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:

2017

  • 2017-01 -- Assessing Managerial Ability: Implications for Corporate Governance

    Assessing Managerial Ability: Implications for Corporate Governance
    Benjamin E. Hermalin and Michael S. Weisbach
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    A manager’s current and potential future employers are continually assessing her or his ability. Such assessment is a crucial component of corporate governance and this chapter provides an overview of the research on that aspect of governance. In particular, we review how assessment generates incentives (both good and bad), generates risks that must be faced by both managers and firms, and affects the contractual relationships between those parties in important ways. Assessment (or learning) proves 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.

  • 2017-02 -- Equity Incentives, Disclosure Quality, and Stock Liquidity Risk

    Equity Incentives, Disclosure Quality, and Stock Liquidity Risk
    Karen H. Wruck and YiLin Wu
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    We provide evidence that CEO equity incentives, especially stock options, influence stock liquidity risk via information disclosure quality. We document a negative association between CEO options and the quality of future managerial disclosure policy. Contributing to the literature on CEO risk-taking, we document a positive association between CEO options and future systematic stock liquidity risk. Controlling for endogeneity, we show that information disclosure quality is an important channel through which CEO options influence stock liquidity risk. Results are robust to various controls for endogeneity and to the use of numerous disclosure quality and stock liquidity risk measures.

  • 2017-03 -- Trading Fees and Intermarket Competition

    Trading Fees and Intermarket Competition
    Marios Payaides, Barbara Rindi, and Ingrid M. Werner
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    We model an order book with liquidity rebates (make fees) and trading fees (take fees) that faces intermarket competition, and use the model's insights to explain changes in market quality and market shares following changes in make-take fees. As predicted by our model, we document that fee changes by one venue affect market quality and market shares for all venues that compete for order flow. Furthermore, we document cross-sectional differences in changes in market quality and market shares following a simultaneous decrease in both make and take fees consistent with traders in large (small) capitalization stocks being more sensitive to the change in make (take) fees.

  • 2017-04 -- What is the Shareholder Wealth Impact of Target CEO Retention in Private Equity Deals?

    What is the Shareholder Wealth Impact of Target CEO Retention in Private Equity Deals?
    Leonce Bargeron, Frederik Schlingemann, René M. Stulz, and Chad Zutter
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    There is a widespread belief among observers that a lower premium is paid when the target CEO is retained by the acquirer in a private equity deal because the CEO’s potential conflicts of interest leads her to negotiate less aggressively on behalf of the target shareholders. Our empirical evidence is not consistent with this belief. We find that, when a private equity acquirer retains the target CEO, target shareholders receive an acquisition premium that is larger by as much as 18% of pre-acquisition firm value when accounting for the endogeneity of the retention decision. Our evidence is consistent with what we call the “valuable CEO hypothesis.” With this hypothesis, retention of the CEO can be valuable to private equity acquirers because, unlike public operating companies with managers in place, these acquirers have to find a CEO to run the post-acquisition company and the incumbent CEO may be the best choice to do so because she has valuable firm-specific human capital. When a private equity acquirer finds a target with a CEO who can manage the post-acquisition company better than other potential CEOs, we expect target shareholders to receive a larger premium because the post-acquisition value of the target is higher.

  • 2017-05 -- Cash, Financial Flexibility, and Product Prices: Evidence from a Natural Experiment in the Airline Industry

    Cash, Financial Flexibility, and Product Prices: Evidence from a Natural Experiment in the Airline Industry
    Sehoon Kim
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    Corporate cash holdings impact firms’ product pricing strategies. Exploiting the Aviation Investment and Reform Act of the 21st Century as a quasi-natural experiment to identify exogenous shocks to competition in the airline industry, I find that firms with more cash than their rivals respond to intensified competition by pricing more aggressively, especially when there is less concern of rival retaliation. Financially flexible firms based on alternative measures respond similarly. Moreover, cash-rich firms experience greater market share gains and long-term profitability growth. The results highlight the importance of strategic interdependencies across firms in the effective use of flexibility provided by cash.

  • 2017-06 -- Impulsive Consumption and Financial Wellbeing: Evidence from an Increase in the Availability of Alcohol

    Impulsive Consumption and Financial Wellbeing: Evidence from an Increase in the Availability of Alcohol
    Itzhak Ben-David and Marieke Bos
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    Increased availability of temptation goods might harm individuals if they have time-inconsistent preferences and consume more in the present than planned before. We study this idea by examining the credit behavior of low-income households around the expansion of the opening hours of retail liquor stores during a nationwide experiment in Sweden. Consistent with store closures serving as commitment devices, expanded operating hours led to higher alcohol consumption (Nordström and Skog 2003) and greater consumer credit uptake and default. Thus, our results show that limiting the availability of temptation goods can improve the financial wellbeing of individuals with inconsistent-time preferences.

  • 2017-07 -- Accounting-based Compensation Contracts, the Cost of Borrowing, and the Structure of Corporate Debt Contracts

    Accounting-based Compensation Contracts, the Cost of Borrowing, and the Structure of Corporate Debt Contracts
    Zhi Li, Lingling Wang, and Karen H. Wruck
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    The recent trend of incorporating accounting-based performance measures into CEO compensation plans influences the firm’s cost of borrowing and the structure of corporate debt contracts. Bank loans to firms that grant long-term accounting-based incentive plans (LTAPs) to CEOs in the prior year have lower spreads and fewer restrictive covenants. Results are strongest for borrowing firms with high leverage and bankruptcy risk, and that are difficult for lenders to monitor, which suggests that LTAPs help align incentives between shareholders and debtholders. Results are robust to alternative measures of borrowing costs, including spreads for new public bonds, credit ratings, and CDS spreads.

  • 2017-08 -- Are Larger Banks Valued More Highly?

    Are Larger Banks Valued More Highly?
    Bernadette A. Minton, René M. Stulz, and Alvaro G. Taboada
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    We investigate whether the value of large banks, defined as banks with assets in excess of the Dodd-Frank threshold for enhanced supervision, increases with the size of their assets using Tobin’s q and market-to-book as our valuation measures. Many argue that large banks receive subsidies from the regulatory safety net, so they should be worth more and their valuation should increase with size. Instead, using a variety of approaches, we find (1) no evidence that large banks are valued more highly, (2) strong cross-sectional evidence that the valuation of large banks falls with size, and (3) strong evidence of a within-bank negative relation between valuation and size for large banks from 1987 to 2006 but not when the post-Dodd-Frank period is included in the sample. The negative relation between bank value and bank size for large banks cannot be systematically explained by differences in ROA or ROE, equity volatility, tail risk, distress risk, and equity discount rates. However, we find that banks with more trading assets are worth less. A 1% increase in trading assets is associated with a Tobin’s q lower by 0.2% in regressions with year and bank fixed effects. This relation between bank value and trading assets helps explain the cross-sectional negative relation between large bank valuation and size. Our results hold when we use instrumental variables for bank size.

  • 2017-09 -- Is Post-Crisis Bond Liquidity Lower?

    Is Post-Crisis Bond Liquidity Lower?
    Mike Anderson and René M. Stulz
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    Price-based liquidity metrics are much better for small trades after the crisis than before the crisis. For large trades, these metrics are generally worse from 2010 to 2012 and better from 2013 to 2014 than from 2004 to 2006. However, turnover falls sharply after the crisis, which is consistent with investors having more difficulty completing trades on acceptable terms. A frequent concern is that post-crisis liquidity could be low when markets are stressed. We consider three stress events: extreme VIX increases, extreme bond yield increases, and downgrades to high yield. We find evidence that liquidity is lower after the crisis for extreme VIX increases. However, we find no evidence that liquidity related to idiosyncratic stress events is worse after the crisis than before the crisis. Our results emphasize the importance of considering how liquidity reacts to shocks which can affect financial stability and of taking into account the information from non-price liquidity metrics.

  • 2017-10 -- Replicating Anomalies

    Replicating Anomalies
    Kewei Hou, Chen Xue, and Lu Zhang
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    The anomalies literature is infested with widespread p-hacking. We replicate the entire anomalies literature in finance and accounting by compiling a largest-to-date data library that contains 447 anomaly variables. With microcaps alleviated via New York Stock Exchange breakpoints and value-weighted returns, 286 anomalies (64%) including 95 out of 102 liquidity variables (93%) are insignificant at the conventional 5% level. Imposing the cutoff t-value of three raises the number of insignificance to 380 (85%). Even for the 161 significant anomalies, their magnitudes are often much lower than originally reported. Out of the 161, the q-factor model leaves 115 alphas insignificant (150 with t < 3). In all, capital markets are more efficient than previously recognized.

  • 2017-11 -- Multinational Firms and the International Transmission of Crises: The Real Economy Channel

    Multinational Firms and the International Transmission of Crises: The Real Economy Channel
    Jan Bena, Serdar Dinc, and Isil Erel
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    This paper studies investment and employment at a subsidiary located in a non-crisis country if its parent firm also has a subsidiary in a crisis country. It finds that investment is about 18% lower in the subsidiaries of these parents relative to the same-industry, same-country subsidiaries of multinational firms that do not have a subsidiary in a crisis country. Net new hiring of employees in these subsidiaries is also lower in these subsidiaries. These results hold for the parents that are unlikely financially constrained and are robust to controlling for subsidiary and parent size, parent cash flow, subsidiary country, industry, year, and parent country, as well as using alternative crisis definitions.

  • 2017-12 -- Price Risk, Production Flexibility, and Liquidity Management: Evidence from Electricity Generating Firms

    Price Risk, Production Flexibility, and Liquidity Management: Evidence from Electricity Generating Firms
    Chen Lin, Thomas Schmid, and Michael S. Weisbach
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    Production inflexibility together with product price uncertainty creates price risk, which is a potentially important factor for liquidity management. We measure price risk for the electricity producing industry based on hourly prices in 40 electricity markets and data on generation technologies of about 70,000 individual power plants. Higher price volatility leads to increased cash holdings, but only in firms using inflexible production technologies. This effect is robust to instrumenting for price volatility using weather forecast data. Price risk affects cash holdings most in financially constrained firms, and in firms that cannot easily hedge electricity prices through derivative markets.

  • 2017-13 -- Corporate Liquidity, Acquisitions, and Macroeconomic Conditions

    Corporate Liquidity, Acquisitions, and Macroeconomic Conditions
    Isil Erel, Yeejin Jang, Bernadette A. Minton, and Michael S. Weisbach
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    Firms hold liquid assets to enhance their ability to invest efficiently when external financing costs are high, especially during poor macroeconomic conditions. Using a sample of 47,378 acquisitions from 36 countries between 1997 and 2014, we study how the relation between firms’ cash holdings and their acquisition decisions changes over macroeconomic cycles. We find that higher cash holdings increase the likelihood a firm will make an acquisition. Better macroeconomic conditions, which lower the cost of external finance, also increase the likelihood of an acquisition. However, larger cash holdings decrease the sensitivity of acquisitions to macroeconomic factors, suggesting that cash holdings lower financing constraints during times when the cost of external finance is high. Announcement day abnormal returns for acquirers follow a consistent pattern: they decrease with acquirer cash holdings and with better macroeconomic conditions. The results are consistent with the view that firms choose liquidity levels to insure against poor macroeconomic conditions.

  • 2017-14 -- Can Reinvestment Risk Explain the Dividend and Bond Term Structures?

    Can Reinvestment Risk Explain the Dividend and Bond Term Structures?
    Andrei S. Gonçalves
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    Contradicting leading asset pricing models, recent evidence indicates the term structure of dividend discount rates is downward sloping despite the typical upward sloping bond yield curve. This paper empirically shows that reinvestment risk explains both the dividend and bond term structures. Intuitively, dividend claims hedge equity reinvestment risk because dividend present values rise as expected returns decline. This hedge is more effective for longer-term dividend claims because they are more sensitive to discount rate variation, resulting in a downward sloping dividend term structure. For bonds, as expected equity returns decline, nominal interest rates rise, and bond prices fall. Consequently, bonds are exposed to equity reinvestment risk, and this exposure increases with duration, giving rise to an upward sloping bond term structure.

  • 2017-15 -- Bank Sovereign Bond Holdings, Sovereign Shock Spillovers, and Moral Hazard During the European Crisis

    Bank Sovereign Bond Holdings, Sovereign Shock Spillovers, and Moral Hazard During the European Crisis
    Andrea Beltratti and René M. Stulz
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    We use days with tail sovereign CDS spread changes of peripheral countries to identify the effects of shocks to the cost of borrowing of these countries on stock returns of banks from other countries. We find that tail sovereign GIIPS CDS changes have an asymmetric impact in that bank stocks benefit more from negative CDS spread shocks than they are hurt by positive shocks, which creates moral hazard and is best explained by a “too-systemic-to-fail” effect. The contagion effects are stronger for more pervasive shocks, so that idiosyncratic shocks to small countries, such as Greece, do not have an economically significant impact, but shocks involving large GIIPS countries or multiple GIIPS countries have such an impact. In our benchmark specification, holdings of peripheral country bonds by banks from other countries do not constitute a statistically or economically significant contagion channel for tail spread increases.

