In support of our mission to promote excellence in financial economics research, the following is an aggregation of the working research being conducted and investigated:
We propose a theory of regulatory arbitrage by banks and test it using trust preferred securities (TPS) issuance. From 1996 to 2007, U.S. banks in the aggregate increased their regulatory capital through issuance of TPS while their net issuance of common stock was negative due to repurchases. We assume that, in the absence of capital requirements, a bank has an optimal capital structure that depends on its business model. Capital requirements can impose constraints on bank decisions. If a bank’s optimal capital structure also meets regulatory capital requirements with a sufficient buffer, the bank is unconstrained by these requirements. We expect that unconstrained banks will not issue TPS, that constrained banks will issue TPS and engage in other forms of regulatory arbitrage, and that banks with TPS will be riskier than other banks with the same amount of regulatory capital, and therefore, more adversely affected by the credit crisis. Our empirical evidence supports these predictions.
Loss mitigation actions (e.g., liquidation or renegotiation) for delinquent mortgages might be hampered by the conflicting goals of claim holders with different levels of seniority. Although similar agency problems arise in corporate bankruptcies, the mortgage market is unique because in a large share of cases junior claimants, in their role as servicers, exercise operational control over loss mitigation actions on mortgages owned by senior claimants. We show that servicers are less likely to act on the first lien mortgage owned by investors when they themselves own the second lien claim secured by the same property. When they do act, such servicers’ choices are skewed towards actions that maximize the value of their junior claims, favoring modification over liquidation and short sales and deeds-in-lieu over foreclosures. We also show that such servicers find it more difficult to avoid taking actions on second lien loans when first liens are modified and that they do not modify their second lien loans on more concessionary terms. We show that these actions transfer wealth from first to second liens and moderately increase borrower welfare.
This paper provides evidence that the 52-week high serves as a psychological barrier, beyond which investors are hesitant to push prices. Two clear predictions emerge and are confirmed in the data. First, nearness to a 52-week high induces expectational errors; investor and analyst expectations are biased in a downward direction for stocks near a 52-week high and biased in an upward direction for stocks trading far from a 52-week high. Consistent with this, earnings surprises are systematically positive for stocks near a 52-week high and systematically negative for stocks far from a 52-week high. A long-short portfolio strategy exploiting biased expectations in the days around announcement earns abnormal returns of 34 basis points per day. Additionally, analyst price target forecasts reveal that analyst expectations of price appreciation are substantially lower for stocks near a 52-week high than for stocks far from a 52-week high. Second, nearness to a 52-week high induces underreaction to news. Consistent with investors being hesitant to push prices above a 52-week high, stocks trading near a 52-week high underreact to positive earnings surprises, while stocks trading far from a 52-week high underreact to negative surprises. A long-short calendar-time portfolio exploiting 52-week high induced underreaction to news earns greater than 150 basis points per month.
A manager’s shareholders, board of directors, and potential future employers are continually assessing his ability. A rich literature has documented that this insight has profound implications for corporate governance because assessment generates incentives (good and bad), introduces assorted risks, and affects the various battles that rage among the relevant actors for corporate control. Consequently, assessment (or learning) is a key perspective from which to study, evaluate, and possibly even regulate corporate governance. Moreover, because learning is a behavior notoriously subject to systematic biases, this perspective is a natural avenue through which to introduce behavioral and psychological insights into the study of corporate governance.
Several states have recently implemented laws requiring the collection of sales tax on online purchases. In practice, however, only Amazon has been affected. We find that households living in these states reduce Amazon expenditures by 9.5%, implying an elasticity of -1.3. We find the effect to be more pronounced for large purchases, for which we estimate an elasticity of -3.2. Further, we find that the decline in Amazon purchases is offset by a 2.0% increase in purchases at local brick-and-mortar retailers and a 19.8% increase in purchases at the online operations of competing retailers.
- Limited Partner Performance and the Maturing of the Private Equity Industry
Berk A. Sensoy, Yingdi Wang, and Michael S. Weisbach
We evaluate the performance of limited partners’ (LPs) private equity investments over time. Using a sample of 14,380 investments by 1,852 LPs in 1,250 buyout and venture funds started between 1991 and 2006, we find that the superior performance of endowment investors in the 1991-1998 period, documented in prior literature, is mostly due to their greater access to the top-performing venture capital partnerships. In the subsequent 1999-2006 period, endowments no longer outperform, and neither have greater access to funds who are likely restrict access nor make better investment selections than other types of institutional investors. We discuss how these results are consistent with the general maturing of the industry, as private equity has transitioned from a niche, poorly understood area to a ubiquitous part of institutional investors’ portfolios.
- Why Did Financial Institutions Sell RMBS at Fire Sale Prices During the Financial Crisis?"
Craig Merrill, Taylor Nadauld, René M. Stulz,and Shane M. Sherlund
Much attention has been paid to the large decreases in value of non-agency residential mortgage-backed securities (RMBS) during the financial crisis. Many observers have argued that the fall in prices was partly caused by fire sales. We use capital requirements and accounting rules to identify circumstances where financial institutions had incentives to engage in fire sales and then examine whether such sales occurred. For financial institutions subject to credit-sensitive capital requirements, capital requirements increase as an asset’s credit becomes impaired. When accounting rules require such an asset’s value to be marked-to-market and the fair value loss to be recognized in earnings, a capital-constrained firm can improve its capital position by selling the credit-impaired asset even if it has to accept a liquidity discount to do so. In contrast, a financial firm whose fair value losses are not recognized in earnings for the purpose of calculating capital requirements is more likely to satisfy capital requirements by selling liquid assets whose value has not fallen and hence would be unlikely to engage in fire sales. Using a sample of 5,000 repeat transactions of non-agency RMBS by insurance companies from 2006 to 2009, we show that insurance companies that became more capital-constrained because of operating losses (uncorrelated with RMBS credit quality) and also recognized fair value losses sold comparable RMBS at much lower prices than other insurance companies during the crisis.
- Do Acquisitions Relieve Target Firms' Financial Constraints?
Isil Erel, Yeejin Jang, and Michael S. Weisbach
Managers often claim that an important source of value in acquisitions is the acquiring firm’s ability to finance investments for the target firm. This claim implies that targets are financially constrained prior to being acquired and that these constraints are eased following the acquisition. We evaluate these predictions on a sample of 5,187 European acquisitions occurring between 2001 and 2008, for which we can observe the target’s financial policies both before and after the acquisition. We examine whether target firms’ post-acquisition financial policies reflect improved access to capital. We find that the level of cash target firms hold, the sensitivity of cash to cash flow, and the sensitivity of investment to cash flow all decline significantly, while investment significantly increases following the acquisition. These effects are stronger in deals that are more likely to be associated with financing improvements. These findings are consistent with the view that acquisitions ease financial frictions in target firms.
- Brand Capital and Firm Value
Frederico Belo, Xiaoji Lin, and Maria Ana Vitorino
We study the role of brand capital - a primary form of intangible capital - for firm valuation and risk in the cross-section of publicly traded firms. Using a novel empirical measure of brand capital stock constructed from firm level advertising expenditures data, we show that: (i) firms with low brand capital investment rates have higher average stock returns than firms with high brand capital investment rates, a difference of 5.2% per annum; (ii) more brand capital intensive firms have higher average stock returns than less brand capital intensive firms, a difference of 4.6% per annum; and (iii) investment in both brand capital and physical capital is volatile and is procyclical. A neoclassical investment-based model augmented with brand capital simultaneously matches the asset pricing facts and key properties of firm-level brand capital and physical capital investment. The model also provides a novel explanation for the empirical links between advertising expenditures and stock returns around seasoned equity offerings (SEO) documented in previous studies. Our findings highlight the importance of brand capital for understanding firms’ market value and risk.
- Learning About CEO Ability and Stock Return Volatility
Yihui Pan, Tracy Yue Wang , and Michael S. Weisbach
When there is uncertainty about a CEO’s quality, news about the firm causes rational investors to update their expectation of the firm’s profitability for two reasons: Updates occur because of the direct effect of the news, and also because the news can cause an updated assessment of the CEO’s quality, affecting expectations of his ability to generate future cash flows. As a CEO’s quality becomes known more precisely over time, the latter effect becomes smaller, lowering the stock price reaction to news, and hence lowering the stock return volatility. Thus, in addition to uncertainty about fundamentals, uncertainty about CEO quality is also a source of stock return volatility, which decreases over a CEO’s tenure as the market learns the CEO’s quality more accurately. We formally model this idea, and evaluate its implications using a large sample of CEO turnovers in U.S. public firms. Our estimates indicate that there is statistically significant and economically important market learning about CEO ability, even for CEOs whose appointments appear to be unrelated to their predecessors’ performance. Also consistent with the learning model is the fact that the learning curve appears to be convex in time, and learning is faster when there is higher ex ante uncertainty about the CEO’s ability and more transparency about the firm’s prospects. Overall, uncertainty about management quality appears to be an important source of stock return volatility.
- Indirect Incentives of Hedge Fund Managers
Jongha Lim, Berk A. Sensoy, and Michael S. Weisbach
Indirect incentives exist in the money management industry when good current performance increases future inflows of new capital, leading to higher future fees. We quantify the magnitude of indirect performance incentives for hedge fund managers. Flows respond quickly and strongly to performance; lagged performance has a monotonically decreasing impact on flows as lags increase up to two years. Conservative estimates indicate that indirect incentives for the average fund are four times as large as direct incentives from incentive fees and returns to managers’ own investment in the fund. For new funds, indirect incentives are seven times as large as direct incentives. Combining direct and indirect incentives, for each dollar generated for their investors in a given year, managers receive close to another dollar in direct performance fees plus the present value of future fees over the expected life of the fund. Older and capacity constrained funds have considerably weaker relations between future flows and performance, leading to weaker indirect incentives. There is no evidence that direct contractual incentives are stronger when market-based indirect incentives are weaker.
- Is there a U.S. high cash holdings puzzle after the financial crisis?
Lee Pinkowitz, René M. Stulz, and Rohan Williamson
Defining normal cash holdings as the holdings a firm with the same characteristics would have had in the late 1990s, we find that the average abnormal cash holdings of U.S. firms after the financial crisis amount to 10% of cash holdings, which represents an 87% increase in abnormal cash holdings from before the crisis. The increase in abnormal cash holdings of U.S. firms is concentrated among highly profitable firms. Strikingly, abnormal cash holdings do not increase more for U.S. firms than for firms in advanced countries from before the crisis to after the crisis. Though abnormal cash holdings of U.S. multinational firms increase sharply in the early 2000s while cash holdings of purely domestic firms do not, there is no increase in abnormal cash holdings by U.S. multinational firms from before the crisis to after. Further evidence shows that the tax explanation for the cash holdings of U.S. multinational firms cannot explain the large abnormal holdings of these firms. In sum, while the high cash holdings of U.S. firms before the crisis are a U.S.-specific puzzle, the increase in cash holdings of U.S. firms from before the crisis to after is not.
- Why High Leverage is Optimal for Banks
Harry DeAngelo and René M. Stulz
Liquidity production is a central role of banks. When there is a market premium for the production of (socially valuable) liquid financial claims and no other departures from the Modigliani and Miller (1958, MM) assumptions, we show that high leverage is optimal for banks. In this model, high leverage is not the result of distortions from agency problems, deposit insurance, or tax motives to borrow. The model can explain (i) why bank leverage increased over the last 150 years or so without invoking any of these distortions, and (ii) why high bank leverage per se does not necessarily cause systemic risk. MM’s leverage irrelevance theorem is inapplicable to banks: Because debt-equity neutrality assigns zero weight to the social value of liquidity, it is an inappropriately equity-biased criterion for assessing whether the high leverage ratios of real-world banks are excessive or socially destructive.
- The Twilight Zone: OTC Regulatory Regimes and Market Quality
Ulf Brüggemann, Aditya Kaul, Christian Leuz, and Ingrid M. Werner
We analyze a comprehensive sample of more than 10,000 U.S. stocks in the OTC market. As little is known about this market, we first characterize OTC firms by trading venue and provide evidence on survival, success, frequency of venue changes, reporting status, and trading activity. A large number of new firms appear on the OTC market each year. With few exceptions, these new firms exhibit poor performance and rarely rise to trade on traditional exchanges. We analyze how market liquidity, price efficiency and crash risk, all of which capture aspects of market quality, differ across OTC venues and firms subject to different regulatory regimes, including federal securities and state blue sky laws. We show that OTC firms that are subject to stricter regulatory regimes have higher market liquidity and price efficiency, and lower return skewness. We also analyze OTC market features that are potential substitutes for SEC registration, such as publication in a securities manual or state merit reviews, and provide evidence on their capital-market effects. This evidence is relevant in light of the JOBS Act and the ensuing relaxation of SEC registration requirements. Overall, our results suggest that investors consider information and regulatory differences when trading OTC stocks.
- Do firms issue more equity when markets are more liquid?
René M. Stulz, Dimitrios Vagias, and Mathijs A. van Dijk
This paper investigates how public equity issuance is related to stock market liquidity. Using quarterly data on IPOs and SEOs in 36 countries over the period 1995-2008, we show that equity issuance is significantly and positively related to contemporaneous and lagged innovations in aggregate local market liquidity. This relation survives the inclusion of proxies for market timing, capital market conditions, growth prospects, asymmetric information, and investor sentiment. Liquidity considerations are as important in explaining equity issuance as market timing considerations. The relation between liquidity and issuance is driven by the quarters with the greatest deterioration in liquidity and is stronger for IPOs than for SEOs. Firms are more likely to carry out private instead of public equity issues and to postpone public equity issues when market liquidity worsens. Overall, we interpret our findings as supportive of the view that market liquidity is an important determinant of equity issuance that is distinct from other determinants examined to date.
- Comovement of Corporate Bonds and Equities
Jack Bao and Kewei Hou
We study heterogeneity in the comovement of corporate bonds and equities, both at the bond level and at the rm level. Using an extended Merton model, we illustrate that corporate bonds that mature late relative to the rest of the bonds in its issuer's maturity structure should have stronger comovement with equities. In contrast, endogenous default models suggest that a bond's position in its issuer's maturity structure has little relation with the strength of the comovement between bonds and equities. Empirically, we nd results consistent with the prediction of the extended Merton model. In addition, we nd that comovement between bonds and equities is stronger for rms with higher credit risk as proxied by the book-to-market ratio and distance-to-default even after controlling for ratings. Our evidence suggests that market participants are able to assess credit quality at a more granularlevel than ratings.
- CEO Investment Cycles
Yihui Pan, Tracy Yue Wang, and Michael S. Weisbach
This paper documents the existence of a CEO Investment Cycle, in which firms disinvest early in a CEO’s tenure and increase investment subsequently, leading to “cyclical” firm growth in assets as well as in employment over CEO tenure. The CEO investment cycle occurs for both firings and non-performance related CEO turnovers, and for CEOs with different relationships with the firm prior to becoming CEO. The magnitude of the CEO cycle is substantial: The estimated difference in investment rate between the first three years of a CEO’s tenure and subsequent years is approximately 6 to 8 percentage points, which is of the same order of magnitude as the differences caused by other factors known to affect investment, such as business cycles or financial constraints. We present a variety of tests suggesting that this investment cycle is best explained by a combination of agency-based theories: Early in his tenure the CEO disinvests poorly performing assets that his predecessor established and was unwilling to give up on. Subsequently, the CEO overinvests when he gains more control over his board. There is no evidence that the investment cycles occur because of shifting CEO skill or productivity shocks. Overall, the results imply that public corporations’ investments deviate substantially from the first-best, and that governancerelated factors internal to the firm are as important as economy-wide factors in explaining firms’investments.
- Limited Managerial Attention and Corporate Aging
Claudio Loderer, René Stulz, and Urs Waelchli
As firms have more assets in place, more of management’s limited attention is focused on managing assets in place rather than developing new growth options. Consequently, as firms grow older, they have fewer growth options and a lower ability to generate new growth options. This simple theory predicts that Tobin’s q falls with age. Further, competition in the product market is expected to slow down the decrease in Tobin’s q because it forces firms to look for alternative sources of rents. Similarly, greater competition in the labor market reduces the decrease in Tobin’s q with age because old firms are in a better position to hire employees that can help with innovation. In contrast, competition in the market for corporate control should accelerate the decline because it forces management to focus more on managing assets in place whose performance is more directly observable than on developing growth options where results may not be observable for some time. We find strong support for these predictions in tests using exogenous variation in competition.
- Tick Size Regulations and Sub-Penny Trading
Sabrina Buti, Barbara Rindi, Yuanji Wen, and Ingrid Werner
We show that following a tick size reduction in a decimal public limit order book (PLB) market quality and welfare fall for illiquid but increase for liquid stocks. If a Sub-Penny Venue (SPV) starts competing with a penny-quoting PLB, market quality deteriorates for illiquid, low priced stocks, while it improves for liquid, high priced stocks. As all traders can demand liquidity on the SPV, traders’ welfare increases. If the PLB facing competition from a SPV lowers its tick size, PLB spread and depth decline and total volume and welfare increase irrespective of stock liquidity.
- Corporate Liquidity Management: A Conceptual Framework and Survey
Heitor Almeida, Murillo Campello, Igor Cunha,and Michael Weisbach
Ensuring that a firm has sufficient liquidity to finance valuable projects that occur in the future is at the heart of the practice of financial management. Yet, while discussion of these issues goes back at least to Keynes (1936), a substantial literature on the ways in which firms manage liquidity has developed only recently. We argue that many of the key issues in liquidity management can be understood through the lens of a framework in which firms face financial constraints and wish to ensure efficient investment in the future. We present such a model and use it to survey many of the empirical findings on liquidity management. Much of the variation in the quantity of liquidity can be explained by the precautionary demand for liquidity. While there are alternatives to cash holdings such as hedging or lines of credit, cash remains “king”, in that it still is the predominate way in which firms ensure future liquidity for future investments. We discuss theories on the choice of liquidity measures and related empirical evidence. In addition, we discuss agency-based theories of liquidity, the real effects of liquidity choices, and the impact of the 2008-9 Financial Crisis on firms’ liquidity management.
- External Habit in a Production Economy
A unified framework for understanding asset prices and aggregate fluctuations is critical for understanding both issues. I show that a real business cycle model with external habit preferences and capital adjustment costs provides one such framework. The estimated model matches the first two moments of the equity premium and risk-free rate, return and dividend predictability regressions, and the second moments of output, consumption, and investment. The model also endogenizes a key mechanism of consumption-based asset pricing models. In order to address the Shiller volatility puzzle, external habit, long-run risk, and disaster models require the assumption that the volatility of marginal utility is countercyclical. In the model, this countercyclical volatility arises endogenously. Production makes precautionary savings effects show up in consumption. These effects lead to countercyclical consumption volatility and countercyclical volatility of marginal utility. External habit amplifies this channel and makes it quantitatively significant.
- The Term Structures of Co-Entropy in International Financial Markets
Fousseni Chabi-Yo and Riccardo Colacito
We propose a new entropy-based correlation measure (co-entropy) to evaluate the performance of international asset pricing models. Co-entropy summarizes in a single number the extent of co-dependence between two variables beyond normality. We document that the co-entropy of international stochastic discount factors (SDFs) can be decomposed into a series of entropy-based correlations of permanent and transitory components of the SDFs. We derive bounds and restrictions on co-entropies of these components, which we then use to analyze the composition of co-dependence of international SDFs. A large cross-section of countries is employed to provide empirical evidence on the entropy-based correlations at various horizons. We find that the co-entropy of the transitory components is always sizably smaller than the co-entropy of the permanent components, with the latter usually being very close to one. Furthermore, the entropy based correlation of transitory components of SDFs increases with the investment horizon, which features an upward sloping term structure of co-entropies. We confront several state-of-the-art international finance models with these empirical regularities, and find that existing models cannot account for the composition of codependence at all horizons.
