic firm behaviors in debt contracting.

Individual Investors’ Dividend Taxes and Corporate Payout Policies
Oliver Zhen Li, Hang Liu, Chenkai Ni, and Kangtao Ye

The 2012 Dividend Tax Reform in China ties individual investors’ dividend tax rates to the length of their share holding period. We find that firms facing a reduction (increase) in their individual investors’ dividend tax rates are more (less) likely to increase dividend payout. Such an effect is concentrated in firms where incentives of controlling shareholders and minority shareholders are aligned. Further, investors respond to this tax law change by reducing trading activities before the cum-dividend day, and successfully lower their dividend tax penalty. Overall, our evidence enhances the notion that individual investors’ tax profiles shape firms’ payout policies.

A Multivariate Model of Strategic Asset Allocation with Longevity Risk
Emilio Bisetti, Carlo A. Favero, Giacomo Nocera, and Claudio Tebaldi

Population-wide increase in life expectancy is a source of aggregate risk. Longevity-linked securities are a natural instrument to reallocate it. This paper extends the standard Campbell and Viceira (2005) strategic asset allocation model by including a longevity-linked investment possibility. Model estimation, based on prices for standardized annuities publicly offered by United States insurance companies, shows that aggregate shocks to survival probabilities are predictors for long-term returns of the longevity-linked securities, and reveals an unexpected predictability pattern. Valuation of longevity risk premium confirms that longevity-linked securities o er inexpensive funding opportunities to asset managers.

Banks’ Internal Capital Markets and Deposit Rates
Itzhak Ben-David, Ajay Palvia, and Chester Spatt

A common view is that deposit rates are determined primarily by supply: depositors require higher deposit rates from risky banks (market discipline). An alternative perspective is market discipline is limited and that internal demand for funding by banks determines rates. Using branch-level deposit rate data, we find little evidence for market discipline as rates are similar across bank capitalization levels. In contrast, banks’ loan growth has a causal effect on deposit rates: e.g., branches’ deposit rates are correlated with loan growth in other states in which their bank has some presence, suggesting internal capital markets help reallocate the bank’s funding.

Institutional Investment Constraints and Stock Prices
Jie Cao, Bing Han, and Qinghai Wang

We test the hypothesis that investment constraints in delegated portfolio management may distort demand for stocks, leading to price underreaction to news and stock return predictability. We find that institutions tend not to buy more of a stock with good news that they already overweight; they are reluctant to sell a stock with bad news that they already underweight. Stocks with good news overweighted by institutions subsequently outperform signi cantly stocks with bad news underweighted by institutions. The impact of institutional investment constraints shed new lights on asset pricing anomalies such as stock price momentum and post earnings announcement drift.

CEO Tournaments: A Cross-Country Analysis of Causes, Cultural Influences and Consequences
Natasha Burns, Kristina Minnick, and Laura Starks

Using a cross-country sample, we examine the CEO tournament structure (measured alternatively as the ratio and the difference of pay between the CEO and other top executives within a firm). We find the tournament structure to vary systematically with firm and country cultural characteristics. In particular, firm size and the cultural values of Power distance, Fair income differences and Competition are significantly associated with variations in tournament structures. We also establish support for the primary implication of tournament theory in that tournament structure tends to be positively related to firm value, even after controlling for endogeneity.

How Do Frictions Affect Corporate Investment? A Structural Approach
M. Cecilia Bustamante

This paper provides a structural approach to test investment equations based on the log-likelihood function of a non-linear investment rule. The analysis integrates the predictions of the q-theory for the commonly studied active region of investment, and provides new inferences on how real and financing frictions affect the probability that a firm invests. Our empirical findings are consistent with the macro-finance literature suggesting that q-theory models with non-convex investment frictions better explain the data. We also find that both real and financing costs of investment are related to the capital intensity of the industry in which firms operate.