  • 2017-16 -- The Economics of Value Investing

    The Economics of Value Investing
    Kewei Hou, Haitao Mo, Chen Xue, and Lu Zhang
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    The investment CAPM provides an economic foundation for Graham and Dodd’s (1934) Security Analysis. Expected returns vary cross-sectionally, depending on firms’ investment, profitability, and expected investment growth. Empirically, many anomaly variables predict future changes in investment-to-assets, in the same direction in which these variables predict future returns. However, the expected investment growth effect in sorts is weak. The investment CAPM has different theoretical properties from Miller and Modigliani’s (1961) valuation model and Penman, Reggiani, Richardson, and Tuna’s (2017) characteristic model. In all, value investing is consistent with efficient markets.

  • 2017-17 -- De Facto Seniority, Credit Risk, and Corporate Bond Prices

    De Facto Seniority, Credit Risk, and Corporate Bond Prices
    Jack Bao and Kewei Hou
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    We study the effect of a bond's place in its issuer's maturity structure on credit risk. Using a structural model as motivation, we argue that bonds due relatively late in their issuers' maturity structure have greater credit risk than do bonds due relatively early. Empirically, we find robust evidence that these later bonds have larger yield spreads and greater comovement with equity and that the magnitude of the effects is consistent with model predictions for investment-grade bonds. Our results highlight the importance of bond-specific credit risk for understanding corporate bond prices.

  • 2017-18 -- U.S. Tick Size Pilot

    U.S. Tick Size Pilot
    Barbara Rindi and Ingrid Werner
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    The U.S. equity markets are currently conducting a pilot study of the effects of a larger tick size on market quality and on the rewards for liquidity provision. We show that the larger tick size causes quoted and effective spreads, but also depth, to increase. This raises the cost for retail-sized liquidity demanding orders by almost fifty percent. However, average trade size increases, suggesting that institutions may benefit from the deeper quotes. The larger tick size translates into forty percent higher profits to liquidity providers despite larger price impacts. We attribute these changes mainly to the changes in tick size for displayed quotes, while there are modest or no effects of requiring all trades to execute on a coarser price grid. Moreover, the bulk of the effects occur for tick-constrained stocks which trading costs more than double. By contrast, trading costs for unconstrained stocks decline by more than ten percent. Finally, we document significant spillovers to stocks with unchanged tick size. Our evidence suggests that some market makers left stocks trading in decimals for the more lucrative pilot stocks, and that the reduced competition causes quoted spreads and rewards for liquidity provision to increase also for stocks trading in decimals.

  • 2017-19 -- Does the Investment Model Explain Value and Momentum Simultaneously?

    Does the Investment Model Explain Value and Momentum Simultaneously?
    Andrei S. Gonçalves, Chen Xue and Lu Zhang
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    Two innovations in the structural investment model go a long way in explaining value and momentum jointly. Firm-level investment returns are constructed from firm-level accounting variables, and are then aggregated to the portfolio level to match with portfolio-level stock returns. In addition, current assets form a separate production input besides physical capital. The model fits well the value, momentum, investment, and profitability premiums jointly, and partially explains the positive stock-investment return correlations, the procyclicality and short-term dynamics of the momentum and profitability premiums, and the countercyclicality and long-term dynamics of the value and investment premiums. However, the model fails to explain momentum crashes.

  • 2017-20 -- Do CEOs Make Their Own Luck? Relative versus Absolute Performance Evaluation and Firm Risk

    Do CEOs Make Their Own Luck? Relative versus Absolute Performance Evaluation and Firm Risk
    Karen H. Wruck and YiLin Wu
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    Influenced by their compensation plans, CEOs make their own luck through decisions that affect future firm risk. After adopting a relative performance evaluation (RPE) plan, total and idiosyncratic risk are higher, and the correlation between firm and industry performance is lower. The opposite is true for firms that adopt absolute performance evaluation (APE) plans. Plans including accounting-based performance metrics and/or cash payouts have weaker risk-related incentives. The higher idiosyncratic risk associated with RPE increases a firm’s exposure to downside stock return risk and lowers credit quality. Our findings are economically consistent with observed differences in firms’ financial and investment policies.

  • 2017-21 -- The Politics of Foreclosures

    The Politics of Foreclosures
    Sumit Agarwal, Gene Amromin, Itzhak Ben-David, and Serdar Dinc
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    U.S. House of Representatives Financial Services Committee considered many important banking reforms in 2009-2010 including the Dodd-Frank Act. We show that during this period, the foreclosure starts on delinquent mortgages were delayed in the districts of committee members even though there was no difference in delinquency rates between committee and non-committee districts. In these areas, banks delayed the start of the foreclosure process by 0.5 months (relative to the 12-month average). The total estimated cost of delay to lenders is an order of magnitude greater than the campaign contributions by the Political Action Committees of the largest mortgage servicing banks to the committee members in that period and is comparable to these banks' lobbying expenditures.

  • 2017-22 -- The Economics of PIPEs

    The Economics of PIPEs
    Jongha Lim, Michael W. Schwert, and Michael S. Weisbach
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    This paper considers a sample of 3,001 private investments in public equities (PIPEs). Issuing firms tend to be small and poorly performing, so have limited access to traditional sources of finance. To attract capital, they offer shares in a PIPE at a substantial discount to the market price, along with warrants and a collection of other rights. Because of the discount at issuance, PIPE returns decline with the holding period, which itself is a function of registration status and liquidity of the shares issued in the PIPE. Assuming that the PIPE investor sells 10% of volume each day following the issuance, the average PIPE investor holds the stock for 384 days and earns an abnormal return of 21.2%. More risky firms tend to raise capital from relatively risk tolerant investors such as hedge funds and private equity funds. PIPEs issued to more constrained firms have higher holding period adjusted returns but these returns are more volatile. The abnormal holding period adjusted returns earned by PIPE investors appear to be compensation for providing capital to otherwise constrained firms.

  • 2017-23 -- Is Borrowing from Banks More Expensive than Borrowing from the Market?

    Is Borrowing from Banks More Expensive than Borrowing from the Market?
    Michael W. Schwert
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    This paper investigates the pricing of bank loans in a dataset of new loans to firms with outstanding bonds. After accounting for seniority, banks earn an economically large interest rate premium relative to the price of credit risk in the bond market. To quantify the bank premium, I apply a structural model that incorporates debt priority and prices corporate bonds accurately. The model matches expected loan recoveries conditional on default, but estimates loan spreads that are 240 basis points smaller, or 84% lower, than observed in the data. Separate analysis of secured bonds shows that seniority is priced appropriately in the bond market, which suggests that the loan premium is special to banks. The revealed preference of firms implies that they place a high value on bank services other than the simple provision of debt capital.

  • 2017-24 -- Procyclical Finance: The Money View

    Procyclical Finance: The Money View
    Yi Li
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    This paper offers a theory of procyclical inside money creation and the resulting instability. Banks hold risky loans and issue safe debt that serves as stores of value and means of payment (“inside money”). Firms hold bank debt to buffer idiosyncratic liquidity shocks that cut off financing precisely when resources are needed for growth. Aggregate shocks to loan return trigger boom-bust cycles through the impact on banks’ balance-sheet capacity. In booms, abundant supply of inside money helps firms manage liquidity. As firms’ enterprise value rises, they want to hold even more money in anticipation of growth opportunities. The feedback loop pushes up bank leverage, so downside risk accumulates as a boom prolongs. In crises, the spiral flips. Inside money supply collapses, and firms’ liquidity management is compromised. The recovery is sluggish, as banks rebuild their capital slowly under low leverage. Introducing government debt as an alternative money (“outside money”) can be counterproductive. Its competition with inside money can amplify the procyclicality of bank leverage, and slow down the rebuild of bank capital in crises, thus making booms more fragile and crises more stagnant.

  • 2017-25 -- Political Uncertainty and Commodity Prices

    Political Uncertainty and Commodity Prices
    Kewei Hou, Ke Tang, and Bohui Zhang
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    Using a comprehensive sample of 87 commodities, we examine the effect of political uncertainty on commodity prices. We show that political uncertainty surrounding U.S. presidential elections has a significant negative impact on commodity prices worldwide, likely due to shrinking demand before the elections. On average, commodity prices decline by 6.4% in the quarter leading up to U.S. elections. This effect holds true for gold, and is stronger for close elections and elections during recessions. On the other hand, political uncertainty in commodity producing countries with little demand pushes commodity prices up by 5.4% in the quarter before their national elections.

  • 2017-26 -- Decreasing Returns or Mean-reversion of Luck? The Case of Private Equity Fund Growth

    Decreasing Returns or Mean-reversion of Luck? The Case of Private Equity Fund Growth
    Andrea Rossi
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    In private equity fund data, there exists a strong negative association between fund growth and performance at the partnership level. As a consequence, there is a consensus that decreasing returns are particularly large. I argue that this inference is unwarranted. In essence, Bayesian-informed expectations reveal that the partnerships whose funds grew the most were on average lucky in the past; as that luck reverts to zero, a spurious negative association between growth and returns is generated in the data. Controlling for this bias, the effect of growth on performance is about 80% smaller and statistically insignificant for both buyout and venture capital funds. Furthermore, I show that, historically, decreasing returns do not seem to have played a major role in the erosion of performance persistence in private equity. These results have implications for fund managers’ and investors’ decisions, and for our understanding of the private equity industry.

  • 2017-27 -- How Do Financial Constraints Affect Product Pricing? Evidence from Weather and Life Insurance Premiums

    How Do Financial Constraints Affect Product Pricing? Evidence from Weather and Life Insurance Premiums
    Shan Ge
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    I identify effects of financial constraints on firms’ product pricing decisions, using a sample of insurance groups (conglomerates) that contain both life and P&C (property & casualty) subsidiaries. P&C subsidiaries’ losses can tighten financial constraints for the life subsidiaries through internal capital markets. I present a model that predicts following P&C losses, premiums should fall for life policies that initially increase insurers’ statutory capital, and rise for policies that initially decrease capital. Empirically, I find that P&C losses cause changes in life insurance premiums as my model predicts. The effects are concentrated in more financially constrained groups. Evidence also indicates that life subsidiaries increase capital transfers to P&C subsidiaries following larger P&C losses. These results hold when instrumenting for P&C losses using data on weather damages, implying that P&C losses do cause changes in life insurance premiums and internal capital transfers. My findings suggest that when financial constraints tighten, firms change product prices to relax the constraints, and how prices change depends on the initial impact of selling the products on firms’ financial resources.

     

  • 201-28 -- Corporate Deleveraging and Financial Flexibility

    Corporate Deleveraging and Financial Flexibility
    Harry DeAngelo, Andrei S. Gonçalves, René M. Stulz
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    Most firms deleverage from their historical peak market-leverage (ML) ratios to near-zero ML, while also markedly increasing cash balances to high levels. Among 4,476 nonfinancial firms with five or more years of post-peak data, median ML is 0.543 at the peak and 0.026 at the later trough, with a six-year median time from peak to trough and with debt repayment and earnings retention accounting for 93.7% of the median peak-to-trough decline in ML. The findings support theories in which firms deleverage to restore ample financial flexibility and are difficult to reconcile with most firms having materially positive leverage targets.

2016

  • 2016-01 -- Day of the Week and the Cross-Section of Returns

    Day of the Week and the Cross-Section of Returns
    Justin Birru
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    Long-short anomaly returns are strongly related to the day of the week. Anomalies for which the speculative leg is the short (long) leg experience the highest (lowest) returns on Monday. The opposite pattern is observed on Fridays. The effects are large; Monday (Friday) alone accounts for over 100% of returns for all anomalies examined for which the short (long) leg is the speculative leg. Consistent with a mispricing explanation, the pattern is driven by the speculative leg. The observed patterns are consistent with the abundance of evidence in the psychology literature that mood increases on Friday and decreases on Monday.

  • 2016-02 -- Systemic Default and Return Predictability in the Stock and Bond Markets

    Systemic Default and Return Predictability in the Stock and Bond Markets
    Jack Bao, Kewei Hou, and Shaojun Zhang
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    Using a structural model of default, we construct a measure of systemic default defined as the probability that many firms default at the same time. Our estimation accounts for correlations in defaults between firms through common exposures to shocks. The systemic default measure spikes during recession periods and is strongly correlated with traditional credit-related macroeconomic measures such as the default spread and VIX. Furthermore, our measure predicts future equity and corporate bond index returns, particularly at the one-year horizon, and even after controlling for many traditional return predictors such as the dividend yield, default spread, inflation, and tail risk.These predictability results are robust to out-of-sample tests.