- Sub-Penny and Queue-Jumping
Sabrina Buti, Francesco Consonni, Barbara Rindi, and Ingrid Werner
Sub-Penny Trading (SPT) is a form of dark trading that allows traders to undercut displayed liquidity. We distinguish between SPT that is queue jumping (QJ) and mid- crossing (MID)and find that QJ is higher for NASDAQ than NYSE stocks. Consistently with Buti, Rindi, Wen and Werner (2013), QJ is positively related to depth and negatively related to stock price. We also find that QJ is associated with improved lit market quality, especially for large capitalization stocks. Sub-penny quotes are allowed for stocks priced below $1.00, and we use this fact to show that QJ increases, the spread improves but depth deteriorates as the price of a stock crosses from above to below($1.00).
- Is sell-side research more valuable in bad times?
Roger K. Loh and René Stulz
In bad times, uncertainty is high, so that investors find it more difficult to assess the prospects of the firms they invest in. Learning models suggest that in such times investors should, everything else equal, value informative signals such as analyst forecasts and recommendations more than in good times. However, the higher uncertainty in bad times and career concerns stemming from troubled employers may make the task of analysts harder, so that analyst output is noisier and hence less valuable in bad times. Consequently, whether analyst forecasts and recommendations are more valuable during bad times is an empirical matter. We examine a large sample of analyst output from 1983 to 2011. We find that analysts work harder in bad times, but their earnings forecasts accuracy is worse and that they disagree more. Despite more inaccurate earnings forecasts, revisions to earnings forecasts and stock recommendations have a more influential stock-price impact during bad times as predicted by a learning model.
- Disentangling Financial Constraints, Precautionary Savings, and Myopia: Household Behavior Surrounding Federal Tax Returns
Brian Baugh, Itzhak Ben-David, and Hoonsuk Park
We explore household consumption surrounding federal tax returns filings and refunds receipt to test various theories of consumption. Because uncertainty regarding the refund is resolved at filing, precautionary savings theory predicts an increase in consumption at this date. Contrary to this prediction, we find that households generally do not increase consumption at filing. Following the receipt of the refunds, consumption of both durables and nondurables increases dramatically and then decays quickly. Our results show that households, on average, are financially constrained, exhibit myopic behavior, and do not respond to precautionary savings motives.
- An Equilibrium Asset Pricing Model with Labor Market Search
Lars-Alexander Kuehn, Nicolas Petrosky-Nadeau and Lu Zhang
Search frictions in the labor market help explain the equity premium in the financial market. We embed the Diamond-Mortensen-Pissarides search framework into a dynamic stochastic general equilibrium model with recursive preferences. The model produces a sizeable equity premium of 4.54% per annum with a low interest rate volatility of 1.34%. The equity premium is strongly countercyclical, and forecastable with labor market tightness, a pattern we confirm in the data. Intriguingly, search frictions, combined with a small labor surplus and large job destruction flows, give rise endogenously to rare disaster risks `a la Rietz (1988) and Barro (2006).
- Access to Capital, Investment, and the Financial Crisis
Kathleen M. Kahle and René M. Stulz
During the recent financial crisis, the impact of an impaired supply of bank credit on non-financial firms is minor compared to the impact of leverage-related financial fragility and a general flight to quality. Although banks were sharply affected by the credit crisis in the fall of 2007, the crisis did not negatively affect capital expenditures or net debt issuance of publicly held non-financial firms during its first year. This is true even for small and unrated firms, which are generally viewed as more dependent on bank financing. After September 2008, capital expenditures and net debt issuance fell sharply and firms hoarded cash. Capital expenditures did not fall more for more bank-dependent firms, but they decreased more for firms that were highly levered before the crisis, regardless of whether these firms had previously accessed public debt markets. In contrast to the response expected from a contraction in bank credit per se, the decrease in net equity issuance for small and unrated firms is greater than the decrease in net debt issuance during the crisis.
- Globalization, Country Governance, and Corporate Investment Decisions: An Analysis of Cross-Border Acquisitions
Jesse Ellis, Sara B. Moeller, Frederik P. Schlingemann and René M. Stulz
Using a sample of control cross-border acquisitions from 56 countries from 1990 to 2007, we find that acquirers from better governed countries gain more from such acquisitions and their gains are higher when targets are from worse governed countries. Other acquirer country characteristics, including the indices for laws protecting investors the earlier literature focuses on, are not consistently related to acquisition gains. However, globalization leaves a strong mark on acquisition returns. Acquisition returns are affected by global factors at least as much as they are by acquirer country factors. First, across all acquisitions, the acquirer’s industry and the year of the acquisition explain more of the stock-price reaction than the country of the acquirer. Second, for acquisitions of private firms or subsidiaries, acquirers gain more when acquisition returns are high for acquirers from other countries. A country’s governance and global mergers and acquisitions activity are important predictors of mergers and acquisitions activity in that country. Finally, we find strong evidence that at the firm-level better alignment of interests between insiders and minority shareholders is associated with greater acquirer returns and weaker evidence that this effect mitigates the adverse impact of poor country governance for the bidder.
- The Quiet Run of 2011: Money Market Funds and the European Debt Crisis
Sergey Chernenko and Adi Sunderam
We show that money market funds transmitted distress across firm during the European sovereign debt crisis. Using a novel data set of US money market fund holdings, we show that funds with large exposures to Eurozone banks suffered significant outflows between June and August 2011. These outflows have significant short-run spillover effects on other firms: non-Eurobank issuers that typically rely on these funds raise less financing in this period. The results are not driven by issuer riskiness or direct exposure to Europe: for the same issuer, money market funds with greater exposure to Eurozone banks decrease their holdings more than other funds. Our results illustrate that instabilities associated with money market funds persist despite recent changes to the regulations governing them..
- Equity-Holding Institutional Lenders: Do They Receive Better Terms?
Jongha Lim, Bernadette A. Minton and Mike Weisbach
The past decade has seen significant changes in the structure of the corporate lending market, with non-commercial bank institutional investors playing larger roles than they historically have played. In addition, non-commercial bank institutional lenders are often equity holders in their borrowing firms. In our sample of 11,137 tranches of institutional “leveraged” loans, 2,008 (18%) have a non-commercial bank institution that also owns at least 0.1% of the firm‟s equity. Such “dual holder” loan tranches have higher spreads than otherwise similar loan tranches without equity holder participation. The dual holder premium is present for both revolver and term loans, and exists within all non-investment grade credit rating classes. Contrary to risk-based explanations of this finding, dual holder tranches are priced with premiums relative to other tranches of the same loan package. Dual holding premiums are higher when the equity-holder‟s stake is larger, when the dual-holder‟s share in the loan is larger, and when the equity holder is a hedge fund or a private equity fund. These premiums likely represent additional compensation to dual holders for providing capital to firms when the firms are having difficulty raising capital otherwise.
- Financing-Motivated Acquisitions
Isil Erel, Yeejin Jang and Mike Weisbach
Managers often claim that an important source of value in acquisitions is the acquiring firm’s ability to finance investments for the target firm. This claim implies that targets are financially constrained prior to being acquired and that these constraints are eased following the acquisition. We evaluate these predictions on a sample of 5,187 European acquisitions occurring between 2001 and 2008, for which we can observe the target’s financial policies following the acquisition. We examine whether these post acquisition financial policies reflect improved access to capital. We find that the level of cash target firms hold, the sensitivity of cash to cash flow, and the sensitivity of investment to cash flow all decline significantly, while investment significantly increases following the acquisition. These effects are stronger in deals that are more likely to be associated with financing improvements. These findings are consistent with the view that acquisitions ease financial frictions in target firms.
- Do Loan Officers' Incentives Lead to Lax Lending Standards?
Sumit Agarwal and Itzhak Ben-David
To understand better the role of loan officers’ incentives in the origins of the financial crisis, we study a controlled field experiment conducted by a large bank. In the experiment, the incentive structure of a subset of small business loan officers was altered from fixed salary to volume-based pay. We use a diff-in-diff design to show that while the characteristics of loan applications did not change, incentive-paid loan officers book 19% loans with dollar amounts larger by 19%. We show that treated loan officers use their discretion more in the booking decision. Although loans booked by incentive-paid loan officers have better observable credit quality, they are 28% more likely to default. The increase in default is concentrated in loans that wouldn’t have been booked in the absence of commission-based compensation, and in loans with excessive dollar amount. Our results support the idea that the explosion in mortgage volume during the housing bubble and the deterioration of underwriting standards can be partly attributed to the incentives of loan officers.
- Predatory Lending and the Subprime Crisis
Sumit Agarwal, Gene Amromin, Izthak Ben-David, Souphala Chomsisengphet, and Douglas D. Evanoff
It is typically argued that predatory lending generated significant social costs and played a central role in creating the subprime crisis. However, there are few estimates of its true effect. We estimate the effect of predatory lending on the residential mortgage default rate using an anti-predatory program implemented in Chicago in 2006. Under the legislation, risky borrowers and risky mortgages triggered mandatory counseling. Following the legislation, market activity decreased by about 35%, where risky borrowers, risky products, and lenders who typically made riskier loans were most affected. Despite the sharp decline in market activity, 18- and 36-month default rates in the treated group exhibited a relative improvement of 12% and 7%, respectively. We estimate that predatory loans have a 6-7% higher default rate than nonpredatory loans. Our results suggest that predatory lending may have not been instrumental in precipitating the financial crisis as often believed.
- Does Aggregate Riskiness Predict Future Economic Downturns
Turan G. Bali, Nusret Cakici, and Fousseni Chabi-Yo
Aumann and Serrano (2008) and Foster and Hart (2009) introduce riskiness measures based on the physical return distribution of gambles. This paper proposes model-free options’ implied measures of riskiness based on the risk-neutral distribution of financial securities. In addition to introducing the forward-looking measures of riskiness, the paper investigates the significance of aggregate riskiness in predicting future economic downturns. The results indicate strong predictive power of aggregate riskiness even after controlling for the realized volatility of the U.S. equity market, the implied volatility of S&P 500 index options(VIX) proxying for financial market uncertainty, as well as the TED spread proxying for interbank credit risk and the perceived health of the banking system.
- Multinationals and the High Cash Holding Puzzle
Lee Pinkowitz, René M. Stulz, and Rohan Williamson
Defining as normal cash holdings the holdings a firm with the same characteristics would have had in the late 1990s, we find that the abnormal cash holdings of U.S. firms after the crisis represent on average 1.86% of assets. While U.S. firms held less cash than comparable foreign firms in the late 1990s, by 2010 they hold more. However, only U.S. multinational firms experience an increase in abnormal cash holdings during the 2000s. U.S. multinational firms had cash holdings similar to those of purely domestic firms in the late 1990s, but they hold over 3% more assets in cash than comparable purely domestic firms after the crisis. Further, U.S. multinationals increased their cash holdings since the late 1990s relative to foreign multinationals by roughly the same percentage as they increased their cash holdings relative to U.S. domestic firms. A detailed analysis shows that the increase in cash holdings of multinational firms cannot be explained by the tax treatment of profit repatriations, that it is intrinsically linked to their R&D intensity, and that firms that become multinational do not increase their abnormal cash holdings after they become multinational. There is no evidence that poor investment opportunities, regulation, or poor governance can explain the abnormal cash holdings of U.S. firms after the crisis.
- Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities?
Craig B. Merrill, Taylor D. Nadauld, René M. Stulz, and Shane M. Sherlund
Much attention has been paid to the large decreases in value of non-agency residential mortgage-backed securities (RMBS) during the financial crisis. Many observers have argued that the fall in prices was partly driven by decreased liquidity and fire sales. We investigate whether capital requirements and accounting rules at financial institutions contributed to the selling of RMBS at fire sale prices. For financial institutions subject to credit-sensitive capital requirements, capital requirements increase as an asset’s credit becomes impaired. When accounting rules require such an asset’s value to be marked-to-market and the fair value loss to be recognized in earnings, a capital-constrained firm can improve its capital position by selling the credit-impaired asset even if it has to accept a liquidity discount to do so. Using a sample of 5,014 repeat transactions of non-agency RMBS by insurance companies from 2006 to 2009, we show that insurance companies that became more capital-constrained because of operating losses (uncorrelated with RMBS credit quality) and also recognized fair value losses sold comparable RMBS at much lower prices than other insurance companies during the crisis.
- Financial globalization and the rise of IPOs outside the U.S.
Craig Doidge, G. Andrew Karolyi, and René M. Stulz
From 1990 to 2011, the share of the world’s initial public offering (IPO) activity outside the U.S. increased with financial globalization. In the 1990s, when financial globalization was lower, there were 0.37 U.S. IPOs for each non-U.S. IPO compared to only 0.12 in the 2000s. Consistent with theoretical predictions, we find that greater financial globalization is associated with a decrease in the importance of national institutions as determinants of a country’s domestic IPO activity. One reason for this decrease is that greater financial globalization makes it easier for firms going public to access foreign capital markets and use foreign institutions. As a result, a large part of the increase in non-U.S. IPO activity occurred through an increase in global IPOs by both small and large firms. U.S. IPO activity did not benefit from increased financial globalization and, consequently, the U.S. share of world IPOs fell. It did so most dramatically for small-firm IPOs, for which its market share fell from 31% in the 1990s to 5% in the 2000s. Our evidence highlights the role of financial globalization in explaining the drop in the U.S. share but it also suggests that some of the drop is due to U.S.-specific factors.
- Long Run Productivity Risk and Aggregate Investment
Jack Favilukis and Xiaoji Lin
We study the implications of long-run risk type shocks - shocks to the growth rate of productivity - for aggregate investment in a DSGE model. Our model offers an alternative to microfrictions explanation of aggregate investment non-linearities, in particular the heteroscedasticity of investment rate. Additionally, consistent with the data, these shocks imply that investment rate is history dependent (rising through an expansion), investment rate growth is positively autocorrelated, and is positively correlated with output growth at various leads and lags. A standard model with shocks to the level of productivity either predicts the opposite or fails to quantitatively capture these features in the data.
- Syndicated Loan Spreads and the Composition of the Syndicate
Jongha Lim, Bernadette A. Minton, and Michael S. Weisbach
The past decade has seen significant changes in the structure of the corporate lending market, with non-bank institutional investors playing larger roles than they historically have played. These non-bank institutional lenders typically have higher required rates of return than banks, but invest in the same loan facilities. We hypothesize that non-bank institutional lenders invest in loan facilities that would not otherwise be filled by banks, so that the arranger has to offer a higher spread to attract the non-bank institution. In a sample of 20,031 leveraged loan facilities originated between 1997 and 2007, we find that, loan facilities including a non-bank institution in their syndicates have higher spreads than otherwise identical bank-only facilities. Contrary to risk-based explanations of this finding, non-bank facilities are priced with premiums relative to bank-only facilities of the same loan package. These premiums for non-bank facilities are substantially larger when a hedge or private equity fund is one of the syndicate members. Consistent with the notion that firms are willing to pay spread premiums when loan facilities are particularly important to the firm, we find that firms spend the capital raised by loan facilities priced at a premium faster than other loan facilities, especially when the premium is associated with a non-bank institutional investor.
- Wage Rigidity: A Solution to Several Asset Pricing Puzzles
Jack Favilukis and Xiaoji Lin
In standard models wages are too volatile and returns too smooth. We make wages sticky through infrequent resetting, resulting in both (i) smoother wages and (ii) volatile returns. Furthermore, the model produces other puzzling features of financial data: (iii) high Sharpe Ratios, (iv) low and smooth interest rates, (v) time-varying equity volatility and premium, and (vi) a value premium. In standard models, highly pro-cyclical and volatile wages are a hedge. The residual - profit - becomes unrealistically smooth, as do returns. Smoother wages act like operating leverage, making profits more risky. Bad times and unproductive firms are especially risky because committed wage payments are high relative to output.
- Labor Hiring, Investment, and Stock Return Predictability in the Cross Section
Santiago Bazdresch, Frederico Belo, and Xiaoji Lin
We study the impact of labor market frictions on asset prices in the cross section of US publicly traded firms. On average, firms with low hiring rates have higher future stock returns than firms with high hiring rates, a difference of 5.2% per annum. Interpreting a hiring decision as analogous to an investment decision, we propose a dynamic neoclassical investment-based model with labor and capital adjustment costs to explain this hiring return spread. Firms that are hiring relatively more have lower macroeconomic risk which explains why high hiring rates predicts low stock returns. The model matches the observed levels of the hiring return spread, key properties of the firm-level hiring and investment rates, and other empirical regularities. Our analysis suggest that labor market frictions can have a significant impact on asset prices in financial markets.
- Reverse Mergers: The Chinese Experiences
Jan Jindra, Torben Voetmann,and Ralph Walking
Chinese reverse mergers (CRMs) claim to provide easy entry to the U.S. and international markets. Recently, a large number of Chinese firms using reverse merger transactions have been listed on the U.S. stock exchanges. We review the historical use and mechanics of these reverse mergers, and contrast them with initial public offerings (IPOs). We also explore settlements of securities class action lawsuits involving Chinese firms. Our analysis shows that larger, more reputable Chinese firms are significantly less likely to pursue reverse mergers. We also find that CRM firms are more likely to be subject to class action litigation in the U.S and that the settlement amounts are smaller for CRM firms than for Chinese IPO firms. Our analysis further indicates that CRM firms significantly underperform the Chinese IPO firms. Thus, the evidence suggests that CRMs are not substitutes for Chinese IPOs.
- Does Wage Rigidly Make Firms Riskier? Evidence From Long-Horizon Return Predictability.
Jack Favilukis and Xiaoji Lin
We explore the relationship between sticky wages and risk. Like operating leverage, sticky wages are a source of risk for the firm. Firms, industries, or times with especially high or rigid wages are especially risky. If wages are sticky then wage growth should negatively forecast future stock returns because falling wages are associated with even bigger falls in output, and increases in operating leverage. Indeed, we find this to be the case in aggregate data, and in industry data. Furthermore, we find that industries with higher wage rigidity have a more negative relationship between wages and returns.
- Policy Intervention in Debt Renegotiation: Evidence from the Home Affordable Modification Program
Sumit Agarwala, Gene Amromina, Itzhak Ben-David,Souphala Chomsisengphetc, Tomasz Piskorskid, and Amit Serue
The main rationale for policy intervention in debt renegotiation is to enhance such activity when foreclosures are perceived to be inefficiently high. We examine the ability of the government to influence debt renegotiation by empirically evaluating the effects of the 2009 Home Affordable Modification Program that provided intermediaries (servicers) with sizeable financial incentives to renegotiate mortgages. A difference-in-difference strategy that exploits variation in program eligibility criteria reveals that the program generated an increase in the intensity of renegotiations while adversely affecting effectiveness of renegotiations performed outside the program. Renegotiations induced by the program resulted in a modest reduction in rate of foreclosures but did not alter the rate of house price decline, durable consumption, or employment in regions with higher exposure to the program. The overall impact of the program will be substantially limited since it will induce renegotiations that will reach just one-third of its targeted 3 to 4 million indebted households. This shortfall is in large part due to low renegotiation intensity of a few large servicers that responded at half the rate than others. The muted response of these servicers cannot be accounted by differences in contract, borrower, or regional characteristics of mortgages across servicers. Instead,their low renegotiation activity—which is also observed before the program—reflects servicer specific factors that appear to be related to their preexisting organizational capabilities. Our findings reveal that the ability of government to quickly induce changes in behavior of large intermediaries through financial incentives is quite limited, underscoring significant barriers to the effectiveness of such polices.
- Digesting Anomalies: An Investment Approach
Kewei Hou, Chen Xue, and Lu Zhang
Motivated from investment-based asset pricing, we propose a new factor model consisting of the market factor, a size factor, an investment factor, and a return on equity factor. The new factor model outperforms the Carhart four-factor model in pricing portfolios formed on earnings surprise, idiosyncratic volatility, financial distress, net stock issues, composite issuance, as wellas on investment and return on equity. The new model performs similarly as the Carhart model in pricing portfolios formed on size and momentum, abnormal corporate investment, as well as on size and book-to-market, but underperforms in pricing the total accrual deciles. The new model’s performance, combined with its clear economic intuition, suggests that it can be used as a new workhorse model for academic research and investment management practice..