Why Do Short Sellers Like Qualitative News?
Bastian von Beschwitz, Oleg Chuprinin, and Massimo Massa

Short sellers trade more on days with qualitative news – i.e. news containing fewer numbers. We show that this behavior is not informationally motivated but can be explained by short sellers exploiting higher liquidity on such days. We document that liquidity and noise trading increase in the presence of qualitative news enabling short sellers to better disguise their informed trades. Natural experiments support our findings. Qualitative news has a bigger effect on short sellers’ trading after a decrease in liquidity following the stock's deletion from S&P 500 and a lower effect when investor attention is distracted by the Olympic Games.

Annual Report Readability, Tone Ambiguity, and the Cost of Borrowing
Mine Ertugrul, Jin Lei, Jiaping Qiu, and Chi Wan

This paper investigates the impact of a firm’s annual report readability and ambiguous tone on its borrowing costs. We find that firms with larger 10-K file sizes and a higher proportion of uncertain and weak modal words in 10-Ks have stricter loan contract terms and greater future stock price crash risk. Our results suggest that readability and tone ambiguity of a firm’s financial disclosures are related to managerial information hoarding. Shareholders of firms with less readable and more ambiguous annual reports not only suffer from less transparent information disclosure but also bear the increased cost of external financing.

The Effect of Labor Unions on CEO Compensation
Qianqian Huang, Feng Jiang, Erik Lie, and Tingting Que

We find evidence that labor unions affect CEO compensation. First, we find that firms with strong unions pay their CEOs less. The negative effect is robust to various tests for endogeneity, including cross-sectional variations and a regression discontinuity design. Second, we find that CEO compensation is curbed before union contract negotiations, especially when the compensation is discretionary and the unions have a strong bargaining position. Third, we report that curbing CEO compensation mitigates the chance of a labor strike, thus providing a rationale for firms to pay CEOs less when facing strong unions.

The Timing and Source of Long-Run Returns Following Repurchases
Leonce Bargeron, Alice Bonaime, and Shawn Thomas

This paper investigates the timing and source of anomalous positive long-run abnormal returns following repurchase authorizations. Returns between program authorization and completion announcements are indistinguishable from zero. Abnormal returns occur only after completion announcements. Long-run returns are largely attributable to announcement returns at subsequent authorizations and takeover attempts, i.e., anomalous post-authorization returns are not persistent drifts but rather step functions. These findings have important implications for prior papers examining this most persistent and widespread anomaly. Further, our results serve to refocus the search for a rational explanation for the anomaly on subsequent repurchase announcements and takeover bids.

Upper Bounds on Return Predictability
Dashan Huang and Guofu Zhou

Can the degree of predictability found in the data be explained by existing asset pricing models? We provide two theoretical upper bounds on the R-squares of predictive regressions. Using data on the market and component portfolios, we find that the empirical R-squares are significantly greater than the theoretical upper bounds. Our results suggest that the most promising direction for future research should aim to identify new state variables that are highly correlated with stock returns, instead of seeking more elaborate stochastic discount factors.

Should Indirect Brokerage Fees Be Capped? Lessons from Mutual Fund Marketing and Distribution Expenses
Natalie Y. Oh, Jerry T. Parwada, and Kian M. E. Tan

Theory predicts that capping brokers’ compensation exacerbates the exploitation of retail investors. We show that regulated caps on mutual fund 12b-1 fees, effectively sales commissions, are associated with negative equity fund performance, but only after a structural shift toward maximum permitted levels of the fees around 2000. Past this break point, flow–performance sensitivity shifts from the middle- to the highest-performing funds, suggesting that the fee cap increases performance-chasing behavior by constraining brokers’ incentives to learn about lower-ranked funds. The policy implication is that regulators must reevaluate the efficacy of caps on brokerage fees.