  • 2016-03 -- Institutional Investments in Pure Play Stocks and Implications for Hedging Decisions

    Institutional Investments in Pure Play Stocks and Implications for Hedging Decisions
    Bernadette A. Minton and Catherine Schrand
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    We show that institutions invest in stocks within an industry that maintain exposure to their underlying industry risk factor. These "pure play" stocks have greater numbers of institutional investors and institutions systematically overweight them in their portfolios while underweighting low industry-exposure stocks of firms in the same nominal industry. Pure play stocks also have greater liquidity measured by stock turnover and price impact. An implication of these results is that catering to these preferences could be an important variable in firms’ risk management decisions, potentially offsetting incentives to reduce volatility via hedging. We further characterize institutions’ investments for pure play stocks across institution type, industries, and over time.

  • 2016-04 -- Hedging Interest Rate Risk Using a Structural Model of Credit Risk

    Hedging Interest Rate Risk Using a Structural Model of Credit Risk
    Jing-Zhi Huang and Zhan Shi
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    Recent evidence has shown that structural models fail to capture interest rate sensitivities of corporate debt. We consider a structural model that incorporates a three-factor dynamic term structure model (DTSM) into the Merton (1974) model. We show that the proposed model largely captures the interest rate exposure of corporate bonds. We also find that for investment-grade bonds, hedging effectiveness substantially improves under the proposed model. Our results indicate that to better capture and hedge the interest rate exposure of corporate bonds, we need to incorporate a more realistic DTSM in the existing structural models.

  • 2016-05 -- Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds

    Liquidity Transformation in Asset Managment: Evidence from the Cash Holdings of Mutual Funds
    Sergey Chernenko and Adi Sunderman
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    We study liquidity transformation in mutual funds using a novel data set on their cash holdings.To provide investors with claims that are more liquid than the underlying assets, funds engage in substantial liquidity management. Specifically, they hold substantial amounts of cash, which they use to accommodate inflows and outflows rather than transacting in the underlying portfolio assets. This is particularly true for funds with illiquid assets and at times of low market liquidity. We provide evidence suggesting that mutual funds’ cash holdings are not large enough to fully mitigate price impact externalities created by the liquidity transformation they engage in.

  • 2016-06 -- How Management Risk Affects Corporate Debt

    How Management Risk Affects Corporate Debt
    Yihui Pan, Tracy Yue Wang, and Michael Weisbach
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    We evaluate whether management risk, coming from uncertainty about management’s value added, affects firms’ default risks and debt pricing. We find that, regardless of the reason for the turnover, CDS spreads, loan spreads and bond yield spreads all increase at the time of management turnover, when management risk is highest, and decline over the first three years of CEO tenure. The effects increase with the prior uncertainty about the new management. These results are consistent with the view that management risk affects firms’ default risk. An understanding of management risk yields a number of implications for corporate finance.

  • 2016-07 -- Why does fast loan growth predict poor performance for banks?

    Why does fast loan growth predict poor performance for banks?
    Rüdiger Fahlenbrach, Robert Prilmeier, and René M. Stulz
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    From 1973 to 2014, the common stock of U.S. banks with loan growth in the top quartile of banks over a three-year period significantly underperforms the common stock of banks with loan growth in the bottom quartile over the next three years. The benchmark-adjusted cumulative difference in performance over three years exceeds twelve percentage points. The high growth banks also have significantly higher crash risk over the three-year period. This poor performance is explained by fast loan growth as asset growth separate from loan growth is not followed by poor performance. These banks reserve less for loan losses when their loans grow quickly than other banks. Subsequently, they have a lower return on assets and increase their loan loss reserves. The poorer performance of the fast growing banks is not explained by merger activity and loan growth through mergers is not accompanied by the same poor loan performance. The evidence is consistent with fast-growing banks, analysts, and investors failing to properly appreciate the extent to which the fast loan growth results from making riskier loans and failing to charge for these risks correctly.

  • 2016-08 -- Industry Familiarity and Trading: Evidence from the Personal Portfolios of Industry Insiders

    Industry Familiarity and Trading: Evidence from the Personal Portfolios of Industry Insiders
    Itzhak Ben-David, Justin Birru, and Andrea Rossi
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    We study whether industry familiarity is an advantage in stock trading by exploring the trading patterns of industry insiders in their own personal portfolios. To do so, we identify accounts of industry insiders in a large dataset provided by a retail discount broker. We find that insiders trade firms from their own industry
    more frequently. Furthermore, they earn abnormal returns exclusively when trading own-industry stocks, especially obscure stocks (small, low analyst coverage, high volatility). In a battery of tests, we find no evidence of the use of private information. The results are most consistent with the interpretation that industry familiarity is an advantage in stock trading.

  • 2016-09 -- Systematic Mistakes in the Mortgage Market and Lack of Financial Sophistication

    Systematic Mistakes in the Mortgage Market and Lack of Financial Sophistication
    Sumit Agarwal, Itzhak Ben-David, and Vincent Yao
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    Institutions often offer a menu of contracts to consumers in an attempt to create a separating equilibrium that reveals borrower types and provides better pricing. We test the effectiveness of a specific set of contracts in the mortgage market: mortgage points. Points allow borrowers to exchange an upfront amount for a decrease in the mortgage rate. We document that, on average, points takers lose about $700. Also, points takers are less financially savvy (less educated, older), and they make mistakes on other dimensions (e.g., inefficiently refinancing their mortgages). Overall, our results show that borrowers overestimate how long they will stay with the mortgage.

  • 2016-10 -- Government Debt and the Returns to Innovation

    Government Debt and the Returns to Innovation
    Mariano Croce, Thien Nguyen, Steve Raymond, and Lukas Schmid
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    Elevated levels of government debt raise concerns about their effects on long-term growth prospects. Using the cross section of US stock returns, we show that (i) high- R&D firms are more exposed to government debt and pay higher expected returns than low-R&D firms; and (ii) higher levels of the debt-to-GDP ratio predict higher risk premia for high-R&D firms. Furthermore, rises in the cost of capital for innovation- intensive firms predict declines in subsequent productivity and economic growth. We propose a production-based asset pricing model with endogenous innovation and fiscal policy shocks that can rationalize key aspects of the empirical evidence. Our study highlights a novel and distinct risk channel shaping the link between government debt and future growth.

  • 2016-11 -- The Liquidity Cost of Private Equity Investments: Evidence from Secondary Market Transactions

    The Liquidity Cost of Private Equity Investments: Evidence from Secondary Market Transactions
    Taylor D. Nadauld, Berk A. Sensoy, Keith Vorkink, and Michael S. Weisbach
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    This paper uses proprietary data from a leading intermediary to understand the magnitude and determinants of transaction costs in the secondary market for private equity stakes. Most transactions occur at a discount to net asset value. Buyers average an annualized public market equivalent of 1.023 compared to 0.976 for sellers, implying that buyers outperform sellers by a market-adjusted five percentage points annually. Both the cross-sectional pattern of transaction costs and the identity of sellers and buyers suggest that the market can be characterized as one in which relatively flexible buyers earn returns by supplying liquidity to investors wishing to exit.

     

  • 2016-12 -- The Structure of Banker’s Pay

    The Structure of Banker’s Pay
    Benjamin Bennett, Radhakrishnan Gopalan, and Anjan Thakor
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    While executive compensation is often blamed for the excessive risk taking by banks, little is known about the operating performance incentives used in the finance industry both prior to and subsequent to the recent crisis. We provide a comprehensive analysis of incentive design -- the link of compensation to operating performance -- in financial firms and compare incentive structures in financial firms to those in non-financial firms. Top executives in financial firms are paid less than their counterparts in non-financial firms of similar size and performance. Banks (and insurance firms) link a larger fraction of top executive pay to short-term accounting metrics like ROE and EPS and a smaller fraction to (long-term) stock price. Performance targets for bankers are not related to the risk of the bank, and ROE targets are not appropriately adjusted for leverage. Consequently, the design of executive compensation in banking may encourage both high leverage and risk-taking, and our evidence provides a potential explanation for the strong positive correlation that we document between the extent of short-term pay for bank CEOs and the risk of the bank before the financial crisis.

  • 2016-13 -- Why does idiosyncratic risk increase with market risk?

    Why does idiosyncratic risk increase with market risk?
    Söhnke M. Bartram, Gregory Brown, and René M. Stulz
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    From 1963 through 2015, idiosyncratic risk (IR) is high when market risk (MR) is high. We show that the positive relation between IR and MR is highly stable through time and is robust across exchanges, firm size, liquidity, and market-to-book groupings. Though stock liquidity affects the strength of the relation, the relation is strong for the most liquid stocks. The relation has roots in fundamentals as higher market risk predicts greater idiosyncratic earnings volatility and as firm characteristics related to the ability of firms to adjust to higher uncertainty help explain the strength of the relation. Consistent with the view that growth options provide a hedge against macroeconomic uncertainty, we find evidence that the relation is weaker for firms with more growth options.

  • 2016-14 -- Measuring Institutional Investors’ Skill at Making Private Equity Investments

    Measuring Institutional Investors’ Skill from Their Investments in Private Equity
    Daniel R. Cavagnaro, Berk A. Sensoy, Yingdi Wang, and Michael S. Weisbach
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    Using a large sample of institutional investors’ investments in private equity funds raised between 1991 and 2011, we estimate the extent to which investors’ skill affects their returns. Bootstrap analyses show that the variance of actual performance is higher than would be expected by chance, suggesting that some investors consistently outperform. Extending the Bayesian approach of Korteweg and Sorensen (2017), we estimate that a one standard deviation increase in skill leads to an increase in annual returns of between one and two percentage points. These results are stronger in the earlier part of the sample period and for venture funds.

  • 2016-15 -- Why does capital no longer flow more to the industries with the best growth opportunities?

    Why does capital no longer flow more to the industries with the best growth opportunities?
    Dong Lee, Hyun-Han Shin, and René M. Stulz
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    With functionally efficient capital markets, we expect capital to flow more to the industries with the best growth opportunities. As a result, these industries should invest more and see their assets grow more relative to industries with the worst growth opportunities. We find that industries that receive more funds have a higher industry Tobin’s q until the mid-1990s, but not since then. Since industries with a higher funding rate grow more, there is a negative correlation not only between an industry’s funding rate and industry q but also between capital expenditures and industry q since the mid-1990s. We show that capital no longer flows more to the industries with the best growth opportunities because, since the middle of the 1990s, firms in high q industries increasingly repurchase shares rather than raise more funding from the capital markets.

  • 2016-16 -- Municipal Bond Liquidity and Default Risk

    Municipal Bond Liquidity and Default Risk
    Michael Schwert
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    This paper examines the pricing of bonds issued by states and local governments. I use three distinct, complementary approaches to decompose municipal bond spreads into default and liquidity components, finding that default risk accounts for 74% to 84% of the average municipal bond spread after adjusting for tax-exempt status. The first approach estimates the liquidity component using transaction data, the second measures the default component with credit default swap data, and the third is a quasi-natural experiment that estimates changes in default risk around pre-refunding events. The price of default risk is high given the rare incidence of municipal default and implies a high risk premium.

  • 2016-17 -- Bank Capital and Lending Relationships

    Bank Capital and Lending Relationships
    Michael Schwert
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    This paper investigates the mechanisms behind the matching of banks and firms in the loan market and the implications of this matching for lending relationships, bank capital, and the provision of credit. I find that bank-dependent firms borrow from well capitalized banks, while firms with access to the bond market borrow from banks with less capital. This matching of bank-dependent firms with stable banks smooths cyclicality in aggregate credit provision and mitigates the effects of bank shocks on the real economy.
     

  • 2016-18 -- Loan Product Steering in Mortgage Markets

    Loan Product Steering in Mortgage Markets
    Sumit Agarwal, Gene Amromin, Itzhak Ben-David, and Douglas D. Evanoff
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    We present evidence of a particular type of loan steering in which lenders lead borrowers to take out high margin mortgage products. We identify this activity by comparing borrowers who were rejected by lenders but were subsequently approved by their affiliates (steered borrowers) to other initially rejected borrowers who obtained loans elsewhere. Although steered borrowers default less, they pay significantly higher interest rates and are more likely to borrow through contracts with unconventional features, such as negative amortization or prepayment penalties. Female borrowers, single borrowers with no co-signers, and borrowers in low-income locations are more likely to be steered.