- Endogenous technological progress and the cross section of stock returns
I study the cross-sectional variation of stock returns and technological progress using a dynamic equilibrium model with production. Technological progress is endogenously driven by research and development (R&D) investment and is composed of two parts. One part is devoted to product innovation; the other, to increasing the productivity of physical investment. The latter is embodied in new tangible capital. The model breaks the symmetry assumed in standard models between tangible and intangible capital, in which the accumulation processes of tangible and intangible capital stock do not aect each other. Qualitatively and, in many cases, quantitatively,the model explains well-documented empirical regularities.
- The Inventory Growth Spread
Frederico Belo and Xiaoji Lin
Previous studies show that firms with low inventory growth outperform firms with high inventory growth in the cross-section of publicly traded firms. In addition, inventory investment is volatile and procyclical, and inventory-to-sales is persistent and countercyclical. We embed an inventory holding motive into the investment-based asset pricing framework by modeling inventory as a factor of production with convex and non-convex adjustment costs. The augmented model simultaneously matches the large inventory growth spread in the data, as well as the time-series properties of the firm level capital investment, inventory investment, and inventory-to-sales. Our conditional single-factor model also implies that traditional unconditional factor models such as the CAPM should fail to explain the inventory growth spread, although not with the same large pricing errors observed in the data.
- Probability Weighting of Rare Events and Currency Returns
Fousseni Chabi-Yo and Zhaogang Song
We show that the probability weighting of rare events, accounting for investors’ attitudes toward extreme downside losses versus upside gains in non-expected utility models, provides a unified explanation for both time-series and cross-sectional variations of currency portfolio returns. We use a simple structural model to show the link between the probability weighting function and pricing kernel, and then estimate them by non-parametric methods using currency options data from 1996 to 2012. The estimates show that a domestic investor over-weights the likelihood of a substantial depreciation or appreciation of foreign currencies, consistent with experimental studies. A global probability weighting measure of left (right) tail events is highly significant in positively (negatively) predicting future currency returns over time series at both individual and portfolios levels. Furthermore, asset pricing tests show that differences in exposure to our global tail weighting measures, of high versus low interest rate currencies and of high versus low past return currencies, can explain the cross-sectional variation in average excess returns across both carry and momentum portfolios. Moreover, our global tail weighting measures remain significant after controlling for existing currency risk factors in the literature, and frequently
- Labor Hetergeneity and Asset Prices: the Importance of Skilled Labor
Frederico Belo and Xiaoji Lin
We show that heterogeneity in the composition of the labor force affects asset prices in financial markets in important ways. Theoretically, we combine a standard model of labor heterogeneity (Acemoglu, 2002) with a standard neoclassical q-theory model with labor adjustment costs. We then show that the negative expected return-hiring rate relation documented in previous studies is steeper in industries with higher labor adjustment costs. Using the overall industry level of labor skill as a proxy for the industry specific size of labor adjustment costs, we provide empirical support for this prediction. The negative expected return-hiring rate relation is twice as large among industries with higher labor skills than in industries with lower labor skills. In addition, we uncover a novel unconditional labor skill return spread. Firms in industries with more skilled labor have on average higher stock returns than firms in industries with low skilled labor, but this difference is only large across small firms. According to this result, firms with higher labor skills labor tend to be more risky because skilled labor is more costly to adjust, which in turn affects the firm’s sensitivity to aggregate shocks in the economy.
- Does Target CEO Retention in Aquisition Involving Private Equity Acquirers Harm Target Shareholders
Leonce L. Bargeron, Frederik P. Schlingemann, René M. Stulz, and Chad J. Zutter
While there is widespread concern that target CEO retention by the acquirer harms target shareholders when the acquirer is a private equity firm, CEO retention can also be valuable to private equity acquirers, and hence potentially benefit shareholders. We find that CEO retention does not harm target shareholders when the acquirer is a private equity firm. In fact, we show that, in acquisitions by private equity firms, better performing CEOs are more likely to be retained and target shareholders gain an additional 10% to 23% of pre-acquisition firm value when the CEO is retained compared to when the CEO is not retained. In contrast, shareholders of targets acquired by operating companies do not benefit from CEO retention. Finally, we find no evidence that the target’s value is artificially depressed ahead of a private equity acquisition where the CEO is retained.
- Why Did Holdings of Highly-Rated Securitization Tranches Differ So Much Across Banks?
Isil Erel, Taylor Nadauld and René M. Stulz
We provide estimates of holdings of highly-rated securitization tranches of American bank holding companies ahead of the credit crisis and evaluate hypotheses that have been advanced to explain these holdings. Our broadest estimates include CDOs as well as holdings in off-balance-sheet conduits. While holdings exceeded Tier 1 capital for some large banks, they were economically trivial for the typical U.S. bank. The banks with high holdings were not riskier before the crisis using conventional measures, but their performance was poorer during the crisis. We find that holdings of highly-rated tranches are explained by a bank’s securitization activity. Theories of highly-rated tranches that are unrelated to a bank’s securitization activity, such as “bad incentives,” “bad governance,” or “bad risk management” theories, have no support in the data.
- Have We Solved The Idiosyncratic Volatility Puzzle?
Kewei Hou and Roger K. Loh
We propose a simple methodology to evaluate a large number of potential explanations for the negative relation between idiosyncratic volatility and subsequent stock returns (the idiosyncratic volatility puzzle). We find that surprisingly many existing explanations explain less than 10% of the puzzle. On the other hand, explanations based on investors’ lottery preferences, short-term return reversal, and earnings shocks show greater promise in explaining the puzzle. Together they account for 60-80% of the negative idiosyncratic volatility-return relation. Our methodology can be applied to evaluate competing explanations for a broad range of topics in asset pricing and corporate finance.
- Collateral Valuation and Borrower Financial Constraints: Evidence from the Residential Real-Estate Market
Sumit Agarwal, Itzhak Ben-David and Vincent Yao
Financially-constrained borrowers have the incentive to influence the appraisal process in order to increase borrowing or reduce the interest rate. The average valuation bias for residential refinance transactions is above 5%. The bias is larger for highly leveraged transactions, and for transactions mediated through a broker, especially where competition is high. Mortgages with inflated valuations default more often; however, lenders partially account for the valuation bias through pricing.
- Globalization, Governance, and the Returns to Cross-Border Acquisitions
Jesse Ellis, Sara B. Moeller, Frederik P. Schlingemann,and René M. Stulz
Using a sample of control cross-border acquisitions from 61 countries from 1990 to 2007, we find that acquirers from countries with better governance gain more from such acquisitions and their gains are higher when targets are from countries with worse governance. Other acquirer country characteristics are not consistently related to acquisition gains. For instance, the anti-self-dealing index of the acquirer has opposite associations with acquirer returns depending on whether the acquisition of a public firm is paid for with cash or equity. Strikingly, global effects in acquisition returns are at least as important as acquirer country effects. First, the acquirer’s industry and the year of the acquisition explain more of the stock-price reaction than the country of the acquirer. Second, for acquisitions of private firms or subsidiaries, acquirers gain more when acquisition returns are high for acquirers from other countries. We find strong evidence that better alignment of interests between insiders and minority shareholders is associated with greater acquirer returns and weaker evidence that this effect mitigates the adverse impact of poor country governance.
- The Role of Securitization in Mortgage Renegotiation
Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet, Douglas D. Evanoff
We study the effects of securitization on post-default renegotiation of residential mortgages over the current financial crisis. Unlike prior studies, we employ unique data that directly observes lender renegotiation actions and covers more than 60% of US mortgage market. Exploiting within-servicer variation in this data, we find that bank-held loans are 26% to 36% more likely to be renegotiated than comparable securitized mortgages (4.2 to 5.7% in absolute terms). Also, modifications of bank-held loans are more efficient: conditional on a modification bank-held loans have lower post-modification default rate by 9% (3.5% in absolute terms). Our findings support the view that frictions introduced by securitization create a significant challenge to effective renegotiation of residential loans.
- Financial Policies, Investment, and the Financial Crisis: Impaired Credit Channel or Diminished Demand for Capital?
Kathleen M. Kahle and René M. Stulz
Though much of the narrative of the financial crisis has focused on the impact of a bank credit supply shock, we show that such a shock cannot explain important features of the financial and investment policies of industrial firms. These features are consistent with a dominant role for the increase in risk and the reduction in demand for goods that occurred during the crisis. The net equity issuance of small firms and unrated firms is abnormally low throughout the crisis, whereas an impaired credit supply by itself would have encouraged these firms to increase their net equity issuance. After September 2008, firms increase their cash holdings rather than use them to mitigate the impact of the credit supply shock. Firms that are more bank-dependent before the crisis do not reduce their capital expenditures more than other firms during the crisis. Finally, the evidence is strongly supportive of theories that emphasize the importance of collateral and corporate net worth in financing and investment policies, as firms with stronger balance sheets reduce capital expenditures less after September 2008.
- Career Concerns and the Busy Life of the Young CEO
Xiaoyang Li, Angie Low, and Anil K. Makhija
Using U.S. plant-level data for firms across a broad spectrum of industries, we compare how career concerns affect the real investment decisions of younger and older CEOs. In contrast to prior research which has examined some specialized labor markets, we find that younger CEOs undertake more active, bolder investment activities, consistent with an attempt on their part to signal confidence and superior abilities. They are more likely to enter new lines of business, as well as exit from existing lines of business. They prefer growth through acquisitions, while older CEOs prefer to build new plants. This busier investment style of the younger CEOs appears not to hurt firm efficiency since younger CEOs are associated with equally high plant-level efficiency compared to older CEOs.
- Do Hedge Funds Manipulate Stock Prices?
revision: June, 2011
Itzhak Ben-David, Francesco Franzoni, Augustin Landier and Rabih Moussawi
We find evidence that hedge funds significantly manipulate stock prices on critical reporting dates. We document that stocks held by hedge funds experience higher returns on the last day of the quarter, followed by a reversal the next day. For example, the stocks in the top quartile of hedge fund holdings exhibit abnormal returns of 30 basis points on the last day of the quarter and a reversal of 25 basis points on the following day. Using intraday data, we show that a significant part of the return is earned during the last minutes of the last day of the quarter, at an increasing rate towards the closing bell. This evidence is consistent with hedge funds’ incentives to inflate their monthly performance by buying the stocks they hold in their portfolios. Evidence of manipulation is stronger for funds that have higher incentives for improving their ranking relative to their peers and a lower cost of doing so. Such dislocations of market prices constitute a negative externality for agents using end-of-month market prices for benchmarking,contracting, or trading purposes.
- Why are U.S. Stocks More Volatile?
Sohnke M. Bartram, Gregory Brown and René M. Stulz
From 1991 to 2006, U.S. stocks are more volatile than stocks of similar foreign firms. A firm’s stock return volatility in a country can be higher than the stock return volatility of a similar firm in another country for reasons that contribute positively (good volatility) or negatively (bad volatility) to shareholder wealth and economic growth. We find that the volatility of U.S. firms is higher mostly because of good volatility. Specifically, firm stock volatility is higher in the U.S. because it increases with investor protection, stock market development, research intensity at the country level, and firm-level investment in R&D. These are all factors that are related to better growth opportunities for firms and better ability to take advantage of these opportunities. Though it is often argued that better disclosure is associated with greater volatility as more information is impounded in stock prices, we find instead that greater disclosure is associated with lower stock volatility.
- Why Do Some CEOs Work for a One-Dollar Salary?
Gilberto Loureiro, Anil K. Makhija and Dan Zhang
We find evidence consistent with the view that $1 CEO salaries are a ruse hiding the rent seeking pursuits of CEOs adopting these pay schemes. CEOs with these arrangements, despite the drastic cuts in salary, have total compensation that is similar to that at other firms, making up lost salary through not-so-visible forms of equity-based compensation. There is greater likelihood of a $1 CEO salary when the CEO is rich, overconfident, owns a sizeable ownership stake, and institutional ownership is relatively low. These powerful CEOs are in a position to draw significant undue private benefits, and need not replace certain salary dollars with risky future income. However, we find that they are at risk of engendering public outrage over their private benefits, against which the $1 salary constitutes valuable deflection of attention. Shareholders of firms with $1 CEO salaries do not fare well in the aftermath of these adoptions. Thus, rather than being the sacrificial acts they are projected to be, our findings suggest that adoptions of $1 CEO salaries are opportunistic behavior of the wealthier, more overconfident, influential CEOs. Overall, these findings support the Managerial Power Hypothesis in the literature, which claims that CEOs employ camouflage in compensation schemes to avoid public outrage over excessive private benefits.
- The U.S. Left Behind: The Rise of IPO Activity Around the World
Craig Doidge, G. Andrew Karolyi and René M. Stulz
During the past two decades, there has been a dramatic change in IPO activity around the world. Though vibrant IPO activity, attributed to better institutions and governance, used to be a strength of the U.S., it no longer is. IPO activity in the U.S. has fallen compared to the rest of the world and U.S. firms go public less than expected based on the economic importance of the U.S. In the early 1990s, the declining U.S. IPO share was due to the extraordinary growth of IPOs in foreign countries; in the 2000s, however, it is due to higher IPO activity abroad combined with lower IPO activity in the U.S. Global IPOs, which are IPOs in which some of the proceeds are raised outside the firm’s home country, play a critical role in the increase in IPO activity outside the U.S. The quality of a country’s institutions is positively related to its domestic IPO activity and negatively related to its global IPO activity. However, home country institutions are more important in explaining IPO activity in the 1990s than in the 2000s. The evidence is consistent with the view that access to global markets helps firms overcome the obstacles of poor institutions. Finally, we show that the dynamics of global IPO activity and country-level IPO activity are strongly affected by global factors.
- Macroeconomic Conditions and Capital Raising
revision: July 2011
Isil Erel, Brandon Julio, Woojin Kim, and Michael S. Weisbach
Do macroeconomic conditions affect firms’ abilities to raise capital? If so, how do they affect the manner in which the capital is raised? We address these questions using a large sample of publicly-traded debt issues, seasoned equity offers, bank loans and private placements of equity and debt. Our results suggest that a borrower’s credit quality significantly affects its ability to raise capital during macroeconomic downturns. For noninvestment-grade borrowers, capital raising tends to be procyclical while for investment-grade borrowers, it is countercyclical. Moreover, proceeds raised by investment grade firms are more likely to be held in cash in recessions than in expansions. Poor market conditions also affect the structure of securities offered, shifting them towards shorter maturities and more security. Overall, our results suggest that macroeconomic conditions influence the securities that firms issue to raise capital, the way in which these securities are structured and indeed firms’ ability to raise capital at all.
- This Time Is the Same: Using Bank Performance in 1998 to Explain Bank Performance During the Recent Financial Crisis
Rüdiger Fahlenbrach, Robert Prilmeier, and René M. Stulz
We investigate whether a bank’s performance during the 1998 crisis, which was viewed at the time as the most dramatic crisis since the Great Depression, predicts its performance during the recent financial crisis. One hypothesis is that a bank that has an especially poor experience in a crisis learns and adapts, so that it performs better in the next crisis. Another hypothesis is that a bank’s poor experience in a crisis is tied to aspects of its business model that are persistent, so that its past performance during one crisis forecasts poor performance during another crisis. We show that banks that performed worse during the 1998 crisis did so as well during the recent financial crisis. This effect is economically important. In particular, it is economically as important as the leverage of banks before the start of the crisis. The result cannot be attributed to banks having the same chief executive in both crises. Banks that relied more on short-term funding, had more leverage, and grew more are more likely to be banks that performed poorly in both crises.
- Variance Bounds on the Permanent and Transitory Components of Stochastic Discount Factors
Gurdip Bakshi and Fousseni Chabi-Yo
When the transitory component of the stochastic discount factors (SDFs) prices the long-term bond, and the permanent component prices other assets, we develop lower bounds on the variance of the permanent component and the transitory component, and on the variance of the ratio of the permanent to the transitory components of SDFs. A salient feature of our bounds is that they incorporate information from average returns and the variance-covariance matrix of returns corresponding to a generic set of assets. Relevant to economic modeling, we examine the tightness of our bounds relative to Alvarez and Jermann (2005, Econometrica). Exactly solved eigenfunction problems are then used to study the empirical attributes of asset pricing models that incorporate long-run risk, external habit persistence, and rare disasters. Specific quantitative implications are developed for the variance of the permanent and the transitory components,the return behavior of the long-term (infinite-maturity) bond, and the comovement between the transitoryand the permanent components of SDFs.
- Liquidity Shocks and Hedge Fund Contagion
Nicole M. Boyson, Christof W. Stahel, and René M. Stulz
In Boyson, Stahel, and Stulz (2010), we investigate whether hedge funds experience worst return contagion – that is, correlations in extremely poor returns that are over and above those expected from economic fundamentals. We find strong evidence of contagion among hedge funds using eight separate style indices for the period from January 1990 to October 2008: the probability of a worst return in a particular index is increasing in the number of other indices that also have extremely poor returns. We then show that large adverse shocks to asset and funding liquidity strongly increase the likelihood of this contagion. In this paper, we further investigate contagion between hedge funds and main markets. We uncover strong evidence of contagion between hedge funds and small-cap, mid-cap and emerging market equity indices, high yield bonds, emerging market bonds, and the Australian Dollar. Finally, we show that this contagion between hedge funds and markets is also significantly linked to liquidity shocks, especially for small-cap domestic equities, Asian equities, high yield bonds, and the Australian Dollar.
- Are Investors Really Reluctant to Realize their Losses? Trading Responses to Past Returns and the Disposition Effect
revision: December 2011
Itzhak Ben-David and David Hirshleifer
We examine how investor preferences and beliefs affect trading in relation to past gains and losses. The probability of selling as a function of profit is V-shaped; for short prior holding periods, investors are much more likely to sell big losers than small ones. There is little evidence of an upward jump in selling probability at zero profits. These findings provide no clear indication that realization preference helps explain investor trading behavior. Furthermore, the disposition effect is not primarily driven by a direct preference for realizing winners rather than losers. Trading based on beliefs can potentially explain these findings.
- Do Private Equity Fund Managers Earn their Fees? Compensation, Ownership, and Cash Flow Performance
David T. Robinson and Berk A. Sensoy
Using a new database of the compensation terms, ownership structures (capital commitments), and quarterly cash flows for a large sample of buyout and venture cap- ital private equity funds from 1984-2010, we investigate the determinants of manager compensation and ownership and how these contract terms relate to the funds’ cash flow performance. Market conditions during fundraising are an important driver of compensation, as pay rises and shifts to fixed components during fundraising booms. We find no evidence that higher compensation or lower managerial ownership are asso- ciated with worse net-of-fee performance, in stark contrast to other asset management settings. Instead, compensation is largely unrelated to net cash flow performance. Our evidence is most consistent with an equilibrium in which compensation terms reflect agency concerns and the productivity of manager skills, and in which managers with higher compensation earn back their pay by delivering higher gross performance.
- Covariances versus Characteristics in General Equilibrium
Xiaoji Lin and Lu Zhang
We question a deep-ingrained doctrine in asset pricing: If an empirical characteristic-return relation is consistent with investor “rationality,” the relation must be “explained” by a risk factor model. The investment approach changes the big picture of asset pricing. Factors formed on characteristics are not necessarily risk factors: Characteristics-based factor models are linear approximations of firm-level investment returns. That characteristics dominate covariances in horse races does not necessarily mean mispricing: Measurement errors in covariances are more likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing.
- Why Did U.S. Banks Invest in Highly-Rated Securitization Tranches?
Isil Erel, Taylor Nadauld and René M. Stulz
We estimate holdings of highly-rated tranches of mortgage securitizations of American deposit-taking banks ahead of the credit crisis and evaluate hypotheses that have been advanced to explain these holdings. We find that holdings of highly-rated tranches were economically trivial for the typical bank, but banks with greater holdings performed more poorly during the crisis. Though univariate comparisons show that banks with large trading books had greater holdings, the holdings of highly-rated tranches are not higher for banks with large trading books in regressions that control for bank size. The ratio of highly-rated tranches holdings to assets increases with bank assets, but not for banks with more than $50 billion of assets. This evidence is inconsistent with explanations for holdings of highly-rated tranches that emphasize the incentives of banks deemed “too-big-to-fail”. Further, the evidence does not provide support for “bad incentives” theories of holdings of highly-rated tranches. We find, however, that banks active in securitization held more highly-rated tranches. Such a result can be consistent with regulatory arbitrage as well as with securitizing banks holding highly-rated tranches to convince investors of the quality of these securities. Our evidence supports the latter hypothesis.