Gender and Board Activeness: The Role of a Critical Mass
Miriam Schwartz-Ziv

This study analyzes detailed minutes of board meetings of business companies in which the Israeli government holds a substantial equity interest. Boards with at least three directors of each gender are found to be at least 79% more active at board meetings than those without such representation. This phenomenon is driven by women directors in particular; they are more active when a critical mass of at least three women is in attendance. Gender-balanced boards are also more likely to replace underperforming CEOs and are particularly active during periods when CEOs are being replaced.

Information Characteristics and Errors in Expectations: Experimental Evidence
Constantinos Antoniou, Glenn W. Harrison, Morten I. Lau, and Daniel Read

We design an experiment to test the hypothesis that, in violation of Bayes Rule, some people respond more forcefully to the strength of information than to its weight. We provide incentives to motivate effort, use naturally occurring information, and control for risk attitude. We find that the strength-weight bias affects expectations, but that its magnitude is significantly lower than originally reported. Controls for non-linear utility further reduce the bias. Our results suggest that incentive compatibility and controls for risk attitude considerably affect inferences on errors in expectations.

Common Macro Factors and Currency Premia
Ilias Filippou and Mark P. Taylor

We study the role of domestic and global factors on payoffs of portfolios mimicking carry, dollar carry and momentum strategies. Using factors summarizing large datasets of macroeconomic and financial variables, we find that global equity market factors are predictive for carry trade returns, while U.S. inflation and consumption variables drive dollar carry trade payoffs, momentum returns are predominantly driven by U.S. inflation factors, and global factors capture the countercyclical nature of currency premia. We also find predictability in the exchange rate component of each strategy and demonstrate strong economic value to risk-averse investors with mean-variance preferences, regardless of base currency.

Stapled Financing, Value Certification, and Lending Efficiency
Hadiye Aslan and Praveen Kumar

We examine whether financing commitments from a target firm’s financial advisor, in the form of stapled financing, provide certification of target value. Using a dataset of leveraged buyouts spanning 2002-2011, and addressing endogeneity issues, we find that stapled financing has significantly positive effects on sellers’ shareholder wealth, especially for targets suffering from greater adverse selection. Stapled financing facilitates deal financing by allowing buyers to obtain lower cost and longer maturity debt, and is positively associated with bidding intensity. Investment banks offering stapled financing appear to trade off higher expected advisory fees against loss of lending effciency ex-post.

Informed Trading Around Stock Split Announcements: Evidence from the Option Market
Philip Gharghori, Edwin D. Maberly, and Annette Nguyen

Prior research shows that splitting firms earn positive abnormal returns and that they experience an increase in stock return volatility. By examining option-implied volatility, we assess option traders’ perceptions on return and volatility changes arising from stock splits. We find that they do expect higher volatility following splits. There is only weak evidence though of option traders anticipating an abnormal increase in stock prices. We also show that our option measures can predict both stock volatility levels and changes after the announcement. However, there is little evidence that they can predict the returns of splitting firms.

Model Uncertainty and Exchange Rate Forecasting
Roy Kouwenberg, Agnieszka Markiewicz, Ralph Verhoeks, and Remco C. J. Zwinkels

Exchange rate models with uncertain and incomplete information predict that investors focus on a small set of fundamentals that changes frequently over time. We design a model selection rule that captures the current set of fundamentals that best predict the exchange rate. Out-of-sample tests show that the forecasts made by this rule significantly beat a random walk for five out of ten currencies. Further, the currency forecasts generate meaningful investment profits. We demonstrate that the strong performance of the model selection rule is driven by time-varying weights attached to a small set of fundamentals, in line with theory.

Short-Term Reversals: The Effects of Past Returns and Institutional Exits
Si Cheng, Allaudeen Hameed, Avanidhar Subrahmanyam, and Sheridan Titman

Price declines over the previous quarter lead to stronger reversals across the subsequent two months. We explain this finding based on the dual notions that liquidity provision can influence reversals, and agents that act as de facto liquidity providers may be less active in past losers. Supporting these observations, we find that active institutions participate less in losing stocks, and that the magnitude of monthly return reversals fluctuates with changes in the number of active institutional investors. Thus, we argue that fluctuations in liquidity provision with past return performance accounts for the link between return reversals and past returns.