  • 2016-19 -- (Priced) Frictions

    (Priced) Frictions
    Kewei Hou, Sehoon Kim, and Ingrid M. Werner
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    We propose a parsimonious measure based solely on daily stock returns to characterize the severity of microstructure frictions at the individual stock level and assess the impact of frictions on the cross section of stock returns. Stocks with the largest frictions command a value-weighted return premium as large as 10% per year on a risk-adjusted basis. The friction premium is stronger among small, low price, volatile, value, and illiquid stocks. Return spreads associated with momentum and idiosyncratic volatility are smaller and statistically less significant than previously documented after screening out stocks with high microstructure frictions. Using UK data, we show that our measure is useful in settings where the availability of quality data on trading volume, bid-ask prices, and intraday high-low prices is limited.

  • 2016-20 -- Investment, Tobin's Q, and Interest Rates

    Investment, Tobin's Q, and Interest Rates
    Xiaoji Lin, Chong Wang, Neng Wang, and Jinqiang Yang
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    To study the impact of stochastic interest rates and capital illiquidity on investment and firm value, we incorporate a widely-used arbitrage-free term structure model of interest rates into a standard q-theoretic framework. Our generalized q model informs us to use corporate credit-risk information to predict investments when empirical measurement issues of Tobin's average q are significant (e.g., equity is much more likely to be mis-priced than debt) as in Philippon (2009). Consistent with our theory, we find that credit spreads and bond q have significant predictive powers on micro-level and aggregate investments corroborating the recent empirical work of Gilchrist and Zakrajšek (2012). We also show that the quantitative effects of the stochastic interest rates and capital illiquidity on investment, Tobin's average q, the duration and user cost of capital, as well as the value of growth opportunities are substantial. These findings are particularly important in today's low interest-rate environment.

  • 2016-21 -- Corporate Deleveraging

    Corporate Deleveraging
    Harry DeAngelo, Andrei S. Gonçalves, and René M. Stulz
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    Proactive deleveraging from all-time peak market leverage (ML) to near-zero ML and negative net debt is the norm among 4,476 nonfinancial firms with five or more years of post-peak data. ML is 0.543 at the historical peak and 0.026 at the later trough for the median firm in this sample, with a six-year median time from peak to trough. These deleveraging episodes are largely proactive, with debt repayment and earnings retention accounting for 93.7% of the peak-to-trough decline in ML for the median firm. Attenuated deleveraging, with ML staying well above zero, is the norm at 3,118 firms that are delisted due to financial distress within four years of peak. Leverage is path dependent, with the key to explaining whether ML is high or low at the post-peak trough being how high it was at the peak and prior trough and whether the firm has had only a short time to deleverage, e.g., due to distress-related delisting. The findings are consistent with proactive deleveraging to avoid distress and to restore financial flexibility, and are hard to reconcile with materially positive target leverage ratios.

  • 2016-22 -- Exchange Traded Funds (ETFs)

    Exchange Traded Funds (ETFs)
    Itzhak Ben-David, Francesco A. Franzoni, and Rabih Moussawi
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    Over nearly a quarter of a century, ETFs have become one of the most popular passive investment vehicles among retail and professional investors due to their low transaction costs and high liquidity. By the end of 2016, the market share of ETFs topped over 10% of the total market capitalization traded on US exchanges, while representing more than 30% of the overall trading volume. ETFs revolutionized the asset management industry by taking market share from traditional investment vehicles such as mutual funds and index futures. Because ETFs rely on arbitrage activity to synchronize their prices with the prices of the underlying portfolio, trading activity at the ETF level translates to trading of the underlying securities. Researchers found that while ETFs enhance price discovery, they also inject non-fundamental volatility to market prices and affect the correlation structure of returns. Furthermore, ETFs impact the liquidity of the underlying portfolios, especially during events of market stress.

  • 2016-23 -- Is the American Public Corporation in Trouble?

    Is the American public corporation in trouble?
    Kathleen Kahle and René M. Stulz
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    We examine the current state of the American public corporation and how it has evolved over the last forty years. There are fewer public corporations now than forty years ago, but they are much older and larger. They invest differently, as the importance of R&D investments has grown relative to capital expenditures. On average, public firms have record high cash holdings and in most recent years they have more cash than long-term debt. They are less profitable than they used to be and profits are more concentrated, as the top 100 firms now account for most of the net income of American public firms. Accounting statements are less informative about the performance and the value of firms because firms increasingly invest in intangible assets that do not appear on their balance sheets. Firms’ total payouts to shareholders as a percent of net income are at record levels, suggesting that firms either lack opportunities to invest or have poor incentives to invest. The credit crisis appears to leave few traces on the course of American public corporations.

  • 2016-24 -- Do Firms Issue More Equity When Markets Become More Liquid?

    Do Firms Issue More Equity When Markets Become More Liquid?
    Rogier M. Hanselaar, René M. Stulz, and Mathijs A. van Dijk
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    Using quarterly data on IPOs and SEOs in 38 countries over the period 1995-2014, we show that changes in equity issuance are significantly and positively related to lagged changes in aggregate local market liquidity. This relation is at least as economically significant as the well-known relation between equity issuance and lagged stock returns. It survives the inclusion of proxies for market timing, capital market conditions, growth prospects, asymmetric information, and investor sentiment, as well as the exclusion of the financial crisis. Changes in liquidity are less relevant for firms that face greater financial pressures, firms in less financially developed countries, and during the financial crisis.

  • 2016-25 -- Limited Risk Sharing and International Equity Returns

    Limited Risk Sharing and International Equity Returns
    Shaojun Zhang
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    I study international risk sharing with limited stock market participation and preference heterogeneity in each country. An incomplete market model jointly generates high cross-country equity return correlation and low aggregate consumption growth correlation, while matching salient features of asset prices. The model further generates several implications that I show in the data: 1) The stockholders' cross-country consumption growth correlation is considerably higher than that of the aggregate; 2) International bond flows help agents share the labor income risk only, while the country-specific financial income fluctuations are negatively correlated with equity inflows only; 3) The stockholders' consumption risk is priced in both the home and foreign equity markets. I show that the financial integration significantly improves the stockholders' welfare without benefiting the non-stockholders.

2015

  • 2015-01 -- Understanding the Variation in the Information Content of Earnings: A Return Decomposition Analysis

    Understanding the Variation in the Information Content of Earnings: A Return Decomposition Analysis
    Kewei Hou, Yinglei Zhang and Zili Zhuang
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    We use the Campbell (1991) return decomposition framework to reexamine the variation in the information content of earnings between profit firms and loss firms and over time. We show that current earnings surprises are more strongly correlated with the discount rate news component of returns for loss firms and in the recent period. This stronger correlation offsets the positive relation between current earnings surprises and the earnings news component of returns, causing the overall earnings-return relation to be weaker for loss firms and during the recent period. Consistent with these findings, we also find that discount rate news is a more important driver of the return variation of loss firms and in the recent period. Our results highlight the importance of time-varying discount rates for understanding the information content of earnings.

  • 2015-02 -- Are Firms in "Boring" Industries Worth Less?

    Are Firms in "Boring" Industries Worth Less?
    Jia Chen, Kewei Hou and René M. Stulz
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    Using theories from the behavioral finance literature to predict that investors are attracted to industries with more salient outcomes and that therefore firms in such industries have higher valuations, we find that firms in industries that have high industry-level dispersion of profitability have on average higher market-to-book ratios than firms in low dispersion industries. This positive relation between market-to-book ratios and industry profitability dispersion is economically large and statistically significant and is robust to controlling for variables used to explain firm-level valuation ratios in the literature. Consistent with the mispricing explanation of this finding, we show that firms in less boring industries have a lower implied cost of equity and lower realized returns. We explore alternative explanations for our finding, but find that these alternative explanations cannot explain our results.

  • 2015-03 -- The CAPM Strikes Back? An Investment Model with Disasters

    The CAPM Strikes Back? An Investment Model with Disasters
    Hang Bai, Kewei Hou, Howard Kung and Lu Zhang
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    Value stocks are more exposed to disaster risk than growth stocks. Embedding disasters into an investment-based asset pricing model induces strong nonlinearity in the pricing kernel. Our single-factor model reproduces the failure of the CAPM in explaining the value premium in finite samples in which disasters are not materialized, and its relative success in samples in which disasters are materialized. The relation between pre-ranking market betas and average returns is flat in simulations, despite a strong positive relation between true market betas and expected returns. Evidence in the long U.S. sample from 1926 to 2014 lends support to the model’s key predictions.

  • 2015-04 -- Tick Size: Theory and Evidence

    Tick Size: Theory and Evidence
    Ingrid Werner, Yuanji Wen, Barbara Rindi, Francesco Consonni, and Sabrina Buti
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    We model a public limit order book where rational traders decide whether to demand or supply liquidity, and where liquidity builds endogenously. The model predicts that a reduction of the tick size will cause spreads and welfare to deteriorate for illiquid but improve for liquid books. We find empirical support for these predictions based on European and U.S. data. The model also generates predictions for volume, but we find less empirical support for these predictions which we attribute to opportunistic High-Frequency-Traders selectively entering the market.

  • 2015-05 -- A Comparison of New Factor Models

    A Comparison of New Factor Models
    Kewei Hou, Chen Xue and Lu Zhang
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    Using hundreds of significant anomalies as testing portfolios, this paper compares the performance of major empirical asset pricing models. The q-factor model and a closely related five-factor model are the two best performing models among a long array of models. The q-factor model outperforms the five-factor model in factor spanning tests and in explaining momentum and profitability anomalies, but the five-factor model has an edge in explaining value-versus-growth anomalies. Investment and profitability, not liquidity, are the key driving forces in the broad cross section of expected stock returns.

  • 2015-06 -- Bank Sovereign Bond Holdings, Sovereign Shock Spillovers, and Moral Hazard During the European Crisis

    Bank Sovereign Bond Holdings, Sovereign Shock Spillovers, and Moral Hazard During the European Crisis
    Andrea Beltratti and René M. Stulz
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    From 2010 to 2012, the relation between bank stock returns from European Union (EU) countries and the returns on sovereign CDS of peripheral (GIIPS) countries is negative. We use days with tail sovereign CDS returns of peripheral countries to identify the effects of shocks to the cost of borrowing of these countries on EU banks from other countries. A CDS tail return affects banks with greater exposure to the country experiencing that return more, but it has an impact on banks regardless of exposure. Shocks to peripheral countries that are more pervasive impact the returns of banks from countries that experience no shock more than shocks to small individual peripheral countries. In general, the impact of tail returns is asymmetric in that banks suffer less from adverse shocks to peripheral countries than they gain from favourable shocks to such countries.

  • 2015-07 -- The U.S. Listing Gap

    The U.S. Listing Gap
    Craig Doidge, George Andrew Karolyi, René M. Stulz
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    Relative to other countries, the U.S. now has abnormally few listed firms. This “U.S. listing gap” is consistent with a decrease in the net benefit of a listing for U.S. firms. Since the listing peak in 1996, the propensity to be listed is lower for all firm size categories and industries, the new list rate is low, and the delist rate is high. The high delist rate accounts for 46% of the listing gap and the low new list rate for 54%. The high delist rate is explained by an unusually high rate of acquisitions of publicly listed firms.

  • 2015-08 -- How much for a haircut? Illiquidity, secondary markets, and the value of private equity

    How much for a haircut? Illiquidity, secondary markets, and the value of private equity
    Nicolas P.B. Bollen and Berk A. Sensoy
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    Limited partners (LPs) of private equity funds commit to invest with extreme levels of illiquidity and significant uncertainty regarding the timing of capital flows. Secondary markets have emerged which alleviate some of the associated cost. This paper develops a subjective valuation model incorporating these institutional features. Model-implied breakeven returns are close to empirically observed average fund returns for moderately risk tolerant LPs with private equity allocations up to 40%. Likewise, optimal portfolio allocations for these LPs are similar to those observed in practice. More risk averse LPs optimally place little, but not zero, weight on private equity.

  • 2015-09 -- The Granular Nature of Large Institutional Investors

    The Granular Nature of Large Institutional Investors
    Itzhak Ben-David, Francesco Franzoni, Rabih Moussawi, and John Sedunov 
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    Over the last four decades, the concentration of institutional assets in equity markets has increased dramatically. We conjecture that large institutions are granular, that is, they cannot be reduced to a collection of smaller independent entities. Hence, the paper studies whether large institutional ownership has a significant impact on asset prices. We provide evidence of a causal effect of ownership by large institutions on the volatility of their stock holdings. As a potential channel for this effect, we show that large institutions generate higher price impact than smaller institutions. Their trades are larger and concentrated on fewer stocks than those of smaller firms. Moreover, the investor flows to units within the same family are more correlated than the flows to independent entities. Finally, the effect of large institutions on volatility is unlikely to be related to improved price discovery, because the stocks owned by large institutions exhibit stronger price inefficiency.