- High Leverage and Willingness to Pay:Evidence from the Residential Housing Market
In pursuit of understanding the mechanism that relates the expansion in credit to the increase in real-estate prices during the real-estate bubble, I explore transaction-level data for 1994-2008. I document a strong correlation between borrowing at high leverage (>95% loan to value) and paying the full listing price or above. Homebuyers in these transactions pay prices that are higher than market prices by 3.4% ($5,700 on average) and they are 22.7% more likely to default on their mortgages, relative to other highly leveraged borrowers. The correlation between leverage and paying high prices is stronger beyond what a mechanical relation predicts: there is a discontinuity in the average leverage around the full listing price. high past price growth (indicative of buyer optimism). The study highlights the importance of buyer sophistication, financial constraints, and beliefs in determining prices and leverage.
- Corporate Acquisitions, Diversification, and the Firm’s Lifecycle
Asli M. Arikan and René M. Stulz
Lifecycle theories of mergers and diversification predict that firms make acquisitions and diversify when their internal growth opportunities become exhausted. Free cash flow theories make similar predictions. In contrast to these theories, we find that the acquisition rate of firms (defined as the number of acquisitions in an IPO cohort-year divided by the number of firms in that cohort-year) follows a u-shape through their lifecycle as public firms, with young and mature firms being equally acquisitive but more so than middle-aged firms. Firms that go public during the merger/IPO wave of the 1990s are significantly more acquisitive early in their public life than firms that go public at other times. Young public firms have a lower acquisition rate of public firms than mature firms, but the opposite is true for acquisitions of private firms and subsidiaries. Strikingly, firms diversify early in their life and there is a 41% chance that a firm’s first acquisition is a diversifying acquisition. The stock market reacts more favorably to acquisitions by young firms than to acquisitions by mature firms except for acquisitions of public firms paid for with stock. There is no evidence that the market reacts more adversely to diversifying acquisitions by young firms than to other acquisitions.
- What do Boards Really Do? Evidence from Minutes of Board Meetings
revision dates: March 2012, January 2012, November, 2011
Miriam Schwartz-Ziv and Michael S. Weisbach
We analyze a unique database from a sample of real-world boardrooms – minutes of board meetings and board-committee meetings of eleven business companies for which the Israeli government holds a substantial equity interest. We use these data to evaluate the underlying assumptions and predictions of models of boards of directors. These models generally fall into two categories: “managerial models” that assume boards play a direct role in managing the firm, and “supervisory models” that assume that boards monitor top management but do not make business decisions themselves. Consistent with the supervisory models, our minutes-based data suggest that boards spend most of their time monitoring management: approximately two-thirds of the issues boards discussed were of a supervisory nature, they were presented with only a single option in 99% of the issues discussed, and they disagreed with the CEO only 2.5% of the time. Nevertheless, at times boards do play a managerial role: Boards requested to receive further information or an update for 8% of the issues discussed, and they took an initiative with respect to 8.1% of them. In 63% of the meetings, boards took at least one of these actions or did not vote in line with the CEO. Taken together our results suggest that boards can be characterized as active monitors.
- ETFs, Arbitrage, and Shock Propagation
Itzhak Ben-David, Francesco Franzoni and Rabih Moussawi
We study whether Exchange Traded Funds (ETFs)—an asset class that has gained paramount importance in recent years—can amplify the exposure of the securities in their baskets to liquidity shocks. As a preliminary step, we show that ETFs are catalysts for high-turnover investors who are, arguably, an important source of liquidity shocks. Then, we show that arbitrage trades propagate the liquidity shocks from ETF prices to the underlying securities. Supporting the claim that ETFs add a layer of shocks to their basket securities, the presence of ETFs is associated with an increase in the volatility of the stocks they hold. Finally, as a case study in shock propagation through ETF arbitrage, we provide results suggesting that ETFs facilitated shock transmission between the futures market and the equity market during the Flash Crash on May 6, 2010. Overall, our results highlight the potential role of financial innovation in increasing non-fundamental volatility and to propagate shocks across markets, especially in association with high-frequency trading..
- Profitability Shocks and the Size Effect in the Cross-Section of Expected Stock Returns
Kewei Hou and Mathijs A. van Dijk
Recent studies report that the size effect in the cross-section of U.S. stock returns has disappeared after the early 1980s. We examine whether the disappearance of the size effect in realized returns can be attributed to unexpected shocks to the profitability of small and big firms. We show that small firms experience large negative profitability shocks after the early 1980s, while big firms experience large positive shocks. As a result, realized returns of small and big firms over this period differ substantially from expected returns. After adjusting for the price impact of profitability shocks, we find that there still is a robust size effect in expected returns. Our results suggest that in-sample cash flow shocks can significantly affect inferences about predictability in the cross-section of stock returns.
- Hedge Fund Stock Trading in the Financial Crisis of 2007-2009 (revisied 9/11),(revised 5/11)
Itzhak Ben-David, Francesco Franzoni and Rabih Moussawi
Hedge funds significantly reduced their equity holdings during the recent financial crisis. In 2008Q3-Q4,hedge funds sold about 29% of their aggregate portfolio. Redemptions and margin calls were the primary drivers of selloffs. Consistent with forced deleveraging, the selloffs took place in volatile and liquid stocks. In comparison, redemptions and stock sales for mutual funds were not as severe. We show that hedge fund investors withdraw capital three times as intensely as mutual fund investors do in response to poor returns. We relate this stronger sensitivity to losses to share liquidity restrictions and institutional ownership in hedge funds.
- Pay for Performance from Future Fund Flows: The Case of Private Equity (revised 09/10)
Ji-Woong Chung, Berk A. Sensoy, Léa H. Stern and Michael S. Weisbach
Lifetime incomes of private equity general partners are affected by their current funds' performance through both carried interest profit sharing provisions, and also by the effect of the current fund's performance on general partners' abilities to raise capital for future funds. We present a learning-based framework for estimating the market-based pay for performance arising from future fundraising. For the typical first-time private equity fund, we estimate that implicit pay for performance from expected future fundraising is approximately the same order of magnitude as the explicit pay for performance general partners receive from carried interest in their current fund, implying that the performance-sensitive component of general partner revenue is about twice as large as commonly discussed. Consistent with the learning framework, we find that implicit pay for performance is stronger when managerial abilities are more scalable and weaker when current performance contains less new information about ability. Specifically, implicit pay for performance is stronger for buyout funds compared to venture capital funds, and declines in the sequence of a partnership's funds. Our framework can be adapted to estimate implicit pay for performance in other asset management settings in which future fund flows and compensation depend on current performance.
- The Implied Cost of Capital:A New Approach (revised 12/11)
Kewei Hou, Mathijs A. van Dijk and Yinglei Zhang
We use earnings forecasts from a cross-sectional model to proxy for cash flow expectations and estimate the implied cost of capital (ICC) for a large sample of firms over 1968-2008. The earnings forecasts generated by the cross-sectional model are superior to analysts’ forecasts in terms of coverage, forecast bias, and earnings response coefficient. Moreover, the model-based ICC is a more reliable proxy for expected returns than the ICC based on analysts’ forecasts. We present evidence on the cross-sectional relation between firm-level characteristics and ex ante expected returns using the model-based ICC.
- The Credit Crisis Around the Globe: Why Did Some Banks Perform Better?
Andrea Beltratti and René M. Stulz
Though overall bank performance from July 2007 to December 2008 was the worst since the Great Depression, there is significant variation in the cross-section of stock returns of large banks across the world during that period. We use this variation to evaluate the importance of factors that have been put forth as having contributed to the poor performance of banks during the credit crisis. Our evidence is inconsistent with the argument that poor governance of banks made the crisis worse, but it is supportive of theories that emphasize the fragility of banks financed with short-run capital market funding. Strikingly, differences in banking regulations across countries are generally uncorrelated with the performance of banks during the crisis, except that banks in countries with more restrictions on banking activities performed better, and are uncorrelated with observable risk measures of banks before the crisis. The better-performing banks had less leverage and lower returns in 2006 than the worst–performing banks.
- Dark Pool Trading Strategies
Sabrina Buti, Barbara Rindi, and Ingrid M. Werner
We model a dynamic financial market where traders traders submit orders either to a limit order book (LOB) or to a Dark Pool (DP). We show that there is a positive liquidity externality in the DP, that orders migrate from the LOB to the DP, but that overall trading volume increases when a DP is introduced. We also demonstrate that DP market share is higher when LOB depth is high, when LOB spreads are narrow, when the tick size is large and when traders seek protection from price impact. Further, while inside quoted depth in the LOB always decreases when a DP is introduced, quoted spreads can narrow for liquid stocks and widen for illiquid ones. We also show that traders' interaction with both LOB and DP generates interesting systematic patterns in order flow: differently from Parlour (1998), the probability of a continuation is greater than that of a reversal only for liquid stocks. In addition when depth decreases on one side of LOB liquidity is drained from DP. When a DP is added to a LOB, total welfare as well as institutional traders' welfare increase but only for liquid stocks; retail traders' welfare instead always decreases. Finally, when flash orders provide select traders with information about the state of the DP, we show that more orders migrate from the LOB to the DP welfare effects are enhanced.
- The Dark Side of Outside Directors: Do They Quit When They are Most Needed?
Rüdiger Fahlenbrach, Angie Low, and René M. Stulz
Outside directors have incentives to resign to protect their reputation or to avoid an increase in their workload when they anticipate that the firm on whose board they sit will perform poorly or disclose adverse news. We call these incentives the dark side of outside directors. We find strong support for the existence of this dark side. Following surprise director departures, affected firms have worse stock and operating performance, are more likely to suffer from an extreme negative return event, are more likely to restate earnings, and have a higher likelihood of being named in a federal class action securities fraud lawsuit.
- Are Acquisition Premiums Lower because of Target CEOs Conflicts of Interest?
Leonce Bargeron, Frederik Schlingemann, René M. Stulz, and Chad Zutter
CEOs have a conflict of interest when their company is the target of an acquisition attempt: They can bargain for private benefits, such as retention by the acquirer, rather than for a higher premium to be paid to their shareholders. We find that target CEO retention by the bidder does not appear to be driven by the CEO bargaining for his own interests at the expense of shareholders. Retention is not associated with a lower premium. Retention is more likely when it is more valuable to the bidder in running the merged firm, in that the CEO is more likely to be retained when she has skills and knowledge that bidder executives do not have and when the incentives of target insiders are well aligned with those of target shareholders. Regardless of retention, shareholders of acquired firms whose CEO is at retirement age receive lower premiums than shareholders of acquired firms with younger CEOs. This lower premium seems to be explained by the apparent reduced acquisition value of firms led by retirement age CEOs rather than by the target CEO conflict of interest.
- Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts
Ulf Axelson, Tim Jenkinson, Per Strömberg, and Michael S. Weisbach
This paper provides an empirical analysis of the financial structure of large buyouts. We collect detailed information on the financing of 1157 worldwide private equity deals from 1980 to 2008. Buyout leverage is cross-sectionally unrelated to the leverage of matched public firms, and is largely driven by factors other than what explains leverage in public firms. In particular, the economy-wide cost of borrowing is the main driver of both the quantity and the composition of debt in these buyouts. Credit conditions also have a strong effect on prices paid in buyouts, even after controlling for prices of equivalent public market companies. Finally, the use of high leverage in transactions negatively affects fund performance, controlling for fund vintage and other relevant characteristics. The results are consistent with the view that the availability of financing impacts booms and busts in the private equity market, and that agency problems between private equity funds and their investors can affect buyout capital structures.
- Diving Into Dark Pools
Sabrina Buti, Barbara Rindi, and Ingrid M. Werner
This paper examines unique data on dark pool activity for a large cross-section of US stocks in 2009. Dark pool activity is concentrated in large firms, stocks with high share volume, high price, low spreads, high depth, and low short-term volatility. NASDAQ (AMEX) stocks have significantly higher (lower) dark pool activity than NYSE stocks controlling for size, share volume, and price. For a given stock, dark pool activity is significantly higher on days with higher share volume, higher depth, and lower intraday volatility. Dark pool activity is significantly lower for days with larger order imbalances relative to share volume and larger absolute returns. We find no evidence supporting the hypothesis that dark pool activity has a detrimental effect on market quality.
- Are Stock Acquirers Overvalued? Evidence from Short Selling Activity
Itzhak Ben-David, Michael S. Drake, and Darren T. Roulstone
We use a novel identification approach to test whether stock acquirers are overvalued prior to merger announcements or whether they have high growth opportunities (Q-theory). We argue that the overvaluation of firms drives both high short selling activity and a higher likelihood of stock mergers. We document that, as early as 12 months before a merger announcement, short selling activity is higher (lower) for firms that eventually make stock (cash) acquisitions. High short interest predicts long-term negative returns following the announcement. Finally, stock (but not cash) acquirers have higher short interest than their targets. We investigate alternative explanations for our results that do not assume short sellers only target overvalued firms and show that these explanations do not appear to explain our results. We conclude that overvalued firms self-select to become stock acquirers and that short selling activity does not completely eliminate acquirer overvaluation.
- Managerial Miscalibration
Itzhak Ben-David, John R. Graham, and Campbell R. Harvey
Miscalibration is a form of overconfidence examined in both psychology and economics. Although it is often analyzed in lab experiments, there is scant evidence about the effects of miscalibration in practice. We test whether top corporate executives are miscalibrated, and study the determinants of their miscalibration. We study a unique panel of over 11,600 probability distributions provided by top financial executives and spanning nearly a decade of stock market expectations. Our results show that financial executives are severely miscalibrated: realized market returns are within the executives’ 80% confidence intervals only 33% of the time. We show that miscalibration improves following poor market performance periods because forecasters extrapolate past returns when forming their lower forecast bound (“worst case scenario”), while they do not update the upper bound (“best case scenario”) much. Finally, we link stock market miscalibration to miscalibration about own-firm project forecasts and increased corporate investment.
- Financial Policies and the Financial Crisis:How Important Was the Systemic Credit Contraction for Industrial Corporations?
Kathleen M. Kahle and René M. Stulz
From the start of the financial crisis (third quarter of 2007) to its peak (first quarter of 2009), both large and investment-grade non-financial firms show no evidence of suffering from an exceptional systemic credit contraction. Instead of decreasing their cash holdings as would be expected with a temporarily impaired credit supply, these firms increase their cash holdings sharply (by 17.8% in the case of investment-grade firms) after the collapse of Lehman. Though small and unrated firms have exceptionally low net debt issuance at the peak of the crisis, their net debt issuance in the first year of the crisis is no different from the last year of the credit boom. In contrast, however, the net equity issuance of small and unrated firms is low throughout 2008, whereas an impaired credit supply by itself would have encouraged firms to increase their equity issuance. On average, the cumulative financing impact of the decrease in net equity issuance from the start to the peak of the crisis is approximately twice the cumulative impact of the decrease in net debt issuance. The decrease in net equity issuance and the increase in cash holdings are also economically important for firms with no debt.
- Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance?
Bernadette Minton, Jerome P. A. Taillard, and Rohan Williamson
During the recent financial crisis, financial expertise among independent directors of commercial banks is negatively related to changes in both firm value and cumulative stock returns. Furthermore, financial expertise is positively associated with risk-taking levels in the run-up to the crisis using both balance-sheet and market-based measures of risk. These results are not driven by powerful CEOs who select independent experts to rubber stamp strategies that satisfy their risk appetite. They are, however, consistent with independent directors with financial expertise recognizing the residual nature of shareholders’ claim and supporting a heightened risk profile for their bank.
- The Value Spread: A Puzzle
Frederico Belo, Chen Xue, and Lu Zhang
The standard dynamic investment model fails to explain the value spread, which is the difference in the market equity-to-capital ratio between extreme book-to-market deciles. Even when the model manages to fit the valuation ratios across some testing assets, the implied expected return errors are large. In contrast to the model’s superior in-sample fit of expected returns, recursive estimation reveals its poor out-of-sample performance. Time series instability and industry heterogeneity of the model parameters are the likely culprits. In all, we conclude that the dynamic investment framework is not yet useful for valuation and expected return estimation in practice.
- Did Securitization Affect the Cost of Corporate Debt?
Taylor D. Nadauld and Michael S. Weisbach
This paper investigates whether the securitization of corporate bank loans had an impact on the price of corporate debt. Our results suggest that loan facilities that are subsequently securitized are associated with a 15 basis point lower spread than that of loans that are not subsequently securitized. To identify the particular role of securitization in loan pricing, we employ a difference in differences approach and consider loan characteristics that are associated with the likelihood of securitization. We document that Term Loan B facilities, facilities originated by banks that originate CLOs, and loans of B-Rated firms are securitized more frequently than other loans. Spreads on facilities estimated to be more likely to be subsequently securitized have lower spreads than otherwise similar facilities. The results are consistent with the view that securitization caused a reduction in the cost of capital.
- Investment-Based Momentum Profits
Laura Xiaolei Liu and Lu Zhang
We offer an investment-based explanation of momentum. The neoclassical theory of investment implies that expected stock returns are related to expected investment returns, defined as the next-period marginal benefits of investment divided by the current-period marginal costs of investment. Empirically, winners have higher expected growth of investment-to-capital and higher expected marginal product of capital and consequently higher expected stock returns than losers. The investment-based expected return model captures well the moment profits across a wide array of momentum portfolios. However, the individual alphas for several testing portfolios are large. All in all, we conclude that momentum is consistent with the value maximization of firms.
- Does Risk Explain Anomalies? Evidence from Expected Return Estimates
Jin (Ginger) Wu and Lu Zhang
Average realized returns equal average expected returns plus average unexpected returns. If anomalies are driven by risk, average expected returns should be close to average realized returns. If anomalies are driven by mispricing, unexpected returns should be more important. We estimate accounting-based expected returns to zero-cost trading strategies formed on anomaly variables such as book-to-market, size, composite issuance, net stock issues, abnormal investment, asset growth, investment-to-assets, accruals, earnings surprises, failure probability, return on assets, and short-term prior returns. Our findings are striking. Except for the value premium, expected return estimates differ dramatically from average return estimates. The evidence suggests that mispricing, not risk, is the main driving force of capital markets anomalies.
- Market-Based Loss Mitigation Practices for Troubled Mortgages Following the Financial Crisis
Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet and Douglas D. Evanoff
The meltdown in residential real-estate prices that commenced in 2006 resulted in unprecedented mortgage delinquency rates. Until mid-2009, lenders and servicers pursued their own individual loss mitigation practices without being significantly influenced by government intervention. Using a unique dataset that precisely identifies loss mitigation actions, we study these methods—liquidation, repayment plans, loan modification, and refinancing—and analyze their effectiveness. We show that the majority of delinquent mortgages do not enter any loss mitigation program or become a part of foreclosure proceedings within 6 months of becoming distressed. We also find that it takes longer to complete foreclosures over time, potentially due to congestion. We further document large heterogeneity in practices across servicers, which is not accounted for by differences in borrower population. Consistent with the idea that securitization induces agency conflicts, we confirm that the likelihood of modification of securitized loans is up to 70% lower relative to portfolio loans. Finally, we find evidence that affordability (as opposed to strategic default due to negative equity) is the prime reason for redefault following modifications. While modification terms are more favorable for weaker borrowers, greater reductions in mortgage payments and/or interest rates are associated with lower redefault rates. Our regression estimates suggest that a 1 percentage point decline in mortgage interest rate is associated with a nearly 4 percentage point decline in default probability. This finding is consistent with the Home Affordable Modification Program (HAMP) focus on improving mortgage affordability.