What Drives the Commonality between Credit Default Swap Spread Changes?
Mike Anderson

This paper documents an increase in the comovement between credit default swap (CDS) spread changes during the 2007-2009 crisis and investigates the source of that increase. One possible explanation is that comovement increased because fundamental values became more correlated. However, I find that changes in fundamentals account for only 23% of the increase in covariance. The remaining increase is attributed to changes in liquidity and the market price of default risk. In contrast, counterparty risk played an insignificant role. Although both contributed, the increase in covariance was driven more by variation in exposures than factor variance-covariance.

Social Screens and Systematic Investor Boycott Risk
H. Arthur Luo and Ronald J. Balvers

We model the pricing implications of screens adopted by socially responsible investors. The model reproduces the empirically observed abnormal return to sin stock, and implies a premium for systematic investor boycott risk that affects targeted as well as non-targeted firms. The investor boycott premium is not displaced by litigation risk, measures of neglect effect, illiquidity, industry momentum or concentration. The investor boycott risk factor is useful in explaining mean returns across industries, and its premium varies with the relative wealth of socially responsible investors and the business cycle.

Unknown Unknowns: Uncertainty About Risk and Stock Returns
Guido Baltussen, Sjoerd van Bekkum, and Bart van der Grient

Stocks with high uncertainty about risk, as measured by the volatility of volatility (vol-of-vol), robustly underperform stocks with low uncertainty about risk by 8 percent per year. This vol-of-vol effect is distinct from (combinations of) at least twenty previously documented return predictors, survives many robustness checks, and holds in the U.S. and across European stock markets. We empirically explore the pricing mechanism behind the vol-of-vol effect. The evidence points towards preference-based explanations, and points away from various alternative explanations. Collectively, our results show that uncertainty about risk is highly relevant for stock prices.

Cash Holdings, Competition, and Innovation
Evgeny Lyandres and Berardino Palazzo

We demonstrate theoretically and empirically that strategic considerations are important in shaping cash policies of innovative firms. In our model, firms compete in product markets with uncertain structure using cash as a commitment device to invest in innovation. We show that firms equilibrium cash holdings are related to expected intensity of competition. The sign and magnitude of this relation depends on firms’ financial constraints. Consistent with the strategic motive for hoarding cash, we show that firms cash holdings are negatively affected by their rivals cash holding choices, more so when competition is expected to be intense.

Blockholder Heterogeneity, CEO Compensation, and Firm Performance
Christopher P. Clifford and Laura Lindsey

This paper examines heterogeneity in blockholder monitoring across investor type. We document which blockholder types (e.g. mutual funds, hedge funds) are more likely to be associated with active monitoring and show that firms targeted by such blockholders are more likely to increase the equity portion of Chief Executive Officer (CEO) pay. Further, using market-wide and exogenous shocks to liquidity to identify differences in efficacy across blockholder types, we observe greater operating performance improvements in actively monitored firms when passive monitoring is less effective, suggesting causal impact. We propose differences in compensation arrangements across blockholder types as a mechanism underlying blockholders’ heterogeneous role.

Spreading the Misery? Sources of Bankruptcy Spillover in the Supply Chain
Madhuparna Kolay, Michael Lemmon, and Elizabeth Tashjian

We document that suppliers to purely financially distressed companies that are highly likely to reorganize in bankruptcy incur little or no spillover costs. In contrast, suppliers to economically distressed firms experience large losses in market value which are linked to proxies for the cost of replacing their bankrupt customer. Suppliers experience increased SG&A expenses and lower margins in the year following their trading partner’s bankruptcy which we link to proxies for partner replacement costs. Suppliers continue to extend trade credit to firms which are healthier and where the cost of replacing the partner is higher.