  • 2015-10 -- Private Equity Performance: A Survey

    Private Equity Performance: A Survey
    Steven N. Kaplan and Berk A. Sensoy
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    We survey the literature on private equity performance, focusing on venture capital and buyout funds rather than portfolio companies. We describe recent findings on performance measures, average fund returns, risk adjustments, cyclicality and liquidity, persistence, interim returns and self-reported net asset values, the performance of different types of investors in funds, and the links between management contracts and fund returns. Buyout funds have outperformed the S&P 500 net of fees on average by about 20% over the life of the fund. Venture capital funds raised in the 1990s outperformed the S&P 500 while those raised in the 2000s underperformed. The results are consistent across a number of datasets and papers. Before the 2000s, buyout and venture capital fund performance showed strong evidence of persistence. Since 2000, buyout fund persistence has declined, while venture capital fund persistence has remained equally strong.

  • 2015-11 -- Fire Sale Discount: Evidence from the Sale of Minority Equity Stakes

    Fire Sale Discount: Evidence from the Sale of Minority Equity Stakes
    Serdar Dinc, Isil Erel, Rose Liao
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    Most of the existing empirical studies estimate the impact of fire sales either without the benefit of market prices from frequent trades, as with aircraft sales, or without observing the prices received by distressed sellers, as with the sales of equity securities by mutual funds facing outflows. We study transactions where the selling firm sells minority equity stakes it holds in publicly-listed third parties. In these transactions, market prices from frequent trades in the shares of those third parties are available and the transaction prices received by the sellers are reported. We estimate the industry-adjusted distressed sale discount based on the four-week window to be about 8% while controlling for the liquidity of the shares sold. This discount magnitude is higher than the 4% estimated for forced sales of stocks by mutual funds without the benefit of observing transaction prices. The discount we estimate becomes 13-14% if the stake sold is more than 5% of the firm or if the stake is sold as a block. Prices recover after the distressed sale.

  • 2015-12 -- The Front Men of Wall Street: The Role of CDO Collateral Managers in the CDO Boom and Bust

    The Dark Side of Specialization: Evidence from Risk Taking by CDO Collateral Managers
    Sergey Chernenko
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    I study the incentives of the collateral managers who selected securities for ABS CDOs-securitizations that figured prominently in the financial crisis. Specialized managers without other businesses that could suff er negative reputational consequences invested in low quality securities underwritten by the CDO's arranger. These securities perform signifi cantly worse than observationally similar securities. Managers investing in these securities were rewarded with additional collateral management assignments. Diversified managers that did assemble CDOs suffered negative reputational consequences during the crisis: institutional investors withdrew from their mutual funds. Overall, the results are consistent with a quid pro quo between collateral managers and CDO underwriters.

  • 2015-13 -- Management Risk and the Cost of Borrowing

    Management Risk and the Cost of Borrowing
    Yihui Pan, Tracy Yue Wang, and Michael S. Weisbach
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    Management risk occurs because uncertainty about future managerial decisions increases a firm’s overall risk. This paper documents the importance of management risk in determining firms’ cost of borrowing. CDS spreads, loan spreads and bond yield spreads all increase at the time of CEO turnover, when management risk is highest, and decline over the first three years of CEO tenure, regardless of the reason for the turnover. Similar but smaller patterns occur around CFO turnovers. The increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of prior uncertainty about the new management. In response to these short-term increases in borrowing costs early in their CEOs’ tenure, firms adjust their propensities to issue external debt, precautionary cash holding, and reliance on internal funds. All of these results suggest that management risk appears to be an important factor in the pricing of corporate debt.

  • 2015-14 -- Bank Capital Requirements: A Quantitative Analysis

    Bank Capital Requirements: A Quantitative Analysis
    Thien T. Nguyen
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    This paper examines the welfare implications of bank capital requirements in a general equilibrium model in which a dynamic banking sector endogenously determines aggregate growth. Due to government bailouts, banks engage in risk-shifting, thereby depressing investment efficiency; furthermore, they over-lever, causing fragility in the financial sector. Capital regulation can address these distortions and has a first-order effect on both growth and welfare. In the model, the optimal level of minimum Tier 1 capital requirement is 8%, greater than that prescribed by both Basel II and III. Increasing bank capital requirements can produce welfare gains greater than 1% of lifetime consumption.

  • 2015-15 -- The Nominal Price Premium

    The Nominal Price Premium
    Justin Birru and Baolian Wang
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    Motivated by the evidence that investors tend to be overly optimistic about low-priced stocks, we examine how nominal price affects the cross section of stock returns. To circumvent the mechanical inverse relationship between price and expected return, we construct a novel way of examining the effect of nominal price on the cross section of stock returns. In the cross-section, a portfolio exploiting this strategy generates a value-weighted (equal-weighted) four-factor alpha of 85 (88) basis points per month. Consistent with a mispricing-based explanation, the results are stronger for hard-to-arbitrage stocks and following high sentiment periods, and strategy returns are highly correlated with contemporaneous changes in sentiment. Evidence from earnings surprises and analyst price target forecasts confirms that beliefs are overly optimistic for low-priced stocks. Providing further evidence that the results reflect a belief-based rather than purely a preference-based channel, we find that the effect is distinct from other gambling related proxies that have been used in the past such as extreme returns, idiosyncratic volatility, and skewness.

  • 2015-16 -- Banks’ Internal Capital Markets and Deposit Rates

    Banks’ Internal Capital Markets and Deposit Rates
    Itzhak Ben-David, Ajay Palvia, and Chester Spatt
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    A common view is that deposit rates are determined primarily by supply: depositors require higher deposit rates from risky banks, thereby creating market discipline. An alternative perspective is that market discipline is limited (e.g., due to deposit insurance and/or enhanced capital regulation) and that internal demand for funding by banks determines rates. Using branch-level deposit rate data, we find little evidence for market discipline as rates are similar across bank capitalization levels. In contrast, banks’ loan growth has a causal effect on deposit rates: e.g., branches’ deposit rates are correlated with loan growth in other states in which their bank has some presence, suggesting internal capital markets help reallocate the bank's funding.

  • 2015-17 -- The Elephant in the Room: The Impact of Labor Obligations on Credit Markets

    The Elephant in the Room: The Impact of Labor Obligations on Credit Markets
    Jack Favilukis, Xiaoji Lin, and Xiaofei Zhao
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    We show that labor market frictions are first-order for understanding credit markets. Wage growth and labor share forecast aggregate credit spreads and debt growth as well as or better than alternative predictors. They also predict credit risk and debt growth in a cross-section of international firms. Finally, high labor share firms choose lower financial leverage. A model with labor market frictions and risky long-term debt can explain these findings, and produce large credit spreads despite realistically low default probabilities. This is because pre-committed payments to labor make other committed payments (i.e. interest) riskier.

  • 2015-18 -- Prices and Volatilities in the Corporate Bond Market

    Prices and Volatilities in the Corporate Bond Market
    Jack Bao, Jia Chen, Kewei Hou, and Lei Lu
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    We document a strong positive cross-sectional relation between corporate bond yield spreads and bond return volatilities. As corporate bond prices are generally attributable to both credit risk and illiquidity as discussed in Huang and Huang (2012), we apply a decomposition methodology to quantify the relative contributions of credit and illiquidity. Overall, our credit and illiquidity proxies can explain almost three quarters of the yield spread-bond volatility relation with credit and illiquidity contributing in a 70:30 ratio. Furthermore, we find that the credit portion of the yield spread-bond volatility relation is important even after controlling for equity volatility. The relation between yield spreads and volatilities is robust to different sample periods, including the financial crisis. We also find the ratio to be smaller for the investment-grade sub-sample, consistent with credit risk being relatively more important for understanding the yield spread-volatility relation in speculative-grade bonds.

  • 2015-19 -- The Investment CAPM

    The Investment CAPM
    Lu Zhang
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    A new class of Capital Asset Pricing Models arises from the first principle of real investment for individual firms. Conceptually as “causal” as the consumption CAPM, yet empirically more tractable, the investment CAPM emerges as a leading asset pricing paradigm. Firms do a good job in aligning investment policies with costs of capital, and this alignment drives many empirical patterns that are anomalous in the consumption CAPM. Most important, integrating the anomalies literature in finance and accounting with neoclassical economics, the investment CAPM succeeds in mounting an efficient markets counterrevolution to behavioral finance in the past 15 years.

2014

  • 2014-01 -- Why Don't All Banks Practice Regulatory Arbitrage? Evidence from Usage of Trust Preferred Securities

    Why Don't All Banks Practice Regulatory Arbitrage? Evidence from Usage of Trust Preferred Securities
    Nicole Boyson, Rüdiger Fahlenbrach, and Rene M. Stulz
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    We investigate why only some banks use regulatory arbitrage. We predict that banks wanting to be riskier than allowed by capital regulations (constrained banks) use regulatory arbitrage while others do not. We find support for this hypothesis using trust preferred securities (TPS) issuance, a form of regulatory arbitrage available to almost all U.S. banks from 1996 to Dodd-Frank. We also find support for predictions that constrained banks are riskier, perform worse during the crisis, and use multiple forms of regulatory arbitrage. We show that neither too-big-to-fail incentives nor misaligned managerial incentives are first-order determinants of this type of regulatory arbitrage.

  • 2014-02 -- Holdup by Junior Claimholders: Evidence from the Mortgage Market

    Holdup by Junior Claimholders: Evidence from the Mortgage Market 
    Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet, and Yan Zhang
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    When borrowers are delinquent, senior debtholders prefer liquidation whereas junior debtholders prefer to maintain their option value by delaying resolution or modifying the loan. In the mortgage market, a conflict of interest (“holdup”) arises when servicers of securitized senior liens are also the owners of the junior liens on the same property. We show that holdup servicers are able to delay action on the first-lien mortgage. When they do act, servicers are more likely to choose resolutions that maintain their option value, favoring modification and soft foreclosures over outright foreclosures. Holdup behavior is more likely to result in borrower self-curing.

  • 2014-03 -- Psychological Barriers, Expectational Errors, and Under reaction

    Psychological Barriers, Expectational Errors, and Underreaction
    Justin Birru
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    This paper provides evidence that the 52-week high serves as a psychological barrier, inducing expectational errors and underreaction to news. Two clear predictions emerge and are confirmed in the data. First, nearness to a 52-week high induces expectational errors; evidence from earnings surprises and analyst price targets indicate that 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. Second, nearness to a 52-week high induces underreaction to news. Among positive earnings surprise stocks, post-announcement drift exists only for those stocks near a 52-week high. The evidence suggests that in contrast to currently offered preference-based explanations, a belief-based explanation may better explain the previously documented 52-week high anomalies.

  • 2014-04 -- Understanding Corporate Governance Through Learning Models of Managerial Competence

    Understanding Corporate Governance Through Learning Models of Managerial Competence
    Benjamin E. Hermalin and Michael S. Weisbach
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    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.

  • 2014-05 -- Can Taxes Shape an Industry? Evidence from the Implementation of the “Amazon Tax”

    The 'Amazon Tax': Empirical Evidence from Amazon and Main Street Retailers
    Brian Baugh, Itzhak Ben-David, and Hoonsuk Park
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    For years, online retailers have maintained a price advantage over brick-and-mortar retailers by not collecting sales tax at the time of sale. Recently, several states have required that the online retailer Amazon collect sales tax during checkout. Using transaction-level data, we document that households living in these states reduce Amazon purchases by 9.4% after sales tax laws were implemented, implying elasticities ranging from –1.2 to –1.4. The effect is more pronounced for large purchases, for which we estimate a reduction of 29.1% in purchases, corresponding to an elasticity of –3.9. Studying competitors in the electronics field, we detect some evidence of substitution toward competing retailers. Consistent with an income effect, we find a reduction in spending in other categories that is concentrated among the heaviest Amazon shoppers.

  • 2014-06 -- Do U.S. Firms Hold More Cash

    Do U.S. Firms Hold More Cash
    Lee Pinkowitz, Rene M. Stulz, and Rohan Williamson
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    Using medians, U.S. firms do not hold more cash than similar foreign firms, irrespective of whether the foreign firms come from countries with good investor protection or not. With means, they do. The means, in contrast to the medians, are affected by U.S. multinationals. U.S. multinationals with high R&D expenditures hold 38.7% more cash than comparable foreign firms, but there is evidence that these high cash holdings may result more from high R&D expenditures than from multinationality. The crisis leaves only small traces in the recent cash holdings of firms. Firms throughout the world decreased their cash holdings during the crisis and replenished their cash holdings afterwards as expected with the precautionary motive for cash holdings. However, U.S. firms hold more cash than firms from countries where the stock market fell less during the crisis. There is no evidence that the determinants of cash holdings changed from before the crisis to after the crisis.