- Excess Volatility of Corporate Bonds
Jack Bao and Jun Pan
This paper examines the connection between the return volatilities of corporate bonds, equities, and Treasuries under the Merton model with stochastic interest rates. Constructing empirical volatilities using bond returns over daily, weekly, and monthly horizons, we find that empirical bond volatilities are too high to be explained by equity and Treasury volatilities. Furthermore, the results are robust to using credit default swaps rather than corporate bonds to measure volatility in the credit market. At the daily return horizon, the excess volatility of corporate bonds is related to known liquidity proxies. However, this relation disappears at the monthly horizon even though corporate bonds continue to be excessively volatile. Thus, there appears to be a disconnect between corporate bonds and equities that goes beyond the illiquidity of corporate bonds.
- Cyclicality, Performance Measurement, and Cash Flow Liquidity in Private Equity
revision date: September 2011; revision date: July 2011
David T. Robinson and Berk A. Sensoy
Public and private equity waves move together. Using quarterly cash flow data for a large sample of venture capital and buyout funds from 1984-2010, we investigate the implications of this co-cyclicality for understanding private equity cash flows and performance. In the cross-section, varying the beta used to assess relative performance has a large effect near a beta of zero, but only a modest effect for more reasonable beta estimates. For instance, buyout funds outperform the S&P 500 by 18% over the life of the fund, and moving to a beta of 1.5 only reduces this to 12%. A similar message comes through in the time series. Though funds raised in hot markets underperform in absolute terms, this underperformance is sharply reduced by a comparison to the S&P 500, and disappears entirely at the levels of beta recently estimated in the literature. These fndings imply that high private equity fundraising forecasts both low private equity cash flows and low market returns, suggesting a positive correlation between private equity net cash flows and public equity valuations. Indeed, while both capital calls and distributions rise with public equity valuations, distributions are more sensitive than calls, so net cash flows are procyclical and private equity funds are liquidity providers (sinks) when market valuations are high (low). Venture cash flows and performance are considerably more procyclical than buyout. Debt market conditions also have a significant impact on cash flows. At the same time, most cash flow variation is idiosyncratic across funds, and most predictable variation is explained by the age of the fund.
- Financial Constraints, Inflated Home Prices, and Borrower Default during the Real-Estate Boom (revised 06/09)
During the housing boom, many subprime home buyers were not able to make a mortgage down payment and therefore were at risk of being rationed from the market. To resolve the issue, some buyers, sellers and intermediaries artificially expanded the scope of transactions by including items that cannot be collateralized. As a result, observed house prices were higher and mortgages larger, ultimately relaxing buyers' financial constraints. I estimate that between 2005 and 2008, up to 16% of highly leveraged (> 95% loan-to-value) transactions in Cook County, Illinois were inflated (with prices higher by 6% to 15%). Inflated transactions are more likely in low-income neighborhoods and when intermediaries have a high stake in the transaction. Although borrowers were twice as likely to default, their mortgage rates were not higher.
- Do target CEOs sell out their shareholders to keep their job in a merger? (revised 09/09)
Leonce Bargeron, Frederik Schlingemann, René M. Stulz, and Chad Zutter
CEOs have a potential conflict of interest when their company is acquired: They can bargain to be retained by the acquirer and for private benefits rather than for a higher premium to be paid to the shareholders. We investigate the determinants of target CEO retention by the acquirer and whether target CEO retention affects the premium paid by the acquirer. The probability that a CEO is retained increases with a private bidder, the performance of the target, and with the fraction of target shares held by insiders. Regardless of the bidder type, we find no evidence that the premium paid is lower when the CEO is retained by the acquirer. Strikingly, the target stock price increases more at the announcement of an acquisition by a private firm when the CEO is retained than when she is not. This result holds whether the private acquirer is a private equity firm or an operating company and for management buyouts.
- Why Do Foreign Firms Leave U.S. Equity Markets? (revised 01/10)(revised 04/09)
Craig Doidge, G. Andrew Karolyi, René M. Stulz
Foreign firms terminate their SEC registration in the aftermath of the Sarbanes-Oxley Act (SOX) because they no longer require outside funds to finance growth opportunities. Deregistering firms' insiders benefit from greater discretion to consume private benefits without having to raise higher cost funds. Foreign firms with more agency problems have worse stock-price reactions to the adoption of Rule 12h-6 in 2007, which made deregistration easier, than those firms more adversely affected by the compliance costs of SOX. Stock-price reactions to deregistration announcements are negative, but less so under Rule 12h-6, and more so for firms that raise fewer funds externally.
- Behavioral Consistency in Corporate Finance: CEO Personal and Corporate Leverage (revised 06/10)
Henrik Cronqvist, Anil K. Makhija, and Scott E. Yonker
We show empirically that firms behave remarkably similarly to how their CEOs behave personally in the context of leverage choices. Using a database of CEOs' leverage in their most recent home purchases, we find a positive, economically significant, robust relation between personal home leverage and corporate leverage in the cross-section and when we examine CEO turnover. The results are consistent with an endogenous matching of CEOs with firms based on leverage preferences on both sides, as well as with CEOs imprinting their personal preferences on the firms they manage, especially when governance is weaker. Besides extending our understanding of the determinants of corporate leverage, this paper shows empirically that CEOs' behavioral consistency across personal and professional situations can, at least in part, predict the corporate financial behavior of the firms they manage.
- Why Do Foreign Firms Have Less Idiosyncratic Risk than U.S. Firms?
Söhnke M. Bartram, Gregory Brown, and René M. Stulz
Using a large panel of firms across the world from 1991-2006, we show that the median foreign firm has lower idiosyncratic risk than a comparable U.S. firm. Country characteristics help explain variation in the level of idiosyncratic risk, but less so than firm characteristics. Idiosyncratic risk falls as government stability and respect for the rule of law improve. Idiosyncratic risk is positively related to stock market development but negatively related to bond market development. Surprisingly, we find that idiosyncratic risk is generally negatively related to corporate disclosure quality. Finally, idiosyncratic risk generally increases with shareholder protection. Though there is evidence that R2 increases with creditor rights and falls with the quality of disclosure, these results are driven by the relations between these variables and systematic risk rather than by the impact of these variables on idiosyncratic risk.
- Macroeconomic Conditions and the Structure of Securities (revised 02/10)(revised 12/09)(revised 04/09)
Isil Erel, Brandon Julio, Woojin Kim, and Michael S. Weisbach
Economic theory, as well as commonly-stated views of practitioners, suggests that macroeconomic conditions can affect both the ability and manner in which firms raise external financing. Theory suggests that downturns should be associated with a shift toward less information-sensitive securities, as well as a ‘flight to quality,’ in which firms can issue high-rated securities but not low-rated ones. We evaluate these hypotheses on a large sample of publicly-traded debt issues, seasoned equity offers, and bank loans. We find that worse macroeconomic conditions lead firms to use less information-sensitive securities. In addition, poor market conditions affect the structure of securities offered, shifting them towards shorter maturities and more security. Furthermore, market conditions affect the quality of securities offered, with worsening conditions substantially lowering the number of low-rated debt issues. Overall, these findings suggest that macroeconomic conditions are important factors in firms’ capital raising decisions.
- When are Analyst Recommendation Changes Influential? (revised 05/10)
Roger K. Loh and René M. Stulz
Typically, the literature evaluates the significance of analyst recommendation changes by their average stock-price impact. With such an approach, recommendation changes can have a significant impact even if no recommendation change has a stock-price impact large enough to be noticed at the stock level. We call a recommendation change that affects the stock price sufficiently to be detectable at the stock level an influential recommendation change and investigate the extent to which recommendation changes are influential. We show that roughly 12% of recommendation changes are influential. We find a similar fraction of recommendation changes are influential using an alternative definition which looks at abnormal turnover at the stock level. Leader, star, and previously influential analysts are more likely to make influential recommendation changes. Recommendation changes away from consensus or accompanied by any sort of earnings forecast are more likely to be influential. Growth, small, high institutional ownership, and high analyst forecast dispersion firms are also more likely to have influential recommendation changes. Strikingly, the frequency of influential recommendation changes increases after Reg FD and the Global Analyst Settlement. Finally, we show that impactful sell-side research tends to be communicated through a recommendation change rather than an earnings forecast.
- Does Governance Travel Around the World? Evidence from Institutional Investors (revised 05/10)(revised 06/09)(revised 04/09)
Reena Aggarwal, Isil Erel, Miguel A. Ferreira, and Pedro P. Matos
We examine whether institutional investors affect corporate governance by analyzing portfolio holdings of institutions in companies from 23 countries during the period 2003-2008. We find that firm-level governance is positively associated with international institutional investment. Changes in institutional ownership over time positively affect subsequent changes in firm-level governance, but the opposite is not true. Foreign institutions and institutions from countries with strong shareholder protection play a crucial role in promoting governance improvements outside of the U.S. Institutional investors affect not only which corporate governance mechanisms are in place, but also outcomes. Firms with higher institutional ownership are more likely to terminate poorly performing CEOs and exhibit improvements in valuation over time. Our results suggest that international portfolio investment by institutional investors promote good corporate governance practices around the world.
- Capital Allocation
Isil Erel, Stewart C. Myers, and James A. Read, Jr.
We demonstrate that financial firms should allocate capital to lines of business based on marginal default values. The marginal default value for a line of business is the derivative of the value of the firm’s option to default with respect to the scale of the line. Marginal default values give a unique allocation of capital that adds up exactly, regardless of the joint probability distribution of returns. Capital allocations follow from the conditions for the bank’s optimal portfolio. The allocations are systematically different from allocations based on VaR or contribution VaR. We also show how regulation based on risk-weighted capital requirements distorts a bank’s investment decisions, even if regulatory arbitrage can be eliminated.
- Determinants of Cross-Border Mergers and Acquisitions
(revised March 2011)
Isil Erel, Rose C. Liao, and Michael S. Weisbach
Despite the fact that one-third of worldwide mergers involve firms from different countries, the vast majority of the academic literature on mergers studies domestic mergers. What little has been written about cross-border mergers has focused on public firms, usually from the United States. Yet, the vast majority of cross-border mergers involve private firms that are not from the United States. We provide an analysis of a sample of 56,978 cross-border mergers occurring between 1990 and 2007. In addition to the factors that motivate domestic mergers,national borders are associated with additional factors that also affect the likelihood that two firms choose to merge. Specifically, geography, the quality of accounting disclosure, and bilateral trade increase the likelihood of mergers between two countries. In addition, valuation appears to play a role in motivating mergers; firms in countries whose stock market has increased in value, whose currency has recently appreciated, and who have a relatively high market to book value tend to be purchasers, and firms from weaker-performing economies tend to be targets.
- Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation
Andrea Beltratti and René M. Stulz
Though overall bank performance from July 2007 to December 2008 was the worst since at least the Great Depression, there is significant variation in the cross-section of stock returns of large banks across the world during that period. We use this variation to evaluate the importance of factors that have been discussed as having contributed to the poor performance of banks during the credit crisis. More specifically, we investigate whether bank performance is related to bank-level governance, country-level governance, country-level regulation, and bank balance sheet and profitability characteristics before the crisis. Banks that the market favored in 2006 had especially poor returns during the crisis. Using conventional indicators of good governance, banks with more shareholder-friendly boards performed worse during the crisis. Banks in countries with stricter capital requirement regulations and with more independent supervisors performed better. Though banks in countries with more powerful supervisors had worse stock returns, we provide some evidence that this may be because these supervisors required banks to raise more capital during the crisis and that doing so was costly for shareholders. Large banks with more Tier 1 capital and more deposit financing at the end of 2006 had significantly higher returns during the crisis. After accounting for country fixed effects, banks with more loans and more liquid assets performed better during the month following the Lehman bankruptcy, and so did banks from countries with stronger capital supervision and more restrictions on bank activities.
- Bank CEO Incentives and the Credit Crisis (revised 08/10)(revised 03/10)(revised 12/09)
Rüdiger Fahlenbrach and René M. Stulz
We investigate whether bank performance during the recent credit crisis is related to chief executive officer (CEO) incentives before the crisis. We find some evidence that banks with CEOs whose incentives were better aligned with the interests of shareholders performed worse and no evidence that they performed better. Banks with higher option compensation and a larger fraction of compensation in cash bonuses for their CEOs did not perform worse during the crisis. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis. Consequently, they suffered extremely large wealth losses in the wake of the crisis.
- Do Investment Banks Have Skill? Performance Persistence of M&A Advisors
Jack Bao and Alex Edmans
We document significant persistence in the average announcement returns to acquisitions advised by an investment bank. Advisors in the top quintile of returns over the past two years outperform the bottom quintile by 1.04% over the next two years, compared to a full-sample average return of 0.72%. Persistence continues to hold after controlling for the component of returns attributable to the acquirer. These results suggest that advisors possess skill, and contrast earlier studies which use bank reputation and market share to measure advisor quality and find no link with returns. Our findings thus advocate a new measure of advisor quality – past performance. However, acquirers instead select banks based on market share, even though it is negatively associated with future performance. The publication of league tables based on value creation, rather than market share, may improve both clients’ selection decisions and advisors’ incentives to turn away bad deals.
- When Constraints Bind
Karl B. Diether and Ingrid M. Werner
We create proxies for constrained supply of lendable shares by combining unique data on loan fees, stock lending activity, and failures to deliver to examine how often contrarian short sale strategies are affected by constraints. We find that constraints, as captured by our measures, clearly affect the strategies of NYSE and Nasdaq short sellers. In some cases 30%-40% of the cross-section experiences a significant reduction in the contrarian response of short sellers to past returns. However, only for extremely high levels of our constraint measures (top 1%) is contrarian behavior by short sellers completely eliminated. We also find that high minus low daily short selling activity portfolios produce abnormal returns for both constrained and unconstrained stock.
- Credit Default Swaps and the Credit Crisis
René M. Stulz
Many observers have argued that credit default swaps contributed significantly to the credit crisis. Of particular concern to these observers are that credit default swaps trade in the largely unregulated over-the-counter market as bilateral contracts involving counterparty risk and that they facilitate speculation involving negative views of a firm’s financial strength. Some observers have suggested that credit default swaps would not have made the crisis worse had they been traded on exchanges. I conclude that credit default swaps did not cause the dramatic events of the credit crisis, that the over-the-counter credit default swaps market worked well during much of the credit crisis, and that exchange trading has both advantages and costs compared to over-the-counter trading. Though I argue that eliminating over-the-counter trading of credit default swaps could reduce social welfare, I also recognize that much research is needed to understand better and quantify the social gains and costs of derivatives in general and credit default swaps in particular.
- Expected Returns and Volatility of Fama-French Factors
In this paper, I show that the variance of Fama-French factors, the variance of the momentum factor, as well as the correlation between these factors, predict an important fraction of the time-series variation in post-1990 aggregate stock market returns. This predictability is particularly strong from one month to one year, and it dominates that afforded by the variance risk premium and other popular predictor variables such as P/D ratio, the P/E ratio, the default spread, and the consumption-wealth ratio. In a simple representative agent economy with recursive preferences, I model the portfolio weight in each asset as a function of a stock's characteristics and show that the market return can be predicted by these variances.
- Default Risk, Idiosyncratic Coskewness and Equity Returns
Fousseni Chabi-Yo and Jun Yang
In this paper, we intend to explain an empirical finding that distressed stocks delivered anomalously low returns. We show that in a model with heterogeneous investors where idiosyncratic skewness is priced, the expected return of risky assets depends on idiosyncratic coskewness betas, which measure the covariance between idiosyncratic variance and the market return. We find that there is a negative (positive) relation between idiosyncratic coskewness and equity returns when idiosyncratic coskewness betas are positive (negative). We construct two idiosyncratic coskewness factors to capture market-wide effect of idiosyncratic coskewness betas. When we control for these two idiosyncratic coskewness factors, the return difference for distress-sorted portfolios becomes insignificant. High stressed firms earn low returns because high stressed firms have high (low) idiosyncratic coskewness betas when idiosyncratic coskewness betas are positive (negative).
- Changing the Nexus: The Evolution and Renegotiation of Venture Capital Contracts
Ola Bengtsson and Berk A. Sensoy
We study empirically how financial contracts evolve and are renegotiated as venture capital (VC)-backed companies secure new rounds of financing. Because VC contract designs vary considerably between companies according to their economic circumstances, it is plausible to expect that the contracts governing successive financing rounds of a quickly-evolving company should often be dissimilar. The data offer little support for this intuitive hypothesis. In fact, the majority of cash flow provisions in a new round contract are recycled from the previous round contract, even when the company has evolved substantially. Such recycling may be beneficial in typical situations because it alleviates information problems in negotiations and reduces the complexity of the company’s nexus of financial contracts (Fama, 1980). However, in some situations restructuring contract design may be necessary to entice investors to provide new capital.Consistent with debt overhang arguments (Myers, 1977), we show that venture capital contracts evolve to include more investor-friendly cash flow provisions when the valuation of the company has not increased since the previous round, when new investors join the new round, or when new round investors hold larger debt-like claims. Although major renegotiations of previous round contracts are rare, minor renegotiations appear to be more common and almost uniformly result in making the previous round contract more similar to the new round contract. Overall, our findings suggest that the tradeoff relevant for changing a company’s nexus of financial contracts is different from the tradeoffs relevant for the initial structuring of this nexus.
- The Effects of Stock Lending on Security Prices: An Experiment (revised 08/10)
Steven N. Kaplan, Tobias J. Moskowitz and Berk A. Sensoy
Working with a sizeable, anonymous money manager, we randomly make available for lending two-thirds of the high-loan fee stocks in the manager’s portfolio and withhold the other third to produce an exogenous shock to loan supply. We implement the lending experiment in two independent phases: the first, from September 5 to 18, 2008, with over $580 million of securities lent; and the second, from June 5 to September 30, 2009, with over $250 million of securities lent. The supply shocks are sizeable and significantly reduce lending fees, but returns, volatility, skewness, and bid-ask spreads remain unaffected. Results are consistent across both phases of the experiment and indicate no adverse effects from securities lending on stock prices.
- The State of Corporate Governance Research
Lucian A. Bebchuk and Michael S. Weisbach
We create proxies for constrained supply of lendable shares by combining unique data on loan fees, stock lending activity, and failures to deliver to examine how often contrarian short sale strategies are affected by constraints. We find that constraints, as captured by our measures, clearly affect the strategies of NYSE and Nasdaq short sellers. In some cases 30%-40% of the cross-section experiences a significant reduction in the contrarian response of short sellers to past returns. However, only for extremely high levels of our constraint measures (top 1%) is contrarian behavior by short sellers completely eliminated. We also find that high minus low daily short selling activity portfolios produce abnormal returns for both constrained and unconstrained stock.
- Investor Abilities and Financial Contracting: Evidence from Venture Capital
Ola Bengtsson and Berk A. Sensoy
Using a large, new database of contractual provisions governing the allocation of cash flow rights between venture capitalists (VCs) and entrepreneurs, we investigate how contract design is impacted by VC abilities to monitor and provide value-added services to the entrepreneur. In doing so, this paper is the first to demonstrate that VC characteristics, in addition to portfolio company characteristics, have a significant impact on VC contract design in the U.S. We find that more experienced VCs, who have superior monitoring and value-added abilities and more frequently join the boards of their portfolio companies, obtain weaker downside-protecting contractual cash flow rights than less experienced VCs. This result is robust to extensive controls and several methods to account for endogenous selection effects. The relation between VC experience and downside protections is weaker when entrepreneurial agency problems are less severe and stronger when VC ownership is greater. The results, together with the existing literature, suggest that VCs with better governance abilities optimally focus less on obtaining downside protections, which are costly from a risk-sharing perspective, and more on upside payoffs and obtaining board representation during negotiations with entrepreneurs. The results also imply that previous estimates of the amount entrepreneurs pay for affiliation with high-quality VCs are overstated.