Key Human Capital
Ryan D. Israelsen and Scott E. Yonker

Firms whose human capital is concentrated in a few irreplaceable employees lack diversification in their human capital stock, exposing them to key human capital risk. Using “key man life insurance" disclosures to measure this risk, we show that exposed firms are riskier. These younger, smaller, growth firms have abnormally high volatility and following announcement of key employee departures, the most exposed firms lose 8% of their value. Key employees tend to be highly educated. They are four times more likely to hold Ph.D.'s than top managers, and firms with key human capital are more innovative.

Shareholder Composition and Managerial Compensation
Shinya Shinozaki, Hiroshi Moriyasu, and Konari Uchida

Stock options are used only sparingly in Japan. Japanese firms are more likely to adopt new stock option plans when they are more (less) owned by directors and arms-length investors (stable and controlling shareholders). Those firms have significantly more independent boards and pay higher dividends surrounding the adoption year than their industry peers. These results suggest that firms adopting stock options endeavor to meet demands for good governance practice from arms-length shareholders and to follow good governance practices in other dimensions. The coexistence of arms-length, stable, and controlling shareholders generates a situation in which stock options are not widely used in Japan.

Optimal Option Portfolio Strategies: Deepening the Puzzle of Index Option Mispricing
José Afonso Faias and Pedro Santa-Clara

Traditional methods of asset allocation (such as mean-variance optimization) are not adequate for option portfolios because the distribution of returns is non-normal and the short sample of option returns available makes it difficult to estimate their distribution. We propose a method to optimize a portfolio of European options, held to maturity, with a myopic objective function that overcomes these limitations. In an out-of-sample exercise, incorporating realistic transaction costs, the portfolio strategy delivers a Sharpe ratio of 0.82 with positive skewness. This performance is mostly obtained by exploiting mispricing between options and not by loading on jump or volatility risk premia.

To Pay or be Paid? The Impact of Taker Fees and Order Flow Inducements on Trading Costs in U.S. Options Markets
Robert Battalio, Andriy Shkilko, and Robert Van Ness

Consistent with prior literature, we find that average relative effective spreads are higher on venues that pay for order flow (PFOF) than on venues utilizing the maker taker (MT) model. This relation becomes more nuanced when liquidity fees are incorporated into liquidity cost measures. For the majority of options, PFOF venues offer lower average liquidity costs net of taker fees. Net liquidity costs for the high-priced options, however, are lower on MT venues. Overall, our results suggest that the inclusion of fees and rebates can rationalize the routing of most, but not all, marketable orders to PFOF venues.

Real Options, Idiosyncratic Skewness, and Diversification
Luca Del Viva, Eero Kasanen, and Lenos Trigeorgis

We show how firm-level real options lead to idiosyncratic skewness in stock returns. We then document empirically that growth option variables are positive and significant determinants of idiosyncratic skewness. The real option impact on skewness is more significant in firms with lottery-type features, small size, high volatility, distressed, low ROA and low book-to-market. We also find that expectation on idiosyncratic skewness is associated with lower Sharpe ratios. This suggests investors are willing to sacrifice mean-variance portfolio efficiency for greater skewness deriving from real options. Further, financial flexibility has a positive incremental impact enhancing the beneficial role of asset flexibility on idiosyncratic skewness.

Seasonal Asset Allocation: Evidence from Mutual Fund Flows
Mark J. Kamstra, Lisa A. Kramer, Maurice D. Levi, and Russ Wermers

We analyze the flow of money between mutual fund categories, finding strong evidence of seasonality in investor risk aversion. Aggregate investor flow data reveal investor preference for safe mutual funds in autumn and risky funds in spring. During September alone, out flows from equity funds average $13 billion, controlling for previously documented flow determinants (e.g., capital-gain overhang). This movement of large amounts of money between fund categories is correlated with seasonality in investor risk aversion, consistent with investors preferring safer (riskier) investments in autumn (spring). We find consistent evidence in Canada, and in Australia where seasons are offset by six months