  • 2014-07 -- New Entropy Restrictions and the Quest for Better Specified Asset Pricing Models

    New Entropy Restrictions and the Quest for Better Specified Asset Pricing Models
    Gurdip Bakshi and Fousseni Chabi-Yo
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    Under the setting that stochastic discount factors (SDFs) jointly price a vector of returns, this paper features entropy-based restrictions on SDFs, and its correlated multiplicative components, to evaluate asset pricing models. Specifically, our entropy bound on the square of the SDFs is intended to capture the time-variation in the conditional volatility of the log SDF as well as distributional non-normalities. Each entropy bound can be inferred from the mean and the variance-covariance matrix of the vector of asset returns. Extending extant treatments, we develop entropy codependence measures and our bounds generalize to multi-period SDFs. Our approach offer ways to improve model performance.

  • 2014-08 -- External Equity Financing Shocks, Financial Flows, and Asset Prices

    External Equity Financing Shocks, Financial Flows, and Asset Prices
    Frederico Belo, Xiaoji Lin, and Fan Yang
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    The ability of corporations to raise external equity financing varies with macroeconomic conditions. We develop a dynamic model economy with external equity financing frictions to evaluate the impact of variation of the aggregate cost of equity issuance on firms’ asset prices and financing policies. Our central finding is that time variation in external equity financing costs is important for the model to quantitatively capture the joint dynamics of firms’ asset prices, real quantities, and financial flows. In the model, growth firms and high investment firms can substitute more easily debt financing for equity financing when it becomes more costly to raise external equity, which tend to occur at times when marginal utility is high. Hence, these firms are less risky in equilibrium. The model also replicates the failure of the unconditional CAPM in pricing the cross section of stock returns. Guided by the theory, we construct an empirical proxy of the aggregate shock to the cost of equity issuance using cross sectional data on U.S. publicly traded firms. We show that the model-implied shock captures systematic risk, and that exposure to this shock helps price the cross section of stock returns of book-to-market, investment, and industry portfolios.

  • 2014-09 -- Were there fire sales in the RMBS market?

    Were there fire sales in the RMBS market?
    Craig B. Merrill, Taylor D. Nadauld, René M. Stulz, and Shane M. Sherlund
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    Many observers have argued that the fall in RMBS prices during the crisis was partly caused by fire sales. We provide an explanation for why financial institutions may have engaged in fire sales using a unique dataset of RMBS transactions for insurance companies. We show that risk-sensitive capital requirements and mark-to-market accounting can jointly create incentives for capital-constrained financial institutions to engage in fire sales of stressed securities because the increased risk can make it too expensive to hold such securities. Further, we find that, in general, RMBS prices behaved as would be expected in the presence of fire sales.

  • 2014-10 -- Governance, Risk Management, and Risk-Taking in Banks

    Goverance, Risk Management, and Risk-Taking in Banks
    Rene M. Stulz
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    This paper examines how governance and risk management affect risk-taking in banks. It distinguishes between good risks, which are risks that have an ex ante private reward for the bank on a stand-alone basis, and bad risks, which do not have such a reward. A well-governed bank takes the amount of risk that maximizes shareholder wealth subject to constraints imposed by laws and regulators. In general, this involves eliminating or mitigating all bad risks to the extent that it is cost effective to do so. The role of risk management in such a bank is not to reduce the bank’s total risk per se. It is to identify and measure the risks the bank is taking, aggregate these risks in a measure of the bank’s total risk, enable the bank to eliminate, mitigate and avoid bad risks, and ensure that its risk level is consistent with its risk appetite. Organizing the risk management function so that it plays that role is challenging because there are limitations in measuring risk and because, while more detailed rules can prevent destructive risk-taking, they also limit the flexibility of an institution in taking advantage of opportunities that increase firm value. Limitations of risk measurement and the decentralized nature of risk-taking imply that setting appropriate incentives for risk-takers and promoting an appropriate risk culture are essential to the success of risk management in performing its function.

  • 2014-11 -- Unemployment Crises

    Unemployment Crises
    Nicolas Petrosky-Nadeau and Lu Zhang
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    A search and matching model, when calibrated to the mean and volatility of unemployment in the postwar sample, can potentially explain the unemployment crisis in the Great Depression. The limited responses of wages from credible bargaining to labor market conditions, along with the congestion externality from matching frictions, cause the unemployment rate to rise sharply in recessions but decline gradually in booms. The frequency, severity, and persistence of unemployment crises in the model are quantitatively consistent with U.S. historical time series. The welfare gain from eliminating business cycle fluctuations is large.

  • 2014-12 -- Influence of Public Opinion on Investor Voting and Proxy Advisors

    Influence of Public Opinion on Investor Voting and Proxy Advisors
    Reena Aggarwal, Isil Erel, and Laura Starks
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    Institutional investors vote corporate proxies on behalf of underlying investors and beneficiaries. We show a strong relation between this voting and public opinion on corporate governance (as reflected in media coverage and surveys), with similarly strong results for voting by mutual funds. We also find that proxy advisors’ recommendations are associated with public opinion. Our results suggest that institutional investors and proxy advisors pay attention to the changing opinions of their beneficiaries and shareholders, as reflected in their voting decisions, and that the proxy voting process serves as a channel for the public to influence corporate behavior.

  • 2014-13 -- Corporate Fire Sales

    Corporate Fire Sales
    Isil Erel

  • 2014-14 -- Does Uncertainty about Management Affect Firms' Costs of Borrowing?

    Does Uncertainty about Management Affect Firms' Costs of Borrowing?
    Yihui Pan, Tracy Yue Wang, Michael Weisbach
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    Uncertainty about management appears to affect firms’ cost of borrowing and financial policies. In a sample of S&P 1500 firms between 1987 and 2010, CDS spreads, loan spreads and bond yield spreads all decline over the first three years of CEO tenure, holding other macroeconomic, firm, and security level factors constant. This decline occurs regardless of the reason for the prior CEO’s departure. Similar but smaller declines occur following turnovers of CFOs. The spreads are more sensitive to CEO tenure when the prior uncertainty about the CEO’s ability is likely to be higher: when he is not an heir apparent, is an outsider, is younger, and when he does not have a prior relationship with the lender. The spread-tenure sensitivity is also higher when the firm has a higher default risk and when the debt claim is riskier. These patterns are consistent with the view that the decline in spreads in a manager’s first three years of tenure reflects the resolution of uncertainty about management. Firms adjust their propensities to issue external debt, precautionary cash holding, and reliance on internal funds in response to these short-term increases in borrowing costs early in their CEOs’ tenure.

  • 2014-15 -- Technology Adoption and the Capital Age Spread

    Technology Adoption, External Financing Frictions, and the Cross Sectional Returns
    Xiaoji Lin
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    We explore the asset pricing implications of an investment-based model that features a stochastic technology frontier and costly technology adoption. Firms adopt the latest technology embodied in new capital to reach a stochastic technology frontier, but this decision entails an adoption cost. The model predicts that old capital firms are more risky and hence offer a higher return than young capital firms. This is because old capital firms are more likely to upgrade their capital in the near future and hence are more exposed to shocks driving the technology frontier. Our empirical analysis supports the model's predictions. We find an annual return spread of 7% between old and young capital firms. The CAPM fails in explaining this return spread.

  • 2014-16 -- The Rise and Fall of Demand for Securitizations

    The Rise and Fall of Demand for Securitizations
    Sergey Chernenko, Samuel G. Hanson, Adi Sunderam
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    Collateralized debt obligations (CDOs) and private-label mortgage-backed securities (MBS) backed by nonprime loans played a central role in the recent financial crisis. Little is known, however, about the underlying forces that drove investor demand for these securitizations. Using micro-data on insurers’ and mutual funds’ bond holdings, we find considerable heterogeneity in investor demand for securitizations in the pre-crisis period. We argue that both investor beliefs and incentives help to explain this variation in demand. By contrast, our data paints a more uniform picture of investor behavior in the crisis. Consistent with theories of optimal liquidation, investors largely traded in more liquid securities such as government-guaranteed MBS to meet their liquidity needs during the crisis.

  • 2014-17 -- Uninformative Feedback and Risk Taking: Evidence from Retail Forex Trading

    Uninformative Feedback and Risk Taking
    Itzhak Ben-David, Justin Birru, Viktor Prokopenya
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    We document evidence consistent with retail day traders in the Forex market attributing random success to their own skill and, as a consequence, increasing risk taking. Although past performance does not predict future success for these traders, traders increase trade sizes, trade size variability, and number of trades with gains, and less with losses. There is a large discontinuity in all of these trading variables around zero past week returns: e.g., traders increase their trade size dramatically following winning weeks, relative to losing weeks. The effects are stronger for novice traders, consistent with more intense “learning” in early trading periods.

2013

  • 2013-01 -- Limited Partner Performance and the Maturing of the Private Equity Industry

    Limited Partner Performance and the Maturing of the Private Equity Industry
    Berk A. Sensoy, Yingdi Wang, and Michael S. Weisbach
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    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.

  • 2013-02 -- Why Did Financial Institutions Sell RMBS at Fire Sale Prices During the Financial Crisis?"

    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
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    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.

  • 2013-03 -- Do Acquisitions Relieve Target Firms' Financial Constraints?

    Do Acquisitions Relieve Target Firms' Financial Constraints?
    Isil Erel, Yeejin Jang, and Michael S. Weisbach
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    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.

  • 2013-04 -- Brand Capital and Firm Value

    Brand Capital and Firm Value
    Frederico Belo, Xiaoji Lin, and Maria Ana Vitorino
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    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.

  • 2013-05 -- Learning About CEO Ability and Stock Return Volatility

    Learning About CEO Ability and Stock Return Volatility
    Yihui Pan, Tracy Yue Wang , and Michael S. Weisbach
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    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.

  • 2013-06 -- Indirect Incentives of Hedge Fund Managers

    Indirect Incentives of Hedge Fund Managers
    Jongha Lim, Berk A. Sensoy, and Michael S. Weisbach
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    Indirect incentives exist in the money management industry when good current performance increases future inflows of capital, leading to higher future fees. For the average hedge fund, indirect incentives are at least 1.4 times as large as direct incentives from incentive fees and managers’ personal stakes in the fund. Combining direct and indirect incentives, manager wealth increases by at least $0.39 for a $1 increase in investor wealth. Younger and more scalable hedge funds have stronger flow-performance relations, leading to stronger indirect incentives. These results have a number of implications for our understanding of incentives in the asset management industry.

  • 2013-07 -- Is there a U.S. high cash holdings puzzle after the financial crisis?

    Is there a U.S. high cash holdings puzzle after the financial crisis?
    Lee Pinkowitz, René M. Stulz, and Rohan Williamson
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    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.

  • 2013-08 -- Why High Leverage is Optimal for Banks

    Why High Leverage is Optimal for Banks
    Harry DeAngelo and René M. Stulz
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    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.

  • 2013-09 -- The Twilight Zone: OTC Regulatory Regimes and Market Quality

    The Twilight Zone: OTC Regulatory Regimes and Market Quality
    Ulf Brüggemann, Aditya Kaul, Christian Leuz, and Ingrid M. Werner
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    We analyze a comprehensive sample of more than 10,000 U.S. OTC stocks. We first show that the OTC market is a large, diverse, and dynamic trading environment with a rich set of regulatory and disclosure regimes, comprising venue rules and state laws beyond SEC regulation. We then exploit this institutional richness to analyze two key dimensions of market quality, liquidity and crash risk, across firms and regulatory regimes. We find that OTC firms that are subject to stricter regulatory regimes and disclosure requirements have higher market quality (higher liquidity and lower crash risk). Our analysis points to an important trade-off in regulating the OTC market and protecting investors: Lowering regulatory requirements (e.g., for disclosure) reduces the compliance burden for smaller firms, but it also reduces market quality.

  • 2013-10 -- Do firms issue more equity when markets are more liquid?

    Do firms issue more equity when markets are more liquid?
    René M. Stulz, Dimitrios Vagias, and Mathijs A. van Dijk
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    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.

  • 2013-11 -- Comovement of Corporate Bonds and Equities

    Comovement of Corporate Bonds and Equities
    Jack Bao and Kewei Hou
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    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.