- Learning to Cope: Voluntary Financial Education Programs and Loan Performance During a Housing Crisis
Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet and Douglas D. Evanoff
Mortgage counseling is regarded as an integral tool in ensuring appropriate choices by prospective home buyers. We use micro-level data from an urban voluntary counseling program aimed at disadvantaged households to assess its effectiveness. We find substantially lower expost delinquency rates among program graduates. This finding is robust to an array of controls and several ways of modeling the probability of selection into counseling treatment. We attribute improved performance to the type of mortgage contract extended to the graduates, to the budgeting and credit management skills taught in the program, and to active post-purchase counseling that seeks to cure delinquency at early stages. The effects appear strongest among the least creditworthy households, suggesting an important role for long-term preparation for homeownership.
- Economic Nationalism in Mergers and Acquisitions (revised 9/11), (revised 06/10)
Serdar Dinc and Isil Erel
This paper studies the government reaction to large corporate merger attempts in the European Union during 1997-2006 using hand-collected data. It documents widespread economic nationalism in which the government prefers the target companies remain domestically owned rather than foreign-owned. This preference is stronger at times and places with strong far-right parties, weaker governments, and against countries for which the people in the target country have little affinity. This nationalism has both direct and indirect economic impact on mergers and impedes capital flows. In particular, nationalist government reactions deter foreign companies from bidding for other companies in that country in future.
- How much do banks use credit derivatives to hedge loans?
Bernadette Minton, René M. Stulz, and Rohan Williamson
This paper examines the use of credit derivatives by US bank holding companies with assets in excess of one billion dollars from 1999 to 2005. Using the Federal Reserve Bank of Chicago Bank Holding Company Database, we find that in 2005 the gross notional amount of credit derivatives held by banks exceeds the amount of loans on their books. Only 23 large banks out of 395 use credit derivatives and most of their derivatives positions are held for dealer activities rather than for hedging of loans. The net notional amount of credit derivatives used for hedging of loans in 2005 represents less than 2% of the total notional amount of credit derivatives held by banks and less than 2% of their loans. Banks hedge less risky loans more than riskier ones. The banks are more likely to be net protection buyers if they have lower capital ratios, a lower net interest rate margin, engage in asset securitization, originate foreign loans, have more commercial and industrial loans in their portfolio, and have fewer agricultural loans. We conclude that the use of credit derivatives by banks to hedge loans is limited because of adverse selection and moral hazard problems and because of the inability of banks to use hedge accounting when hedging with credit derivatives. Our evidence raises important questions about the validity of the often-held view that the use of credit derivatives makes banks sounder.
- Investor inattention and the underreaction to stock recommendations
Investors’ reaction to stock recommendations is often incomplete so that there is a predictable post-recommendation drift. I investigate whether investor inattention contributes to this drift by using turnover as a proxy for investor attention. I find that the recommendation drift of firms with low prior turnover is more than double in magnitude compared to that of firms with high prior turnover. Additional proxies for attention, such as analyst coverage, institutional ownership, the amount of distracting news in a day, or a measure of residual turnover that controls for liquidity and uncertainty, produce similar results. Volume reactions around the recommendation event show that investors fail to react promptly to recommendations on low attention stocks. Together, the evidence suggests that investor inattention is a plausible explanation for investors’ underreaction to stock recommendations.
- Diversification, Productivity, and Financial Constraints: Empirical Evidence from the US Electric Utility Industry?
Mika Goto, Angie Low, and Anil K. Makhija
We examine the real effects of parent firm diversification on their electric utility operating companies over the period, 1990-2003. Since electric utility operating companies produce a single homogenous product, we can better measure their Total Factor Productivity and make valid comparisons of productivity across firms. We find that, consistent with a diversification discount, greater parent diversification is associated with lower productivity across electric utility operating companies. However, the productivity of the electric utility operating companies improves with greater parent diversification over time. Diversification appears to provide an alternative channel to divert investment dollars away from overinvestment in the core electric business. Finally, we find that the improvement in the productivity of the electric utility operating companies from greater parent firm diversification over time is limited to financially constrained firms. This suggests that when managers have no resources to waste, it is more likely that any diversification activities are carefully planned and undertaken for strategic purposes that can help to increase productivity of the core business.
- The Changing Nature of Chapter 11
Sreedhar T. Bharath, Venky Panchapegesan, and Ingrid Werner
The U.S. Chapter 11 bankruptcy system has long been viewed as debtor friendly, with frequency of absolute priority deviations (APD) in favor of equity holders commonplace, as high as 75%, before 1990. In the 1991-2005 period, we find a secular decline in the frequency of APD to 22%, with the frequency as low as 9% for the period 2000-2005. We identify the increasing importance of debtor-in-possession (DIP) financing and key employee retention plans (KERP) in bankruptcy as the key drivers of this secular decline. We also find management turnover in Chapter 11 has increased by 65% since 1990 and that APD are more likely when management has substantial share holdings in the firm. The time spent in bankruptcy has also declined from about 23 months before 1990 to 16 months after 2000. Collectively, these results are consistent with the thesis that Chapter 11 has increasingly become creditor friendly over the years. We discuss the implications of our results for models that assume that equity has a valuable dilatory option in the bankruptcy process.
- Shareholder Rights, Boards, and CEO Compensation
I analyze the role of executive compensation in corporate governance. As proxies for corporate governance, I use board size, board independence, CEO-chair duality, institutional ownership concentration, CEO tenure, and an index of shareholder rights. The results from a broad cross-section of large U.S. public firms are inconsistent with recent claims that entrenched managers design their own compensation contracts. The interactions of the corporate governance mechanisms with total pay-for-performance and excess compensation can be explained by governance substitution. If a firm has generally weaker governance, the compensation contract helps better align the interests of shareholders and the CEO.
- Off but Not Gone: A Study of Nasdaq Delistings
Jeffrey H. Harris Venkatesh Panchapegesan, and Ingrid Werner
We examine 1,098 Nasdaq firms delisted in 1999-2002 that subsequently traded in the OTC Bulletin Board and/or the Pink Sheets. Market quality deteriorates significantly after delisting: share volume declines by two-thirds; quoted spreads almost triple from 12.1 to 33.9 percent; and effective spreads triple from 3.3 to 9.9 percent. Volatility triples from 4.4 to 14.3 percent, but quickly reverts to slightly elevated levels. Deterioration is significantly larger for more severe violations (e.g. bankruptcy) than for lesser infractions (e.g. minimum bid price). We find the OTC Bulletin Board provides a "soft landing" for delisted firms relative to the Pink Sheets. Although the delisting process takes at least 90 days, the drop in market quality is concentrated on the delisting date, highlighting the benefits of Nasdaq listing and the economic rationale for tiered listing fees. We argue that the increased costs resulting from enforcing Nasdaq’s minor (non-core) listing criteria outweigh the benefits.
- Commodity price exposure and ownership clienteles
Phil Davies, Bernadette Minton, and Catherine Schrand
This paper examines the association between commodity price exposure and investor interest in stocks of firms in two commodity-based industries: Gold Mining, and Oil and Gas Exploration. Investors, on average, are attracted to commodity price exposure. Using market-based measures of commodity price exposure, there is robust evidence that commodity stocks with high commodity price exposures have higher turnover and a larger number of institutional investors, in particular mutual fund investors, than commodity stocks with low exposures. We conduct cross-sectional analysis that condition on the source of the exposure, the type of investor, and the performance of the underlying commodity. Overall, investors’ revealed preferences for high exposure stocks appear to reflect a desire to gain exposure to the underlying commodity through an exposed equity security. They are not consistent with an attraction to exposure because of its transparency.
- Hedge fund contagion and liquidity
Nicole M. Boyson, Christof W. Stahel, and René M. Stulz
Using hedge fund indices representing eight different styles, we find strong evidence of contagion within the hedge fund sector: controlling for a number of risk factors, the average probability that a hedge fund style index has extreme poor performance (lower 10% tail) increases from 2% to 21% as the number of other hedge fund style indices with extreme poor performance increases from zero to seven. We investigate how changes in funding and asset liquidity intensify this contagion, and find that the likelihood of contagion is high when prime brokerage firms have poor performance (which would be expected to affect hedge fund funding liquidity adversely) and when stock market liquidity (a proxy for asset liquidity) is low. Finally, we examine whether extreme poor performance in the stock, bond, and currency markets is more likely when contagion in the hedge fund sector is high. We find no evidence that contagion in the hedge fund sector is associated with extreme poor performance in the stock and bond markets, but find significant evidence that performance in the currency market is worse when hedge fund contagion is high, consistent with the effects of an unwinding of carry trades.
- Estimating the Effects of Large Shareholders Using a Geographic Instrument (revised 04/09)
Bo Becker, Henrik Cronqvist, and Rüdiger Fahlenbrach
Large shareholders may play an important role for firm performance and policies, but identifying an effect empirically presents a challenge due to the endogeneity of ownership structures. We develop and test an empirical framework which allows us to separate selection from treatment effects of large shareholders. Unlike other blockholders, individuals tend to hold blocks in public firms located close to where they reside. Using this empirical observation, we develop an instrument - the density of wealthy individuals near a firm’s headquarters - for the presence of a large, non-managerial individual shareholder in a firm. These shareholders have a large impact on firms, controlling for selection effects. Consistent with theories of large shareholders as monitors, we find that they increase firm profitability, increase dividends, reduce corporate cash holdings, and reduce executive compensation. Consistent with the view that there exist conflicts between large and small owners in public firms, we uncover evidence of substitution toward less tax-efficient forms of distribution in firms with blocks. In addition, large shareholders reduce the liquidity of the firm’s stock.
- Why do firms appoint CEOs as outside directors?
Rüdiger Fahlenbrach, Angie Low, and René M. Stulz
We examine the determinants of appointments of outside CEOs to boards and how these appointments impact the appointing companies. We find that CEOs are most likely to join boards of large established firms that are geographically close, pursue similar financial and investment policies, and have comparable governance mechanisms to their own firms. It is also more likely that CEOs join firms with low insider ownership and firms with boards that already have other CEO directors. Except for the case of board interlocks, there is no evidence supporting the view that CEO directors have any impact on the appointing firm during their tenure, either positively or negatively. Appointments of CEO directors do not have a significant impact on the appointing firm’s operating performance, its decision-making, the compensation of its CEO, or on the monitoring of management by the board. However, operating performance drops significantly for CEO director appointments when the CEO of the appointing firm already sits on the board of the appointee’s firm.
- What Determines the Structure of Corporate Debt Issues?
Brandon Julio, Woojin Kim, and Michael S. Weisbach
Publicly-traded debt securities differ on a number of dimensions, including quality, maturity, seniority, security, and convertibility. Finance research has provided a number of theories as to why firms should issue debt with different features; yet, there is very little empirical work testing these theories. We consider a sample of 14,867 debt issues in the U.S. between 1971 and 2004. Our goal is to test the implications of these theories, and, more generally, to establish a set of stylized facts regarding the circumstances under which firms issue different types of debt.
Our results suggest that there are three main types of factors that affect the structure of debt issues: First, firm-specific factors such as leverage, growth opportunities and cash holdings are related with the convertibility, maturity and security structure of issued bonds. Second, economy-wide factors, in particular the state of the macroeconomy, affect the quality distribution of securities offered; in particular, during recessions, firms issue fewer poor quality bonds than in good times but similar numbers of high-quality bonds. Finally, controlling for firm characteristics and economy-wide factors, project specific factors appear to influence the types of securities that are issued. Consistent with commonly stated ‘maturity-matching’ arguments, long-term, nonconvertible bonds are more likely to be issued by firms investing in fixed assets, while convertible and short-term bonds are more likely to finance investment in R&D.
- Thriving in the midst of financial distress? An analysis of firms exposed to asbestos litigation
Jérôme Ph. A. Taillard
Asbestos litigation is one of the most important mass tort litigations in the history of the United States. I analyze a comprehensive sample of 270 firms that were exposed to an unprecedented wave of asbestos litigation in the wake of U.S. Supreme Court decisions in Amchem (1997) and Ortiz (1999). Due to insurance coverage, most firms in the sample have manageable cash outflows and do not suffer materially from the litigation. Because of the long delay between exposure to asbestos and its related illnesses, the remaining firms with substantial cash outflows and liabilities offer a rare natural experiment to study financial distress unrelated to economic distress. When analyzing this sub-sample throughout the distress period, I find little evidence of indirect costs of financial distress. This surprising result can be directly related to the strategic use of Chapter 11 as it provides a safe harbor through the stay in litigation and the "channeling injunction", which allows for a definitive solution for the legal liabilities. There is also evidence of a positive role for the disciplinary effects of financial distress as firms subject to increased bank monitoring and increased legal liabilities actively restructure and refocus on core operations.
- Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization
René M. Stulz
As barriers to international investment fall and technology improves, the cost advantages for a firm’s securities to trade publicly in the country in which that firm is located and for that country to have a market for publicly traded securities distinct from the capital markets of other countries will progressively disappear. However, securities laws remain an important determinant of whether and where securities are issued, how they are valued, who owns them, and where they trade. The value of public firms depends on these laws, so that identical firms subject to different laws are likely to have different values. We show that mandatory disclosure through securities laws can decrease agency costs between corporate insiders and minority shareholders, but only provided the investors can act on the information disclosed and the laws cannot be weakened ex post too much through lobbying by corporate insiders. With financial globalization, national disclosure laws can have wide-ranging effects on a country’s welfare, on firms and on investor portfolios, including the extent to which share holdings reveal a home bias. In equilibrium, if firms can choose the securities laws they are subject to when they go public, some firms will choose stronger securities laws than those of the country in which they are located and some firms will do the opposite. These effects of securities laws can be expected to become smaller if differences in national laws and their enforcement decrease and if the costs of private solutions to manage corporate agency conflicts that are substitutes for securities laws fall.
- Why Do Foreign Firms Leave U.S. Equity Markets? An Analysis of Deregistrations Under SEC Exchange Act Rule 12h-6
Craig Doidge, G. Andrew Karolyi, and René M. Stulz
On March 21, 2007, the Securities and Exchange Commission (SEC) adopted Exchange Act Rule 12h-6 which makes it easier for foreign private issuers to deregister and terminate the reporting obligations associated with a listing on a major U.S. exchange. We examine the characteristics of 59 firms that immediately announced they would deregister under the new rules, their potential motivations for doing so, as well as the economic consequences of their decisions. We find that these firms experienced significantly slower growth and lower stock returns than other U.S. exchange-listed foreign firms in the years preceding the decision. There is weak evidence that firms experience negative stock returns when they announce deregistration and stronger evidence that the stock-price reaction is worse for firms with higher growth. When we examine stock-price reactions around events associated with the passage of the Sarbanes-Oxley Act (SOX), we find negative average stock-price reactions with some specifications but not others. Further, there is no evidence that deregistering firms were affected more negatively by SOX than foreign-listed firms that did not deregister. Our evidence supports the hypothesis that foreign firms list shares in the U.S. in order to raise capital at the lowest possible cost to finance growth opportunities and that, when those opportunities disappear, a listing becomes less valuable to corporate insiders so that firms are more likely to deregister and go home.
- Why are Buyouts Levered? The Financial Structure of Private Equity Funds
Ulf Axelson, Per Strömberg, and Michael S. Weisbach
Private equity funds are important actors in the economy, yet there is little analysis explaining their financial structure. In our model the financial structure minimizes agency conflicts between fund managers and investors. Relative to financing each deal separately, raising a fund where the manager receives a fraction of aggregate excess returns reduces incentives to make bad investments. Efficiency is further improved by requiring funds to also use deal-by-deal debt financing, which becomes unavailable in states where internal discipline fails. Private equity investment becomes highly sensitive to economy-wide availability of credit and investments in bad states outperform investments in good states.
- Corporate Financial and Investment Policies when Future Financing is not Frictionless
Heitor Almeida, Murillo Campello, and Michael S. Weisbach
We study a model in which future financing constraints leas firms to have a preference for investments with sorter payback periods, investments with less risk, and investments that utilize more pledgeable assets. The model also shows how investment distortions towards more liquid, safer assets vary with the marginal cost of external financing and with firm internal cash flows. Our theory helps reconcile and interpret a number of patterns reported in the empirical literature, in areas such as risk-taking behavior, capital structure choices, hedging strategies, and cash management policies. For example, contrary to Jensen and Meckling (1976), we show that firms may reduce rather than increase risk when leverage increases exogenously. Furthermore, firms in economies with less developed financial markets will not only take different quantities of investment, but will also take different kinds of investment (safer, short-term projects that are potentially less profitable). We also point out to several predictions that have not been empirically examined. For example, our model predicts that investment safety and liquidity are complementary: constrained firms are specially likely to decrease the risk of their most liquid investments.
- Information Disclosure and Corporate Governance (revised 08/09)(revised 06/10)(revised01/30/11)
Benjamin E. Hermalin and Michael S. Weisbach
In public-policy discussions about corporate disclosure, more is typically judged better than less. In particular, better disclosure is seen as a way to reduce the agency problems that plague firms. We show that this view is incomplete. In particular, our theoretical analysis shows that increased disclosure is a two-edged sword: More information permits principals to make better decisions; but it can, itself, generate additional agency problems and other costs for shareholders, including increased executive compensation. Consequently, there can exist a point beyond which additional disclosure decreases firm value. We further show that larger firms will tend to adopt stricter disclosure rules than smaller firms, ceteris paribus. Firms with better disclosure will tend, all else equal, to employ more able management. We show that governance reforms that have imposed greater disclosure could, in part, explain recent increases in both ceo compensation and ceo turnover rates.
- Risk Management Failures: What Are They and When Do They Happen?
René M. Stulz
A large loss is not evidence of a risk management failure because a large loss can happen even if risk management is flawless. I provide a typology of risk management failures and show how various types of risk management failures occur. Because of the limitations of past data in assessing the probability and the implications of a financial crisis, I conclude that financial institutions should use scenarios for credible financial crisis threats even if they perceive the probability of such events to be extremely small.
- Estimating Affine Multifactor Term Structure Models Using Closed-Form Likelihood Expansions (revised 05/09)(revised 07/09)
We develop and implement a technique for maximum likelihood estimation in closed-form of multivariate affine yield models of the term structure of interest rates. We derive closed-form approximations to the likelihood functions for all nine of the Dai and Singleton (2000) canonical affine models with one, two, or three underlying factors. Monte Carlo simulations reveal that this technique very accurately approximates true maximum likelihood, which is, in general, infeasible for affine models. We also apply the method to a dataset consisting of synthetic US Treasury strips, and find parameter estimates for nine different affine yield models, each using two different market price of risk specifications. One advantage of maximum likelihood estimation is the ability to compare non-nested models using likelihood ratio tests. We find, using these tests, that the choice of preferred canonical model can depend on the market price of risk specification. Comparison to other approximation methods, Euler and QML, on both simulated and real data suggest that our approximation technique is much closer to true MLE than alternative methods.
- Does Mandatory Loan Review Affect Mortgage Contract Choice and Performance? (revised 04/2011 and 06/09)
Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet, and Douglas D. Evanoff
We explore the effects of mandatory third-party review of mortgage contracts on the terms, availability,and performance of mortgage credit. Our study is based on a legislative pilot carried out by the State of Illinois in a selected set of zip codes in 2006. Mortgage applicants with low FICO scores were required to attend loan reviews by financial counselors. Applicants with higher FICO scores had to attend counseling only if they chose “risky mortgages.” We find that low-FICO applicants for whom counselor review was mandatory did not materially change their contract choice. Conversely, applicants who could avoid counseling by choosing less risky mortgages did so. Although ex post default rates among low-FICO borrowers in the pilot program declined by 25%, we find that the educational component of counselor review played only a minor role. Instead, external review presented strong incentives for lenders to impose tighter ex ante screening on low-credit-quality borrowers.
- The Role of Boards of Directors in Corporate Governance: A Conceptual Framework & Survey (revised 04/09)
Renée Adams, Benjamin E. Hermalin and Michael S. Weisbach
This paper is a survey of the literature on boards of directors, with an emphasis on research done subsequent to the Hermalin and Weisbach (2003) survey. The two questions most asked about boards are what determines their makeup and what determines their actions? These questions are fundamentally intertwined, which complicates the study of boards because makeup and actions are jointly endogenous. A focus of this survey is how the literature, theoretical as well as empirically, deals-or on occasions fails to deal-with this complication. We suggest that many studies of boards can best be interpreted as joint statements about both the director-selection process and the effect of board composition on board actions and firm performance.