The Strategic Behavior of Firms with Debt
Jerome Reboul Anna Toldrà-Simats

We empirically study the strategic behavior of levered firms in a non-competitive and in a competitive environment. We find that regulation induces firms to increase leverage, and this reduces their ability to compete when deregulation occurs. Large and small levered firms adopt different strategies upon deregulation. Whereas more levered small firms charge higher prices to increase margins at the expense of market shares, highly-levered larger firms prey on their rivals by increasing output and reducing prices to increase their market shares. The dfference in their behavior is due to differences in their probability of bankruptcy, and their financing constraints.

Alliances and Return Predictability
Jie Cao, Tarun Chordia, and Chen Lin

Building on the growing literature on inter-firm links and limited attention, we find evidence of return predictability across alliance partners. A long-short portfolio sorted on lagged returns of strategic alliance partners provides a return of 89 basis points per month that is robust to a number of specifications. Investor inattention and limits to arbitrage may be the source of the underreaction of a firm’s returns to that of its partners’.

Industrial Electricity Usage and Stock Returns
Zhi Da, Dayong Huang, and Hayong Yun

The industrial electricity usage growth rate predicts future stock returns up to one year with an R-squared of 9%. High industrial electricity usage today predicts low stock returns in the future, consistent with a countercyclical risk premium. Industrial electricity usage tracks the output of the most cyclical sectors. Our findings bridge a gap between the asset pricing literature and the business cycle literature, which uses industrial electricity usage to gauge production and output in real time. Industrial electricity growth compares favorably with traditional -financial variables, and it outperforms Cooper and Priestley's (2009) output gap measure in real time.

Horizon Pricing
Avraham Kamara, Robert A. Korajczyk, Xiaoxia Lou, and Ronnie Sadka

The literature documents heterogeneity in the delay of stock-price reaction to systematic shocks, implying that asset risk depends on investment horizon. We study the pricing of risk factors across investment horizons. Value (liquidity) risk is priced over intermediate (short) horizons. Conditioning horizon-factor exposures on firm characteristics indicates that characteristics, with the exception of momentum, are not priced beyond their contribution to systematic risk. Long- horizon institutional investors overweight assets with high intermediate-horizon exposures to HML risk and high short-horizon exposures to liquidity risk. The results highlight the importance of investment horizon in determining risk premia.

Strategic Delays and Clustering in Hedge Fund Reported Returns
George O. Aragon and Vikram Nanda

We use a novel database to study timeliness of hedge-fund monthly performance disclosures. Managers engage in strategic timing: poor monthly returns are reported with delay, sometimes clustered with stronger subsequent performance, suggestive of `performance smoothing'. We posit that propensity to delay could reveal operational-risk and/or poor-managerial quality. Consistent with this, a portfolio strategy that buys (sells) funds with historically timely (untimely) reporting delivers 3% annual-style-adjusted returns. Investor flows are lower following reporting delays, though there are potential benefits to managers from delaying when performance is sufficiently poor. We conclude timely disclosure is an important consideration for hedge-fund managers and investors.

Anchoring Credit Default Swap Spreads to Firm Fundamentals
Jennie Bai and Liuren Wu

This paper examines the extent to which firm fundamentals can explain the cross-sectional variation of credit default swap (CDS) spreads. The paper constructs a fundamental CDS valuation by combining the Merton distance-to-default measure with a long list of firm fundamental characteristics. Regressing market CDS quotes against the fundamental valuation cross-sectionally generates an average R-squared of 77%. The cross-sectional explanatory power is stable over time, and robust in out-of-sample tests. Deviations between market quotes and the valuation predict significantly future market movements. The results highlight the important role of firm fundamentals in differentiating the credit quality of different firms.