  • 2013-12 -- CEO Investment Cycles

    CEO Investment Cycles
    Yihui Pan, Tracy Yue Wang, and Michael S. Weisbach
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    This paper documents the existence of a CEO Investment Cycle, in which disinvestment decreases over CEO tenure while investment increases, leading to “cyclical” firm growth in assets as well as in employment. The estimated variation in investment rate over the CEO cycle is of the same order of magnitude as the differences caused by business cycles or financial constraints. This investment cycle appears to reflect CEOs’ preference for investment growth, which leads to increasing investment quantity and decreasing investment quality over time as the CEO gains more control over his board.

  • 2013-13 -- Limited Managerial Attention and Corporate Aging

    Limited Managerial Attention and Corporate Aging
    Claudio Loderer, René Stulz, and Urs Waelchli
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    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.

  • 2013-14 -- Tick Size Regulations and Sub-Penny Trading

    Tick Size Regulations and Sub-Penny Trading
    Sabrina Buti, Barbara Rindi, Yuanji Wen, and Ingrid Werner
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    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.

  • 2013-15 -- Corporate Liquidity Management: A Conceptual Framework and Survey

    Corporate Liquidity Management: A Conceptual Framework and Survey
    Heitor Almeida, Murillo Campello, Igor Cunha,and Michael Weisbach
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    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.

  • 2013-16 -- External Habit in a Production Economy

    External Habit in a Production Economy
    Andrew Chen
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    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.

  • 2013-17 -- The Term Structures of Co-Entropy in International Financial Markets

    The Term Structures of Co-Entropy in International Financial Markets
    Fousseni Chabi-Yo and Riccardo Colacito
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    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.

  • 2013-18 -- Sub-Penny and Queue-Jumping

    Sub-Penny and Queue-Jumping
    Sabrina Buti, Francesco Consonni, Barbara Rindi, Yuanji Wen, and Ingrid Werner
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    We develop a model where a public limit order book (PLB) competes with a Sub-Penny Venue, which allows Sub-Penny Trading (SPT). SPT occurs when a trader undercuts orders in the PLB by less than one penny, a practice we call queue-jumping (QJ). QJ is higher for NASDAQ than for NYSE stocks. We confirm the model's predictions that QJ increases in liquidity and in the tick-to-price ratio. We also find that QJ is associated with improved PLB market quality, especially for large capitalization stocks. Finally, we show that High Frequency Trading is negatively related to QJ.

  • 2013-19 -- Is Sell-Side Research More Valuable in Bad Times?

    Is Sell-Side Research More Valuable in Bad Times?
    Roger K. Loh and René Stulz
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    Because uncertainty is high in bad times, investors find it harder to assess firm prospects and, hence, should value analyst output more. However, higher uncertainty makes analysts’ tasks harder so it is unclear if analyst output is more valuable in bad times. We find that, in bad times, analyst revisions have a larger stock-price impact, earnings forecast errors per unit of uncertainty fall, reports are more frequent and longer, and the impact of analyst output increases more for harder-to-value firms. These results are consistent with analysts working harder and investors relying more on analysts in bad times.

  • 2013-20 -- Disentangling Financial Constraints, Precautionary Savings, and Myopia: Household Behavior Surrounding Federal Tax Returns

    Disentangling Financial Constraints, Precautionary Savings, and Myopia: Household Behavior Surrounding Federal Tax Returns
    Brian Baugh, Itzhak Ben-David, and Hoonsuk Park
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    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.

2012

  • 2012-01 -- An Equilibrium Asset Pricing Model with Labor Market Search

    An Equilibrium Asset Pricing Model with Labor Market Search
    Lars-Alexander Kuehn, Nicolas Petrosky-Nadeau and Lu Zhang
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    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).

  • 2012-02 -- Access to Capital, Investment, and the Financial Crisis

    Access to Capital, Investment, and the Financial Crisis
    Kathleen M. Kahle and René M. Stulz
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    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.

  • 2012-03 -- Globalization, Country Governance, and Corporate Investment Decisions: An Analysis of Cross-Border Acquisitions

    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
    Download Paper
    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.

  • 2012-04 -- The Quiet Run of 2011: Money Market Funds and the European Debt Crisis

    The Quiet Run of 2011: Money Market Funds and the European Debt Crisis
    Sergey Chernenko and Adi Sunderam
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    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..

  • 2012-05 -- Equity-Holding Institutional Lenders: Do They Receive Better Terms?

    Equity-Holding Institutional Lenders: Do They Receive Better Terms?
    Jongha Lim, Bernadette A. Minton and Mike Weisbach
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    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.

  • 2012-06 -- Financing-Motivated Acquisitions

    Financing-Motivated Acquisitions
    Isil Erel, Yeejin Jang and Mike Weisbach
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    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.

  • 2012-07 -- Loan Prospecting and the Loss of the Soft Information

    Do Loan Officers' Incentives Lead to Lax Lending Standards?
    Sumit Agarwal and Itzhak Ben-David
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    We study a controlled experiment in which bank’s loan officers were incentivized to prospect for new applications. The dollar volume of approved loans increased; however, we find that loan officers did not source new applications and that the expected default rate did not change. Instead, the bank relied on favorable hard information when approving loans and ignored unfavorable soft information. Furthermore, loan officers convinced approved applicants to borrow larger amounts. Both factors contributed to an ex post higher default rate and to the loss of the predictive power of the bank’s credit default model.

  • 2012-08 -- Predatory Lending and the Subprime Crisis

    Predatory Lending and the Subprime Crisis
    Sumit Agarwal, Gene Amromin, Izthak Ben-David, Souphala Chomsisengphet, and Douglas D. Evanoff
    Download Paper
    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.

  • 2012-09 -- Does Aggregate Riskiness Predict Future Economic Downturns

    Does Aggregate Riskiness Predict Future Economic Downturns
    Turan G. Bali, Nusret Cakici, and Fousseni Chabi-Yo
    Download Paper
    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.

  • 2012-10 -- Multinationals and the High Cash Holding Puzzle

    Multinationals and the High Cash Holding Puzzle
    Lee Pinkowitz, René M. Stulz, and Rohan Williamson
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    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.

  • 2012-11
     
  • 2012-12 -- Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities?

    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
    Download Paper
    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.

  • 2013-13 -- Financial globalization and the rise of IPOs outside the U.S.

    Financial globalization and the rise of IPOs outside the U.S.
    Craig Doidge, G. Andrew Karolyi, and René M. Stulz
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    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.

  • 2012-14 -- Long Run Productivity Risk and Aggregate Investment

    Long Run Productivity Risk and Aggregate Investment
    Jack Favilukis and Xiaoji Lin
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    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.

  • 2012-15 -- Syndicated Loan Spreads and the Composition of the Syndicate

    Syndicated Loan Spreads and the Composition of the Syndicate
    Jongha Lim, Bernadette A. Minton, and Michael S. Weisbach
    Download Paper
    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.

  • 2012-16 -- Wage Rigidity: A Solution to Several Asset Pricing Puzzles

    Wage Rigidity: A Solution to Several Asset Pricing Puzzles
    Jack Favilukis and Xiaoji Lin
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    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.

  • 2012-17 -- Labor Hiring, Investment, and Stock Return Predictability in the Cross Section

    Labor Hiring, Investment, and Stock Return Predictability in the Cross Section
    Santiago Bazdresch, Frederico Belo, and Xiaoji Lin
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    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.

  • 2012-18 -- Reverse Mergers: The Chinese Experiences

    Reverse Mergers: The Chinese Experiences
    Jan Jindra, Torben Voetmann,and Ralph Walking
    Download Paper
    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.

  • 2012-19 -- Does Wage Rigidly Make Firms Riskier? Evidence From Long-Horizon Return Predictability.

    Does Wage Rigidly Make Firms Riskier? Evidence From Long-Horizon Return Predictability.
    Jack Favilukis and Xiaoji Lin
    Download Paper
    We explore the relationship between sticky wages and risk. Like operating leverage, sticky wages are a source of risk for the firm. Firms, industries, regions, 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, this is the case in aggregate, industry, and U.S. state level data. Furthermore, this relation is stronger in industries and U.S. states with higher wage rigidity.

  • 2012-20 -- Policy Intervention in Debt Renegotiation: Evidence from the Home Affordable Modification Program

    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
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    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.

  • 2012-21 -- Digesting Anomalies: An Investment Approach

    Digesting Anomalies: An Investment Approach
    Kewei Hou, Chen Xue, and Lu Zhang
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    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..

  • 2012-22 -- Endogenous technological progress and the cross section of stock returns

    Endogenous technological progress and the cross section of stock returns
    Xiaoji Lin
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    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 a ect each other. Qualitatively and, in many cases, quantitatively,the model explains well-documented empirical regularities.

  • 2012-23 -- The Inventory Growth Spread

    The Inventory Growth Spread
    Frederico Belo and Xiaoji Lin
    Download Paper
    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.

  • 2012-24 -- Probability Weighting of Rare Events and Currency Returns

    Probability Weighting of Rare Events and Currency Returns
    Fousseni Chabi-Yo and Zhaogang Song
    Download Paper
    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

  • 2012-25 -- Labor-Force Heterogeneity and Asset Prices: The Importance of Skilled Labor

    Labor-Force Heterogeneity and Asset Prices: The Importance of Skilled Labor
    Frederico Belo, Xiaoji Lin, Jun Li, and Xiaofei Zhao
    Download Paper
    We investigate the impact of labor-force heterogeneity on asset prices in a neoclassical model with labor and capital adjustment costs, and with aggregate productivity and adjustment cost shocks. We document that the negative firms’ hiring rate-future stock return relation identified in previous studies is significantly steeper in industries that rely relatively more on high skill workers than on low skill workers. A long low hiring rate firms and short high hiring rate firms portfolio earns an average annual stock return of 8.6% in
    high skill industries, and only 0.9% in low skill industries. Moreover, this pattern is not explained by the standard CAPM. This finding is consistent with a neoclassical model of investment with labor force heterogeneity if it is more costly to replace high skill than low skill workers. This differential cost makes the returns of the firms in the high skill to be more exposed to the aggregate adjustment cost shock. We provide empirical support for this economic mechanism using a model-implied adjustment cost shock proxy.

  • 2012-26 -- Does Target CEO Retention in Aquisition Involving Private Equity Acquirers Harm Target Shareholders

    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
    Download Paper
    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.

  • 2012-27 -- Why Did Holdings of Highly-Rated Securitization Tranches Differ So Much Across Banks?

    Why Did Holdings of Highly-Rated Securitization Tranches Differ So Much Across Banks?
    Isil Erel, Taylor Nadauld and René M. Stulz
    Download Paper
    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.

  • 2012-28 -- Have We Solved The Idiosyncratic Volatility Puzzle?

    Have We Solved The Idiosyncratic Volatility Puzzle?
    Kewei Hou and Roger K. Loh
    Download Paper
    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.

  • 2012-29 -- Collateral Valuation and Borrower Financial Constraints: Evidence from the Residential Real-Estate Market

    Collateral Valuation and Borrower Financial Constraints: Evidence from the Residential Real-Estate Market
    Sumit Agarwal, Itzhak Ben-David and Vincent Yao
    Download Paper
    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.

2011

  • 2011-01 -- Globalization, Governance, and the Returns to Cross-Border Acquisitions

    Globalization, Governance, and the Returns to Cross-Border Acquisitions
    Jesse Ellis, Sara B. Moeller, Frederik P. Schlingemann,and René M. Stulz
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    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.

  • 2011-02 -- The Role of Securitization in Mortgage Renegotiation

    The Role of Securitization in Mortgage Renegotiation
    Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet, Douglas D. Evanoff
    Download Paper
    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.

  • 2011-03 -- Financial Policies, Investment, and the Financial Crisis: Impaired Credit Channel or Diminished Demand for Capital?

    Financial Policies, Investment, and the Financial Crisis: Impaired Credit Channel or Diminished Demand for Capital?
    Kathleen M. Kahle and René M. Stulz
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    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.

  • 2011-04 -- Career Concerns and the Busy Life of the Young CEO

    Career Concerns and the Busy Life of the Young CEO
    Xiaoyang Li, Angie Low, and Anil K. Makhija
    revision:July 2011 
    Download Paper
    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.

  • 2011-05 -- Do Hedge Funds Manipulate Stock Prices?

    Do Hedge Funds Manipulate Stock Prices?
    Itzhak Ben-David, Francesco Franzoni, Augustin Landier and Rabih Moussawi
    revision: June, 2011
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    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.

  • 2011-06 -- Why are U.S. Stocks More Volatile?

    Why are U.S. Stocks More Volatile?
    Sohnke M. Bartram, Gregory Brown and René M. Stulz
    Download Paper
    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.