- Investor Demand for Industry Factor Price Exposure (revised 06/10)
Phil Davies, Bernadette Minton, and Catherine Schrand
Models of information acquisition predict that investors learn about a common risk factor and apply that information to valuations of stocks exposed to the risk factor (category learning). Category learning leads to higher levels of investor interest in stocks exposed to the factor, with investors forgoing portfolio diversification. Industry exposure is a candidate for category learning. Consistent with these predictions, we find that the number of institutions holding a stock is positively associated with the stock’s industry exposure. Moreover, institutional investors systematically overweight (underweight) high (low) industry exposure stocks. Investor preferences for industry exposure are greatest among smaller institutions and institutions that follow a transient investment style, and most pronounced in industries where the returns to learning about industry risk are greatest. Our results are consistent with the notion that investors do engage in category learning.
- Discussion of ‘A Lobbying Approach to Evaluating the Sarbanes-Oxley Act of 2002’
G. Andrew Karolyi
This article discusses the main contributions and findings of Hochberg, Sapienza and Vissing-Jorgensen’s ‘A Lobbying Approach to Evaluating the Sarbanes-Oxley Act of 2002.’ I offer a synopsis of the Journal of Accounting Research conference discussion of the paper as well as provide some broader perspectives on the two main lines of inquiry to which the paper contributes. The first perspective focuses on the impact of the Sarbanes-Oxley Act (SOX) and, in particular, how this study and others face the challenge of benchmarking of the price and quantity effects of the Act. I discuss the strengths and weaknesses of the authors’ identification strategy that separates out firms whose insiders actively lobbied the Securities and Exchange Commission’s rule-making process in the aftermath of SOX. The second perspective considers the motivations for and consequences of lobbying activity. I survey existing research in Economics, Accounting and Management which shows that lobbying propensity is predictable, confirms it is most likely to be conducted by agents most affected by the rule changes, but also warns that there are firm-specific, industry-specific, and even issue-specific factors that can complicate these interpretations.
- Changing Times: The Pricing Problem in Non-Linear Models
Finding conditional moments and derivative prices is a common application in continuous-time financial economics, but these quantities are known in closed-form only for a few specific models. Recent research identifies a large class of models for which solutions to such problems have convergent power series, allowing approximation even when not known in closed-form. However, such power series may converge slowly or not at all for long time horizons, limiting their practical use. We develop the method of time transformation, in which the variable representing time is replaced by a non-linear function of itself. With appropriate choice of the time transformation, power series often converge for much longer time horizons, and also much faster, sometimes uniformly for all time horizons. For applications such as bond pricing, in which the time-to-maturity may be many years, rapid convergence is very important for practical application. The ability to approximate solutions accurately and in closed-form simplifies the estimation of non-a±ne continuous-time term structure models, since the bond pricing problem must be solved for many different parameter vectors during a typical estimation procedure. We show through several examples that the series are easy to derive, and, using term structure models for which bond prices are known explicitly, also show that the series are extremely accurate over a wide range of interest rate levels for arbitrarily long maturities; in some cases, they are many orders of magnitude more accurate than series constructed without time transformations. Other potential applications include pricing of callable bonds and credit derivatives.
- Pricing Kernels with Coskewness and Volatility Risk (revised 03/09)
I investigate a pricing kernel in which coskewness and the market volatility risk factors are endogenously determined. I show that the price of coskewness and market volatility risk are restricted by investor risk aversion and skewness preference. The risk aversion is estimated to be between two and five and significant. The price of volatility risk ranges from -1.5% to -0.15% per year. Consistent with theory, I find that the pricing kernel is decreasing in the aggregate wealth and increasing in the market volatility. When I project my estimated pricing kernel on a polynomial function of the market return, doing so produces the puzzling behaviors observed in pricing kernel. Using pricing kernels, I examine the sources of the idiosyncratic volatility premium. I find that nonzero risk aversion and firms' non-systematic coskewness determine the premium on idiosyncratic volatility risk. When I control for the non-systematic coskewness factor, I find no significant relation between idiosyncratic volatility and stock expected returns. My results are robust across different sample periods, different measures of market volatility and firm characteristics.
- Does Corporate Culture Matter for Firm Policies?
Henrik Cronqvist, Angie Low, and Mattias Nilsson
Economic theories suggest that a firm’s corporate culture matters for its policy choices. We construct a parent-spinoff firm panel dataset that allows us to identify culture effects in firm policies from behavior that is inherited by a spinoff firm from its parent after the firms split up. We find positive and significant relations between spinoff firms’ and their parents’ choices of investment, financial, and operational policies. Consistent with predictions from economic theories of corporate culture, we find that the culture effects are long-term and stronger for internally grown business units and older firms. Our evidence also suggests that firms preserve their cultures by selecting managers who fit into their cultures. Finally, we find a strong relation between spinoff firms’ and their parents’ profitability, suggesting that corporate culture ultimately also affects economic performance. These results are robust to a series of robustness checks, and cannot be explained by alternatives such as governance or product market links. The contribution of this paper is to introduce the notion of corporate culture in a formal empirical analysis of firm policies and performance.
- A Note on the Dai-Singleton Canonical Representation of Affine Term Structure Models (revised 09/08)
Patrick Cheridito, Damir Filipovic, and Robert L. Kimmel
Dai and Singleton (2000) study a class of term structure models for interest rates that specify the short rate as an affine combination of the components of an N-dimensional affine diffusion process. Observable quantities of such models are invariant under regular affine transformations of the underlying diffusion process. In their canonical form, the models in Dai and Singleton (2000) are based on diffusion processes with diagonal diffusion matrices. This motivates the following question: Can the diffusion matrix of an affine diffusion process always be diagonalized by means of a regular affine transformation?
We show that if the state space of the diffusion is of the form D = Rm+ x RN - m for integers 0 = m= N satisfying m = 1 or m = N - 1, there exists a regular affine transformation of D onto itself that diagonalizes the diffusion matrix. On the other hand, we provide examples of affine diffusion processes with state space R2+ x R2 whose diffusion matrices cannot be diagonalized through regular affine transformation. This shows that for 2 = m = N - 2, the assumption of diagonal diffusion matrices may impose unnecessary restrictions and result in an avoidable loss of generality.
- Hedge Funds: Past, Present, and Future
René M. Stulz
Assets managed by hedge funds have grown faster over the last ten years than assets managed by mutual funds. Hedge funds and mutual funds perform the same economic function, but hedge funds are largely unregulated while mutual funds are tightly regulated. This paper compares the organization, performance, and risks of hedge funds and mutual funds. It then examines whether one can expect increasing convergence between these two investment vehicles and concludes that the performance gap between hedge funds and mutual funds will narrow, that regulatory developments will limit the flexibility of hedge funds, and that hedge funds will become more institutionalized.
- Former CEO Directors: Lingering CEOs or Valuable Resources? (revised 08/10)(revised 01/10)(revised 09/08)
Rüdiger Fahlenbrach, Bernadette A. Minton, and Carrie H. Pan
We investigate corporate governance experts’ claim that it is detrimental to a firm to reappoint former CEOs as directors after they step down as CEOs. We find that more successful and more powerful former CEOs are more likely to be reappointed to the board multiple times after they step down as CEOs. Firms benefit on average from the presence of former CEOs on their boards. Firms with former CEO directors have better accounting performance, have higher relative turnover-performance sensitivity of the successor CEO, and can rehire their former CEO directors as CEOs after extremely poor firm performance under the successor CEOs.
- The Impact of Shareholder Power on Bondholders: Evidence from Mergers and Acquisitions
Angie Low, Anil K. Makhija, and Anthony B. Sanders
Takeovers result in the transfer of bondholders’ claims from the target to the acquiring firm, providing a setting to examine the impact of shareholder power on bondholders. We find that excess returns to target bondholders at M & A announcements are positively related to the holdings of the top 5 acquirer institutional owners, a measure of shareholder power. This supports the view that stronger shareholder power, through superior monitoring of managers, can be beneficial to bondholders as well. Our findings are robust to various proxies for shareholder power, adjustments for endogeneity, controls for target shareholder power, and other controls for firm and deal characteristics that have been shown to affect bondholders’ wealth during takeovers.
- Complex Times: Asset Pricing and Conditional Moments under Non-Affine Diffusions (revised 08/08)
Robert L. Kimmel
Many applications in continuous-time financial economics require calculation of conditional moments or contingent claims prices, but such expressions are known in closed-form for only a few specific models. Power series (in the time variable) for these quantities are easily derived, but often fail to converge, even for very short time horizons. We characterize a large class of continuous-time non-a±ne conditional moment and contingent claim pricing problems with solutions that are analytic in the time variable, and that therefore can be represented by convergent power series. The ability to approximate solutions accurately and in closed-form simplifies the estimation of latent variable models, since the state vector must be extracted from observed quantities for many different parameter vectors during a typical estimation procedure.
- Do Entrenched Managers Pay Their Workers More?
Henrik Cronqvist, Fredrik Heyman, Mattias Nilsson, Helena Svaleryd, and Jonas Vlachos
Analyzing a large panel that matches public firms with worker-level data, we find that managerial entrenchment affects workers’ pay. CEOs with more control pay their workers more, but financial incentives through ownership of cash flow rights mitigate such behavior. These findings do not seem to be driven by productivity differences, and are not affected by a series of robustness tests. Moreover, we find that entrenched CEOs pay more to (i) workers associated with aggressive unions; (ii) workers closer to the CEO in the corporate hierarchy, such as CFOs, division vice-presidents and other top-executives; and (iii) workers geographically closer to the corporate headquarters. This evidence is consistent with entrenched CEOs paying higher wages to enjoy non-pecuniary private benefits such as lower effort wage bargaining and improved social relations with certain workers. More generally, our results show that managerial ownership and corporate governance can play an important role for labor market outcomes.
- Why do private acquirers pay so little compared to public acquirers?
Leonce Bargeron, Frederik Schlingemann, René M. Stulz, and Chad Zutter
We find that the announcement gain to target shareholders from acquisitions is significantly lower if a private firm instead of a public firm makes the acquisition. Non-operating firms like private equity funds make the majority of private bidder acquisitions. On average, target shareholders receive 55% more if a public firm instead of a private equity fund makes the acquisition. There is no evidence that the difference in premiums is driven by observable differences in targets. We find that target shareholder gains depend critically on the managerial ownership of the bidder. In particular, there is no difference in target shareholder gains between acquisitions made by public bidders with high managerial ownership and by private bidders. Such evidence suggests that the differences in managerial incentives between private and public firms have an important impact on target shareholder gains and that managers of firms with diffuse ownership may pay too much for acquisitions.
- Has New York become less competitive in global markets? Evaluating foreign listing choices over time
Craig Doidge, G. Andrew Karolyi, and René M. Stulz
We study the determinants and consequences of cross-listings on the New York and London stock exchanges from 1990 to 2005. This investigation enables us to evaluate the relative benefits of New York and London exchange listings and to assess whether these relative benefits have changed over time, perhaps as a result of the passage of the Sarbanes-Oxley Act of Congress (SOX) in 2002. We find that cross-listings have been falling on U.S. exchanges as well as on the Main Market in London. This decline in cross-listings is explained by changes in firm characteristics rather than by changes in the benefits of cross-listing. We show that, after controlling for firm characteristics, there is no deficit in cross-listing counts on U.S. exchanges related to SOX. Investigating the valuation differential between listed and nonlisted firms (the "cross-listing premium") from 1990 to 2005, we find that there is a significant premium for U.S. exchange listings every year, that the premium has not fallen significantly in recent years, that it persists when allowing for unobservable firm characteristics, and that there is a permanent premium in event time. In contrast, there is no premium for listings on London’s Main Market for any year. Crosslisting in the U.S. leads firms to increase their capital-raising activity at home and abroad while a London listing has no such impact. Our evidence is consistent with the theory that an exchange listing in New York has unique governance benefits for foreign firms. These benefits have not been seriously eroded by SOX and cannot be replicated through a London listing.
- The Impact of Competition and Corporate Structure on Productive Efficiency: The Case of the U.S. Electric Utility Industry, 1990-2004
Mika Goto and Anil K. Makhija
In this study, we present empirical evidence on the productive efficiency of electric utilities in the United States over the period, 1990-2004. This is a period marked by major attempts to introduce competition in the industry with the expectation that it will lead firms to improve their productive efficiency and ultimately to lower consumer prices. The actual experience has been surprising, since electricity prices have either fallen little or even risen sharply in some states. Relying on recent advances in the estimation of productive efficiency, we find that firms in jurisdictions that adopted competitive mechanisms have lower productive efficiency compared to firms in jurisdictions where rate-of-return regulation was retained. Furthermore, we provide evidence that firms in states that adopted competition have experienced decreases in productive efficiency, while firms in states with traditional regulation saw increases in efficiency over time. Since the introduction of deregulation has brought greater discretion to managers, we also examine the impact of various organizational choices on productive efficiency. Interestingly, the separation of the generation function from other functions, a hallmark of the effort to deregulate the industry, is associated with an adverse impact on productive efficiency. These findings question the claim that competition necessarily fosters higher productive efficiency. Alternatively, true competition may have been circumvented.
- Fairness Opinions in Mergers and Acquisitions
Anil K. Makhija and Rajesh P. Narayanan
Fairness opinions provided by investment banks advising on mergers and acquisitions have been criticized for being conflicted in aiding bankers further their goal of completing the deal as opposed to aiding boards (and shareholders) by providing an honest appraisal of deal value. We find empirical support for this criticism. We find that shareholders on both sides of the deal, aware of the conflict of interest facing advisors, rationally discount deals where advisors provide fairness opinions. The reputation of the advisor serves to mitigate this discount, while the contingent nature of advisory fees appears to have no impact. Furthermore, consistent with the criticism of fairness opinions, we find evidence suggesting that fairness opinions are sought by boards for the legal cover they provide against shareholders unhappy with the deal’s terms. Thus, altogether our findings suggest that investment bankers and boards may be complicit in using fairness opinions to further their own interests at an expense to shareholders.
- Managerial ownership dynamics and firm value (revised 01/08)
Rüdiger Fahlenbrach and René M. Stulz
From 1988 to 2003, the average change in managerial ownership is significantly negative every year for American firms. We find that managers are more likely to significantly decrease their ownership when their firms are performing well, but not more likely to increase their ownership when their firms have poor performance. Because investors learn about the total change in managerial ownership with a lag, changes in Tobin’s q in a period can be affected by changes in managerial ownership in the previous period. In an efficient market, it is unlikely that changes in managerial ownership in one period are caused by future changes in q. When controlling for past stock returns, we find that large increases in managerial ownership increase q. This result is driven by increases in shares held by officers, while increases in shares held by directors appear unrelated to changes in firm value. There is no evidence that large decreases in ownership have an adverse impact on firm value. We argue that our evidence cannot be wholly explained by existing theories and propose a managerial discretion theory of ownership consistent with our evidence.
- Fundamentals, Market Timing, and Seasoned Equity Offerings
Harry DeAngelo, Linda DeAngelo, and René Stulz
Firms conduct SEOs to resolve a near-term liquidity squeeze, and not primarily to exploit market timing opportunities. Without the SEO proceeds, 62.6% of issuers would have insufficient cash to implement their chosen operating and non-SEO financing decisions the year after the SEO. Although the SEO decision is positively related to a firm’s market-to-book (M/B) ratio and prior excess stock return and negatively related to its future excess return, these relations are economically immaterial. For example, a 150% swing in future net of market stock returns (from a 75% gain to a 75% loss over three years) increases by only 1% the probability of an SEO in the immediately prior year. Strikingly, most firms with quintessential"market timer" characteristics fail to issue stock and a non-trivial number of mature firms do issue stock, with current and former dividend payers raising more than half of all issue proceeds.
- Differences in Governance Practice between U.S. and Foreign Firms: Measurement, Causes, and Consequences
Reena Aggarwal, Isil Erel, René Stulz, and Rohan Williamson
We construct a firm-level governance index that increases with minority shareholder protection. Compared to U.S. matching firms, only 12.68% of foreign firms have a higher index. The value of foreign firms falls as their index decreases relative to the index of matching U.S. firms. Our results suggest that lower country-level investor protection and other country characteristics make it suboptimal for foreign firms to invest as much in governance as U.S. firms do. Overall, we find that minority shareholders benefit from governance improvements and do so partly at the expense of controlling shareholders.
- An Assessment of Terrorism-Related Investing Strategies
G. Andrew Karolyi
Do terrorism-related investing strategies lead to superior investment performance? This study evaluates the risks and returns to two different terrorism-related investment strategies in the U.S. markets over the period from 1994-2006. The first strategy evaluates a sub-portfolio of S&P 500 stocks constructed on the basis of terrorism-related risk scores that measure their operations in countries with a high incidence of terrorism-related activity. The second strategy evaluates a ‘terror-free’ sub-portfolio of S&P 500 stocks in which stocks are screened if they have operations in countries that the U.S. Department of State has designated as state-sponsors of terrorism. I find that the terrorism-related risk exposure portfolio would have earned, on average, an economically small and statistically insignificant 16 basis point premium per month with a tracking error of 2.8% per month and that of the terror-free portfolio an even smaller -1.6 basis point premium per month with a tracking error of 25 basis points per month. Return attribution analysis using a multi-factor model uncovers interesting differences in systematic exposures to market risks, and factors related to size, market-to-book ratios and momentum.
- Common Patterns in Commonality in Returns, Liquidity, and Turnover around the World
G. Andrew Karolyi, Kuan-Hui Lee, and Mathijs A. van Dijk
We uncover similar cross-country and time-series patterns in co-movement or "commonality" in stock returns, liquidity, and trading activity across 40 developed and emerging countries. The extent to which the liquidity and turnover of individual stocks within a country move together is related to the same institutional characteristics as is comovement in stock returns. Commonality is greater in countries with weaker investor protection and a more opaque information environment. Monthly variation in commonality in returns, liquidity, and turnover is also driven by common determinants. Commonality increases during times of high market volatility, large market declines, and high interest rates, and is negatively related to capital market openness. Our results are consistent with theoretical models in which changes in the wealth and collateral value of traders and financial intermediaries endogenously affect liquidity, trading, and pricing.
- Do Funds Need Governance? Evidence from Variable Annuity-Mutual Fund Twins
Richard Evans and Rüdiger Fahlenbrach
We study the roles of traditional governance (boards, sponsors, etc.) and market governance (investors voting with their feet) in mutual funds and variable annuities. We find that market governance is less pronounced for variable annuity investors. Using a matched sample of variable annuity-mutual fund twins, we find that variable annuity investors are less sensitive to poor performance and high fees than mutual fund investors. Given the weaker role played by market governance, we then examine the role played by traditional governance in variable annuities. Variable annuity boards and sponsors add alternative investment options and replace advisors on behalf of their investors after poor performance and high fees. These traditional governance mechanisms are, however, less effective when conflicts of interest exist between variable annuity sponsors and fund advisors.
- Relationships, Corporate Governance, and Performance: Evidence from Private Placements of Common Stock (revised 05/08)
Karen H. Wruck and YiLin Wu
Utilizing a large sample with unique data gathered directly from private placement contracts, we address two important questions that remain unresolved in the literature. First, what types of relationships connect private placement investors and issuers, and how do these relationships affect issuer performance, deal structure and corporate governance? Second, do relationships between issuers and investors, or a lack thereof, shed light on the performance "puzzle" associated with private placements? Our primary finding is a strong, positive association between new relationships formed around the time of a placement and issuer performance at announcement and post-placement. The vast majority of new relationships are governance-related, so our findings are consistent with increased monitoring and/or stronger governance creating value for investors. We also find that relationship investors are more likely to gain governance influence than other investors. Issuers in "new economy" industries and with high specific risk grant investors more governance influence than other issuers, suggesting that access to governance is especially valuable when information asymmetries and/or specific investments are important.