Speculators, Prices and Market Volatility
Celso Brunetti, Bahattin Büyüksahin, and Jeffrey H. Harris

We employ data over 2005–2009 which uniquely identify categories of traders to test how speculators like hedge funds and swap dealers relate to volatility and price changes. Examining various sub-periods where price trends are strong, we find little evidence that speculators destabilize financial markets. To the contrary, hedge fund position changes are negatively related to volatility in corn, crude oil and natural gas futures markets. Additionally, swap dealer activity is largely unrelated to contemporaneous volatility. Our evidence is consistent with the hypothesis that hedge funds provide valuable liquidity and largely serve to stabilize futures markets.

The Dynamics of Performance Volatility and Firm Valuation
Jianxin (Daniel) Chi and Xunhua Su

We construct a model to illustrate the dynamics of cash flow volatility and firm valuation. As a firm progressively invests into its growth opportunities, its book value increases and catches up with its market value, reducing the valuation multiple (Q). Cash flow volatility (CFV) decreases due to the diversification effect of investing into more market segments. We document a positive CFV-Q association, which varies with firm size, investment opportunities, and the correlation across market segments. Empirical findings strongly support the model’s predictions and are robust to alternative explanations offered by extant studies on firm growth, volatility, and valuation.

Buyers versus Sellers: Who Initiates Trades and When?
Tarun Chordia, Amit Goyal, and Narasimhan Jegadeesh

Models that examine investor’s motivations to trade often make opposite predictions about the relation between trading decisions and past returns. We find that, in the aggregate, both buyer- and seller-initiated trades increase with past returns. The difference between buyer- and seller-initiated trades is negatively related to short horizon returns but positively related to returns over longer horizons. Tax-loss related seller-initiated trades in December and January are accompanied by increased buyer-initiated trades. Past returns significantly affect trading decisions and these findings are consistent with a number of different models of trading behavior.

Sovereign Default Risk and the US Equity Market
Alexandre Jeanneret

This paper develops an international asset-pricing model with defaultable firms and governments that demonstrates how sovereign credit risk in Europe affects US equity market prices. The risk of a sovereign debt crisis is a threat to economic growth that reduces the value of international equities and increases their volatility. The effect is strongest under adverse economic conditions, when firms are in financial distress. A structural estimation of the model shows that sovereign default risk helps explain the level and the dynamics of equity volatility in Europe and the US over the 1991-2013 period.

Time-Varying Liquidity and Momentum Profits
Doron Avramov, Si Cheng, and Allaudeen Hameed

A basic intuition is that arbitrage is easier when markets are most liquid. Surprisingly, we find that momentum profits are markedly larger in liquid market states. This finding is not explained by variation in liquidity risk, time-varying exposure to risk factors, or changes in macroeconomic condition, cross-sectional return dispersion, and investor sentiment. The predictive performance of aggregate market illiquidity for momentum profits uniformly exceed that of market return and market volatility states. While momentum strategies are unconditionally unprofitable in US, Japan, and Eurozone countries in the last decade, they are substantial following liquid market states.

Creative Destruction and Asset Prices
Joachim Grammig and Stephan Jank

We relate Schumpeter's notion of creative destruction to asset pricing, thereby offering a novel explanation of size and value premia. We argue that small-value firms must offer higher expected returns to compensate for the risk posed by serendipitous invention activity, whereas large-growth stocks provide protection against creative destruction and receive expected return discounts. A two-factor model that accounts for creative destruction risk effectively explains the cross-sectional return variation of size and book-to-market sorted portfolios. The estimated risk compensations associated with creative destruction are substantial and statistically significant, indicating their relevance for asset pricing.

Sentiment and the Effectiveness of Technical Analysis: Evidence from the Hedge Fund Industry
David M. Smith, Na Wang, Ying Wang, and Edward J. Zychowicz

This paper presents a unique test of the effectiveness of technical analysis in different sentiment environments by focusing on its usage by perhaps the most sophisticated and astute investors, namely hedge fund managers. We document that during high-sentiment periods, hedge funds using technical analysis exhibit higher performance, lower risk, and superior market-timing ability than non-users. The advantages of using technical analysis disappear or even reverse in low-sentiment periods. Our findings are consistent with the view that technical analysis is relatively more useful in high-sentiment periods with larger mispricing, which cannot be fully exploited by arbitrage activities due to short-sale impediments.

Asymmetric Information, Financial Reporting, and Open Market Share Repurchases
Matthew T. Billett and Miaomiao Yu

We explore the link between open market share repurchases (OMRs) and asymmetric information - based on financial reporting quality - and find opaque firms experience positive abnormal returns twice the magnitude of transparent firms. These significant differences remain after controlling for governance, earnings management, and firm characteristics. We document significantly positive long-run post-announcement returns for opaque firms, but not for transparent firms. We find takeover activity and premiums rise with repurchase activity by opaque firms and may explain some of the wealth effects. Our results suggest that asymmetric information plays an important role in the wealth effects around OMRs.

Do Banks Issue Equity When They Are Poorly Capitalized?
Valeriya Dinger and Francesco Vallascas

Debt overhang and moral hazard predict that poorly capitalized banks have a lower likelihood to issue equity, while the presence of regulatory and market pressures posit an opposite theoretical prediction. By using an international sample of bank Seasoned Equity Offerings (SEOs), we show that the likelihood of issuing SEOs is higher in poorly capitalized banks and that such banks prefer SEOs to alternative capitalization strategies. A series of tests exploring the variation of capital regulation and market discipline show that market mechanisms rather than capital regulation are the primary driver of the decision to issue by poorly capitalized banks.

Initial Public Offering Allocations, Price Support, and Secondary Investors
Sturla Lyngnes Fjesme

Tying Initial Public Offering (IPO) allocations to after-listing purchases of other IPO shares, as a form of price support, has generated much theoretical interest and media attention. Price support is price manipulation and can reduce secondary investor return. Obtaining data to investigate price support has in the past proven to be difficult. We document that price support is harming secondary investor return using new data from the Oslo Stock Exchange. We also show that investors who engage in price support are allocated more future oversubscribed allocations while harmed secondary investors significantly reduce their future participation in the secondary market.

Continuing Overreaction and Stock Return Predictability
Suk Joon Byun, Sonya S. Lim, and Sang Hyun Yun

We study the return predictability of a measure of continuing overreaction based on the weighted average of signed volumes. We find that the strategies of buying stocks with upward continuing overreaction and selling stocks with downward continuing overreaction generate significant positive returns, and that our measure of continuing overreaction is a better predictor of future returns than past returns. The results are stronger among stocks primarily held by investors more prone to biased self-attribution. Our results provide direct support for the model of return predictability based on overconfidence and biased self-attribution.

The Determinants and Performance Impact of Outside Board Leadership
Steven Balsam, John Puthenpurackal, and Arun Upadhyay

Outside board chairs are more likely in firms that are smaller, have greater stock volatility and R&D intensity, have a lower proportion of inside directors and less institutional ownership, and when CEOs have shorter tenure and lower ownership. We also find the existence of an outside chair associated with geographical and industry norms. An outside chair is positively associated with firm performance, a finding robust to various estimation methods including event study and multivariate analyses incorporating controls for endogeneity, as well as market and accounting measures of performance. We note however, the outside chair-firm performance relationship varies with firm characteristics.

Estimating Beta
Fabian Hollstein and Marcel Prokopczuk

We conduct a comprehensive comparison of market beta estimation techniques. We study the performance of several historical, time-series model, and option implied estimators for estimating realized market beta. Thereby, we find the hybrid methodology of Buss and Vilkov (2012) to consistently outperform all other approaches. In addition, all other approaches, including fully implied and GARCH-based methods for dynamic conditional beta, are dominated by a simple beta estimate based on historical (co-) variances and a Kalman filter based approach. Our conclusions remain unchanged after performing several robustness checks.

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.

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.

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.

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.

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.

Last updated November 13, 2015.