- Is there hedge fund contagion?
Nicole M. Boyson, Christof W. Stahel, and René M. Stulz
We examine whether hedge funds experience contagion. First, we consider whether extreme movements in equity, fixed income, and currency markets are contagious to hedge funds. Second, we investigate whether extreme adverse returns in one hedge fund style are contagious to other hedge fund styles. To conduct this examination, we estimate binomial and multinomial logit models of contagion using daily returns on hedge fund style indices as well as monthly returns on indices with a longer history. Our main finding is that there is no evidence of contagion from equity, fixed income, and foreign exchange markets to hedge funds, except for weak evidence of contagion for one single daily hedge fund style index. By contrast, we find strong evidence of contagion across hedge fund styles, so that hedge fund styles tend to have poor coincident returns.
- Co-Movements of Index Options and Futures Quotes (revision 2005-10)
Rüdiger Fahlenbrach and Patrik Sandås
We re-examine the co-movements of index options and futures quotes first studied in Bakshi, Cao, and Chen (2000). We show that the frequency of quote co-movements that are inconsistent with standard option pricing models is significantly higher around option trades. We examine empirically two explanations for these co-movements. First, we show that in simulations the stochastic volatility model can generate approximately the right frequency of inconsistent co-movements when its parameters are chosen to match observed option prices. But even allowing for different regimes in trade and no-trade periods the model generates virtually the same frequency of inconsistent co-movements. Second, we examine the quote co-movements in event-time around trades and show that they are consistent with either traders picking off stale option quotes or with traders submitting aggressive limit orders. Our evidence suggest that inconsistent co-movements reflect both departures from the univariate diffusion model and market microstructure frictions.
- The Accrual Anomaly: Risk or Mispricing?
David Hirshleifer, Kewei Hou, Siew Hong Teoh
We document considerable return comovement associated with accruals after controlling for other common factors. An accrual-based factor-mimicking portfolio has a Sharpe ratio of 0.15, higher than that of the market factor or the HML factor of Fama and French (1993). In time series regressions, a model that includes the Fama-French factors and the additional accrual factor captures the accrual anomaly in average returns. However, further time series and cross-sectional tests indicate that it is the accrual characteristic rather than the accrual factor loading that predicts returns. These findings favor a behavioral explanation for the accrual anomaly.
- Price and Volatility Transmission across Borders
Louis Gagnon and G. Andrew Karolyi
Over the past forty years, financial markets throughout the world have steadily become more open to foreign investors. With open markets, asset prices are determined globally. A vast literature on portfolio choice and asset pricing has evolved to study the importance of global factors as well as local factors as determinants of portfolio choice and of expected returns on risky assets. There is growing evidence that risk premia are increasingly determined globally. An important outcome of this force of globalization is increased comovement in asset prices across markets. This survey study examines the literature on the dynamics of comovements in asset prices and volatility across markets around the world. The literature began in the 1970s in conjunction with early theoretical developments on international asset pricing models, but it blossomed in the late 1980s and early 1990s with the availability of comprehensive international stock market databases and the development of econometric methodology to model these dynamics.
- The Consequences of Terrorism for Financial Markets: What Do We Know?
G. Andrew Karolyi
The objective of this article is to outline what we, as researchers, know and, more importantly, what we do not yet know about the consequences of terrorism for financial markets. I argue that a number of the efforts used to assess quantitatively the risk of terrorist attacks are limited in scope and are hampered by the limits of the databases used to operationalize such models. I also describe some of the most recent research that has sought to measure the magnitude of the impact of terrorist attacks on financial markets. Most of them have focused on the events surrounding the September 11, 2001 attacks, though a few have broadened the perspective over time and for countries beyond the U.S.
- How has CEO Turnover Changed? Increasingly Performance Sensitive Boards and Increasingly Uneasy CEOs
Steven N. Kaplan and Bernadette A. Minton
We study CEO turnover - both internal (board driven) and external (through takeover and bankruptcy) - from 1992 to 2004 for a sample of large U.S. companies. Annual CEO turnover is higher than that estimated in previous studies over earlier periods. Turnover is 14.5% from 1992 to 2004, implying an average tenure as CEO of less than seven years. In the more recent period since 1998, total CEO turnover increases to 16.1%, implying an average tenure of just over six years. Internal turnover is significantly related to three components of firm performance - performance relative to industry, industry performance relative to the overall market, and the performance of the overall stock market. The relation of internal turnover to performance intensifies after 1997 in that turnover after 1998 is more strongly related to all three measures of performance in the contemporaneous year. External turnover is also related to all three measures of performance over the entire sample period, but there is not a sharp difference between the two sub-periods. We discuss the implications of these finding for various issues in corporate governance.
- Investor Overreaction, Cross-Sectional Dispersion of Firm Valuations, and Expected Stock Returns
I develop and test the theoretical predictions that when investor overreaction to market-wide news is larger, firm valuations in the cross section become more dispersed and stocks earn lower expected returns. Consistent with these predictions, measures of cross-sectional dispersion of firm valuations are negatively related to subsequent market and portfolio excess returns, especially for sets of firms with highly subjective valuations and significant limits to arbitrage. Further, these firms underperform those with the opposite characteristics in periods when beginning-of-period firm valuation dispersion is high. In contrast, they overperform when beginning-of-period firm valuation dispersion is low.
- What Factors Drive Global Stock Returns? (Current Version: January 2011)
Kewei Hou, G. Andrew Karolyi, and Bong-Chan Kho
Using monthly returns for over 27,000 stocks from 49 countries over a three-decade period, we show that a multifactor model that includes factor-mimicking portfolios based on momentum and cash flow-to-price captures significant time series variation in global stock returns, and has lower pricing errors and fewer model rejections than the global CAPM or a popular model that uses size and book-to-market factors. We find reliable evidence that the global cash flow-to-price factor is related to a covariance risk model. In contrast, we reject the covariance risk model in favor of a characteristic model for size and book-to-market factors.
- The World Price of Liquidity Risk
This paper specifies and tests an equilibrium asset pricing model with liquidity risk at the global level. The analysis encompasses 25,000 individual stocks from 48 developed and emerging countries around the world from 1988 to 2004. Though we cannot find evidence that the liquidity adjusted capital asset pricing model of Acharya and Pedersen (2005) holds in international financial markets, cross-sectional as well as time-series tests show that liquidity risks arising from the covariances of individual stocks' return and liquidity with local and global market factors are priced. Furthermore, we show that the US market is an important driving force of world-market liquidity risk. We interpret our evidence as consistent with an intertemporal capital asset pricing model (Merton (1973)) in which stochastic shocks to global liquidity serve as a priced state variable.
- Information, Trading Volume, and International Stock Return Comovements: Evidence from Cross-listed Stocks (updated 02/07)
Louis Gagnon and G. Andrew Karolyi
This paper investigates the dynamic relation between returns and trading volume in international stock markets. We test the heterogeneous-agent, rational expectations model of Llorente, Michaely, Saar, and Wang (2002) for a comprehensive sample of 556 foreign stocks cross-listed on U.S. markets from 36 different markets. Their model argues that investors trade to speculate on their private information or to rebalance their portfolios and predicts that returns associated with portfolio rebalancing tend to reverse themselves while returns generated by speculative trades tend to continue themselves. We test this prediction by analyzing the relationship between trading volume and return comovements between the home and U.S. markets for the cross-listed shares. We hypothesize that returns in the home (U.S.) market on high-volume days are more likely to continue to spill over into the U.S. (home) market for those stocks subject to the risk of greater informed trading. Our empirical evidence provides support for this hypothesis, which highlights the link between information, trading volume and international stock return comovements that has eluded previous empirical investigations.
- Financial globalization, governance, and the evolution of the home bias
Bong-Chan Kho, René M. Stulz, and Francis E. Warnock
Despite the disappearance of formal barriers to international investment across countries, we find that the average home bias of U.S. investors towards the 46 countries with the largest equity markets did not fall from 1994 to 2004 when countries are equally weighted but fell when countries are weighted by market capitalization. This evidence is inconsistent with portfolio theory explanations of the home bias, but is consistent with what we call the optimal insider ownership theory of the home bias. Since foreign investors can only own shares not held by insiders, there will be a large home bias towards countries in which insiders own large stakes in corporations. Consequently, for the home bias to fall substantially, insider ownership has to fall in countries where it is high. Poor governance leads to concentrated insider ownership, so that governance improvements make it possible for corporate ownership to become more dispersed and for the home bias to fall. We find that the home bias of U.S. investors decreased the most towards countries in which the ownership by corporate insiders is low and countries in which ownership by corporate insiders fell. Using firm-level data for Korea, we find that portfolio equity investment by foreign investors in Korean firms is inversely related to insider ownership and that the firms that attract the most foreign portfolio equity investment are large firms with dispersed ownership.
- It’s SHO Time! Short-Sale Price-Tests and Market Quality (updated 08/07)
Karl B. Diether, Kuan-Hui Lee, and Ingrid M. Werner
We examine the effects of the SEC mandated temporary suspension of short-sale price-tests for a set of Pilot securities. While short-selling activity increased both for NYSE and NASDAQ-listed Pilot stocks, returns and volatility at the daily level are unaffected. NYSE-listed Pilot stocks experience more symmetric trading patterns and a slight increase in spreads and intraday volatility after the suspension while there is a smaller effect on market quality for NASDAQ listed Pilot stocks. The results suggest that the effect of the price-tests on market quality can largely be attributed to the distortions in order flow created by the price-tests in the first place. Therefore, we believe that the price-tests can safely be permanently suspended.
- Large Shareholders and Corporate Policies
Henrik Cronqvist and Rüdiger Fahlenbrach
We develop an empirical framework that allows us to analyze the effects of heterogeneity across large shareholders, and we construct a new blockholder-firm panel data set in which we can track all unique blockholders among large U.S. public firms. We find statistically significant and economically important blockholder fixed effects in investment, financial, and executive compensation policies. This evidence suggests that blockholders vary in their beliefs, skills, or preferences. Different large shareholders have distinct investment and governance styles: they differ in their approaches to corporate investment and growth, their appetites for financial leverage, and their attitudes towards CEO pay. We also find blockholder fixed effects in firm performance measures, and differences in style are systematically related to firm performance differences. Our results are consistent with influence for activist, pension fund, corporate, individual, and private equity blockholders, but consistent with systematic selection for mutual funds. Finally, we analyze sources of the heterogeneity, and find that blockholders with a larger block size, board membership, direct management involvement as officers, or with a single decision maker are associated with larger effects on corporate policies and firm performance.
- Enterprise Risk Management: Theory and Practice
Brian Nocco and René M. Stulz
In this paper, we explain how enterprise risk management creates value for shareholders. In contrast to the existing finance literature, we emphasize the organizational benefits of risk management. We show how a firm should choose its risk appetite and measure risk when implementing enterprise risk management. We also provide an extensive guide to the implementation issues faced by firms that implement enterprise risk management.
- Advertising and Portfolio Choice
This paper examines the role that advertising plays in the mutual fund industry and whether advertising affects investors’ fund and portfolio choices. Content analysis shows that only a small fraction of fund advertising is directly informative about characteristics relevant for rational investors, such as fund fees. Higher quantities of advertising do not signal ex ante higher unobservable fund manager ability, because funds that advertise more are not associated with higher post-advertising excess returns. Fund advertising is shown to affect investors’choices, although it provides little information. These results do not seem to be driven by the endogeneity of advertising, and are robust to a series of robustness checks. Finally, advertising is found to steer people towards portfolios with higher fees and more risk, through higher exposure to equities, more active management, more "hot" sectors, and more home bias. This evidence has implications for welfare analysis, asset pricing and public policy, and may serve as a starting point for broader analysis of marketing and persuasion efforts in financial markets.
- Why do U.S. firms hold so much more cash than they used to? (updated 03/07)
Thomas W. Bates, Kathleen M. Kahle, and René M. Stulz
The average cash to assets ratio for U.S. industrial firms increases by 129% from 1980 to 2004. Because of this increase in the average cash ratio, firms at the end of the sample period can pay back all of their debt obligations with their cash holdings, so that the average firm has no leverage when leverage is measured by net debt. This change in cash ratios and net debt is the result of a secular trend rather than the outcome of the recent buildup in cash holdings of some large firms, but is more pronounced for firms that do not pay dividends. The average cash ratio increases over the sample period because firms change: their cash flow becomes riskier, they hold fewer inventories and accounts receivable, and are increasingly R&D intensive. The precautionary motive for cash holdings appears to explain the increase in the average cash ratio.
- Subordinations Levels in Structured Financing
Xudong An, Yongheng Deng, and Anthony B. Sanders
Subordination levels are of critical importance in the classic senior-subordinated structure for securitized financing (such as collateralized debt obligations and commercial mortgage-backed securities). Subordination levels determine the amount of credit support that the senior bonds (or tranches) require from the subordinated bonds (or tranches) and are provided by the rating agencies. Thus, ratings agencies play an important role in the pricing and risk management of structured finance products.
The finance literature has numerous studies examining whether securities with higher risk (as predicted by asset pricing models, such as the CAPM) earn higher ex-post average returns. In a similar vein, it is of interest to examine whether securities (or tranches) with greater levels of subordination experience higher ex-post levels of delinquencies and default. In this paper, we examine whether bonds (or tranches) with greater levels of subordination do, in fact, experience higher ex-post levels of delinquencies and default.
Recent studies have found that rating agencies follow a "learning by doing" approach in subordination structuring (Riddiough and Chiang, 2004). As expected, the rating agencies were conservative in the early stages with regard to subordination levels given the paucity of information about delinquencies, defaults and prepayments on loans. As time progresses and more information is available regarding loan performance,subordination levels adjusted to new levels. This paper focuses on cross sectional differences in subordination levels. We examine if this relationship between subordination and ex-post delinquencies and defaults is conforming to rational expectation.
We perform both a deal level and a loan level analysis using commercial mortgage-backed securities (CMBS). Our results show that the expected loss for CMBS pools are a statistically significant factor in explaining both AAA and BBB bond subordinations; however, expected loss accounts for less than 30 percent of the variation. Even considering the rating agencies’ practice of incorporating differences in loan terms, borrower quality, deal structural and information quality into their subordination structure, the empirical fit is still too low. These findings indicate the difficulty in determining subordination levels apriori.
- The Effect of Bank Mergers on Loan Prices: Evidence from the U.S. (updated 12/07)
Bank mergers can increase or decrease loan spreads, depending on whether the increased market power outweighs efficiency gains. Using proprietary loan-level data for U.S. commercial banks, I find that, on average, mergers reduce loan spreads, with the magnitude of the reduction being larger when post-merger cost savings increase. My results suggest that the relation between spreads and the extent of market overlap between merging banks is non-monotonic. Market overlap increases cost savings and consequently lowers spreads, but when the overlap is sufficiently large, spreads increase, potentially due to the market-power effect dominating the cost savings. Furthermore, the average reduction in spreads is significant for small businesses.
- Managerial Risk-Taking Behavior and Equity-Based Compensation
I study managers' risk-taking behavior and how it is affected by equity-based compensation. I find that in response to an exogenous increase in takeover protection in Delaware during the mid-1990s, managers lower firm risk by 5%. I also find that the decrease in firm risk is concentrated among firms with low managerial equity-based incentives. In particular, firms with low CEO portfolio sensitivity to stock return volatility experience more than 10% reduction in risk. Further, firms respond to the increased protection accorded by the regime shift with greater incentives for risk-taking.
- The Economics of Conflicts of Interest in Financial Institutions
Hamid Mehran and René M. Stulz
A conflict of interest exists when a party to a transaction could potentially make a gain from taking actions that are detrimental to the other party in the transaction. This paper examines the economics of conflicts of interest in financial institutions and reviews the growing empirical literature (mostly focused on analysts) on the economic implications of these conflicts. Economic analysis shows that, although conflicts of interest are omnipresent when contracting is costly and parties are imperfectly informed, there are important factors that mitigate their impact and, strikingly, it is possible for customers of financial institutions to benefit from the existence of such conflicts. The empirical literature reaches conclusions that differ across types of conflicts of interest, but overall these conclusions are more ambivalent and certainly more benign than the conclusions drawn by journalists and politicians from mostly anecdotal evidence. Though much has been made of conflicts of interest arising from investment banking activities, there is no consensus in the empirical literature supporting the view that conflicts resulting from these activities had a systematic adverse impact on customers of financial institutions.
- List Prices, Sale Prices, and Marketing Time: An Application to U.S. Housing Markets
Donald R. Haurin, Jessica L. Haurin, Taylor Nadauld, and Anthony B. Sanders
Many goods are marketed after first stating a list price, with the expectation that the eventual sales price will differ. In this paper we first extend search theory to include the seller setting a list price. Holding constant the mean of the buyers’ distribution of potential offers for a good, we assume that the greater the list price, the slower the arrival rate of offers but the greater is the maximal offer. This tradeoff determines the optimal list price, which is set simultaneously with the seller’s reservation price. Comparative statics are derived through a set numerical sensitivity tests, where we show that the greater the variance of the distribution of buyers’ potential offers, the greater is the ratio of the list price to expected sales price. Thus, sellers of atypical goods will tend to set a relatively high list price compared with standard goods. We test this hypothesis using data from the Columbus, Ohio housing market and find substantial support. Other applications could include the market for fine art or autos.
- R2 and Price Inefficiency
Kewei Hou, Lin Peng, and Wei Xiong
Motivated by the recent debate on return R2 as an information-efficiency measure, this paper proposes and examines a new hypothesis that R2 is related to investors’ biases in processing information. We provide a model to show that R2 decreases with the degree of the marginal investor’s overreaction to firm-specific information. This theoretical result motivates an empirical hypothesis that stocks with lower R2 should exhibit more pronounced overreaction-driven price momentum. Empirically, we confirm that such a negative relationship between R2 and price momentum exists, and find this relationship robust to controls for risk as well as several alternative mechanisms, such as slow information diffusion, information uncertainty, fundamental R2 and illiquidity. Furthermore, we also document stronger long-run price reversals for stocks with lower R2. Taken together, our results suggest that return R2 could be related to price inefficiency.
- Commercial Mortgage-backed Securities (CMBS) Terminations, Regional and Property-Type Risk
Yongheng Deng, John M. Quigley, and Anthony B. Sanders
Option theory predicts that mortgage default or prepayment will be exercised if the call or put option is "in the money." We extend our analysis to commercial mortgages using data from commercial mortgage-backed securities (CMBS). The paper presents a model of the competing risks of mortgage termination (default and prepayment) using data from commercial mortgage-backed securities (CMBS) deals. Our results show that the option model explains both default and prepayment for commercial mortgages. We find that loan specific variables (such as loan-to-value ratio, debt service coverage ratio, loan-rate spread and prepayment prevention) are important explanatory variables for both default and prepayment. We also find that default and prepayment vary across regions of the country; given that regional economies do not move in perfect lock-step, we would expect there to be cross-sectional variation in default rates. However, the degree of variation across regions in terms of prepayments is not as predictable. The largest differences are across property types, both in terms of default and prepayment risk.
- Do U.S. Firms Have the Best Corporate Governance? A Cross-Country Examination of the Relation between Corporate Governance and Shareholder Wealth
Reena Aggarwal, Isil Erel, René Stulz, and Rohan Williamson
We compare the governance of foreign firms to the governance of similar U.S. firms. Using an index of firm governance attributes, we find that, on average, foreign firms have worse governance than matching U.S. firms. Roughly 8% of foreign firms have better governance than comparable U.S. firms. The majority of these firms are either in the U.K. or in Canada. When we define a firm’s governance gap as the difference between the quality of its governance and the governance of a comparable U.S. firm, we find that the value of foreign firms increases with the governance gap. This result suggests that firms are rewarded by the markets for having better governance than their U.S. peers. It is therefore not the case that foreign firms are better off simply mimicking the governance of comparable U.S. firms. Among the individual governance attributes considered, we find that firms with board and audit committee independence are valued more. In contrast, other attributes, such as the separation of the chairman of the board and of the CEO functions, do not appear to be associated with higher shareholder wealth.