  • 2011-07 -- Why Do Some CEOs Work for a One-Dollar Salary?

    Why Do Some CEOs Work for a One-Dollar Salary?
    Gilberto Loureiro, Anil K. Makhija and Dan Zhang
    Download Paper
    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.

  • 2011-08 -- The U.S. Left Behind: The Rise of IPO Activity Around the World

    The U.S. Left Behind: The Rise of IPO Activity Around the World
    Craig Doidge, G. Andrew Karolyi and René M. Stulz
    Download Paper
    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.

  • 2011-09 -- Macroeconomic Conditions and Capital Raising

    Macroeconomic Conditions and Capital Raising
    Isil Erel, Brandon Julio, Woojin Kim, and Michael S. Weisbach
    revision: July 2011
    Download Paper
    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.

  • 2011-10 -- This Time Is the Same: Using Bank Performance in 1998 to Explain Bank Performance During the Recent Financial Crisis

    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
    Download Paper
    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.

  • 2011-11 -- Variance Bounds on the Permanent and Transitory Components of Stochastic Discount Factors

    Variance Bounds on the Permanent and Transitory Components of Stochastic Discount Factors
    Gurdip Bakshi and Fousseni Chabi-Yo
    Download Paper
    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.

  • 2011-12 -- Liquidity Shocks and Hedge Fund Contagion

    Liquidity Shocks and Hedge Fund Contagion
    Nicole M. Boyson, Christof W. Stahel, and René M. Stulz
    Download Paper
    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.

  • 2011-13 -- Are Investors Really Reluctant to Realize their Losses? Trading Responses to Past Returns and the Disposition Effect

    Are Investors Really Reluctant to Realize their Losses? Trading Responses to Past Returns and the Disposition Effect
    Itzhak Ben-David and David Hirshleifer
    revision: December 2011
    Download Paper
    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.

  • 2011-14 -- Do Private Equity Fund Managers Earn their Fees? Compensation, Ownership, and Cash Flow Performance

    Do Private Equity Fund Managers Earn their Fees? Compensation, Ownership, and Cash Flow Performance
    David T. Robinson and Berk A. Sensoy
    Download Paper
    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.

  • 2011-15 -- Covariance's versus Characteristics in General Equilibrium

    Covariances versus Characteristics in General Equilibrium
    Xiaoji Lin and Lu Zhang
    Download Paper
    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.

  • 2011-16 -- Why Did U.S. Banks Invest in Highly-Rated Securitization Tranches?

    Why Did U.S. Banks Invest in Highly-Rated Securitization Tranches?
    Isil Erel, Taylor Nadauld and René M. Stulz
    Download Paper
    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.

  • 2011-17 -- High Leverage and Willingness to Pay: Evidence from the Residential Housing Market

    High Leverage and Willingness to Pay: Evidence from the Residential Housing Market
    Itzhak Ben-David
    Download Paper
    Homebuyers who pay the full-listing price are more likely to take a mortgage with at 100% loan-to-value than otherwise lower prices. These homebuyers overpay by 3.4% ($5,700 on average) and 22.7% more likely to default on their mortgages. The correlation is not mechanical: there is a discontinuity in the
    average leverage around the full listing price. The correlation is stronger for financially constrained and unsophisticated homebuyers, and in areas of high past price growth (potentially indicative of buyer optimism). The study helps explaining how expansion in credit translated to higher prices during 2001-2006.

  • 2011-18 -- Corporate Acquisitions, Diversification, and the Firm’s Lifecycle

    Corporate Acquisitions, Diversification, and the Firm’s Lifecycle
    Asli M. Arikan and René M. Stulz
    Download Paper
    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.

  • 2011-19 -- What do Boards Really Do? Evidence from Minutes of Board Meetings

    What do Boards Really Do? Evidence from Minutes of Board Meetings
    Miriam Schwartz-Ziv and Michael S. Weisbach
    revision dates: March 2012, January 2012, November, 2011
    Download Paper
    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.

  • 2011-20 -- Do ETFs Increase Volatility

    Do ETFs Increase Volatility
    Itzhak Ben-David, Francesco Franzoni and Rabih Moussawi
    Download Paper
    An ongoing debate in finance centers on the impact of derivatives on the efficiency of prices of the underlying securities. The paper contributes to this literature by studying whether exchange traded funds (ETFs)—an asset of increasing importance—affect the non-fundamental volatility of the stocks in their baskets. Using identification strategies based on the mechanical variation in ETF ownership, including regression discontinuity, we show that stocks owned by ETFs exhibit significantly higher intraday and daily volatility. Variance-ratio tests, as well as price reversals, suggest that the mean-reverting component of stock prices is inflated by ETF ownership. We estimate that an increase of one standard deviation in ETF ownership is associated with an increase of 19% in intraday stock volatility. Our evidence suggests that ETFs attract a new layer of demand shocks to the stock market due to their high liquidity.

2010

  • 2010-01 -- Profitability Shocks and the Size Effect in the Cross-Section of Expected Stock Returns

    Profitability Shocks and the Size Effect in the Cross-Section of Expected Stock Returns
    Kewei Hou and Mathijs A. van Dijk
    Download Paper
    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.

  • 2010-02 -- Hedge Fund Stock Trading in the Financial Crisis of 2007-2009

    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
    Download Paper
    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.

  • 2010-03 -- Pay for Performance from Future Fund Flows: The Case of Private Equity

    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
    Download Paper
    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.

  • 2010-04 -- The Implied Cost of Capital: A New Approach

    The Implied Cost of Capital:A New Approach  (revised 12/11)
    Kewei Hou, Mathijs A. van Dijk and Yinglei Zhang
    Download Paper
    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.

  • 2010-05 -- The Credit Crisis Around the Globe: Why Did Some Banks Perform Better?

    The Credit Crisis Around the Globe: Why Did Some Banks Perform Better?
    Andrea Beltratti and René M. Stulz
    Download Paper
    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.

  • 2010-06 -- Dark Pool Trading Strategies, Market Quality and Welfare

    Dark Pool Trading Strategies, Market Quality and Welfare
    Sabrina Buti, Barbara Rindi, and Ingrid M. Werner
    Download Paper
    We show that when a continuous dark pool is added to a limit order book that opens illiquid, book and consolidated fill rates and volume increase, but spread widens, depth declines and welfare deteriorates. The adverse effects on market quality and welfare are mitigated when book-liquidity builds but so are the positive effects on trading activity. All effects are stronger when traders' valuations are less dispersed, access to the dark pool is greater, horizon is longer, and relative tick size larger.

  • 2010-07 -- Do Independent Director Departures Predict Future Bad Events?

    Do Independent Director Departures Predict Future Bad Events?
    Rüdiger Fahlenbrach, Angie Low, and René M. Stulz
    Download Paper
    Following surprise independent director departures, affected firms have worse stock and operating performance, are more likely to restate earnings, face shareholder litigation, suffer from an extreme negative return event, and make worse mergers and acquisitions. The announcement returns to surprise director departures are negative, suggesting that the market infers bad news from surprise departures. We use exogenous variation in independent director departures triggered by director deaths to test whether surprise independent director departures cause these negative outcomes or whether an anticipation of negative outcomes is responsible for the surprise director departure. Our evidence is more consistent with the latter.

  • 2010-08 -- Are Acquisition Premiums Lower because of Target CEOs Conflicts of Interest?

    Are Acquisition Premiums Lower because of Target CEOs Conflicts of Interest?
    Leonce Bargeron, Frederik Schlingemann, René M. Stulz, and Chad Zutter
    Download Paper
    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.

  • 2010-09 -- Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts

    Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts
    Ulf Axelson, Tim Jenkinson, Per Strömberg, and Michael S. Weisbach
    Download Paper
    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.

  • 2010-10 -- Diving Into Dark Pools

    Diving Into Dark Pools
    Sabrina Buti, Barbara Rindi, and Ingrid M. Werner
    Download Paper
    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.

  • 2010-11 -- Are Stock Acquirers Overvalued? Evidence from Short Selling Activity

    Are Stock Acquirers Overvalued? Evidence from Short Selling Activity
    Itzhak Ben-David, Michael S. Drake, and Darren T. Roulstone
    Download Paper
    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.

  • 2010-12 -- Managerial Miscalibration

    Managerial Miscalibration
    Itzhak Ben-David, John R. Graham, and Campbell R. Harvey
    Download Paper
    We test whether top financial executives are miscalibrated using a unique 10-year panel that includes over 13,300 probability distributions of expected stock market returns. We find that executives are severely miscalibrated, producing distributions that are too narrow: realized market returns are within the executives’ 80% confidence intervals only 36% of the time. We show that the lower bound of the forecast confidence interval is lower during times of high market uncertainty; however, ex-post miscalibration is worst during these episodes. We also find that executives who are miscalibrated about the stock market show similar miscalibration regarding their own firms’ prospects. Finally, firms with miscalibrated executives appear to follow more aggressive corporate policies: investing more and using more debt financing.

     

  • 2010-13 -- Financial Policies and the Financial Crisis: How Important Was the Systemic Credit Contraction for Industrial Corporations?

    Financial Policies and the Financial Crisis:How Important Was the Systemic Credit Contraction for Industrial Corporations?
    Kathleen M. Kahle and René M. Stulz
    Download Paper
    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.

  • 2010-14 -- Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance?

    Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance?
    Bernadette Minton, Jerome P. A. Taillard, and Rohan Williamson
    revision: 6/2011
    Download Paper
    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.

  • 2010-15 -- The Value Spread: A Puzzle

    The Value Spread: A Puzzle
    Frederico Belo, Chen Xue, and Lu Zhang
    Download Paper
    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.

  • 2010-16 -- Did Securitization Affect the Cost of Corporate Debt?

    Did Securitization Affect the Cost of Corporate Debt?
    Taylor D. Nadauld and Michael S. Weisbach
    Download Paper
    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.

  • 2010-17 -- Investment-Based Momentum Profits

    Investment-Based Momentum Profits
    Laura Xiaolei Liu and Lu Zhang
    Download Paper
    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.

  • 2010-18 -- Does Risk Explain Anomalies? Evidence from Expected Return Estimates

    Does Risk Explain Anomalies? Evidence from Expected Return Estimates
    Jin (Ginger) Wu and Lu Zhang
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    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.

  • 2010-19 -- Market-Based Loss Mitigation Practices for Troubled Mortgages Following the Financial Crisis

    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
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    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.

  • 2010-20 -- Excess Volatility of Corporate Bonds

    Excess Volatility of Corporate Bonds
    Jack Bao and Jun Pan
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    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.

  • 2010-21 -- Cyclicality, Performance Measurement, and Cash Flow Liquidity in Private Equity

    Cyclicality, Performance Measurement, and Cash Flow Liquidity in Private Equity 
    David T. Robinson and Berk A. Sensoy
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    We study the liquidity properties of private equity cash flows using data from 837 buyout and venture capital funds from 1984-2010. Most cash flow variation at a point in time is diversifiable – either idiosyncratic to a given fund or explained by the fund’s age. Both capital calls and distributions also have a procyclical systematic component. Distributions are more sensitive than calls, implying procyclical aggregate net cash flows. A consequence is that the well-known finding that funds raised in hot markets underperform in absolute terms is sharply attenuated when comparing to public equities. Consistent with a liquidity premium for calling capital in bad times, we find that funds with a relatively high propensity to do so perform better in both absolute and relative terms. Venture capital cash flows and performance are considerably more cyclical than buyout, and the links between cyclical cash flows and performance are likewise stronger.

2009

  • 2009-01 -- Financial Constraints, Inflated Home Prices, and Borrower Default during the Real-Estate Boom

    Financial Constraints, Inflated Home Prices, and Borrower Default during the Real-Estate Boom (revised 06/09)
    Itzhak Ben-David
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    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.

  • 2009-02 -- Do target CEOs sell out their shareholders to keep their job in a merger?

    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
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    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.

  • 2009-03 -- Why Do Foreign Firms Leave U.S. Equity Markets?

    Why Do Foreign Firms Leave U.S. Equity Markets? (revised 01/10)(revised 04/09)
    Craig Doidge, G. Andrew Karolyi, René M. Stulz
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    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.

  • 2009-04 -- Behavioral Consistency in Corporate Finance: CEO Personal and Corporate Leverage

    Behavioral Consistency in Corporate Finance: CEO Personal and Corporate Leverage (revised 06/10)
    Henrik Cronqvist, Anil K. Makhija, and Scott E. Yonker
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    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.

  • 2009-05 -- Why Do Foreign Firms Have Less Idiosyncratic Risk than U.S. Firms?

    Why Do Foreign Firms Have Less Idiosyncratic Risk than U.S. Firms?
    Söhnke M. Bartram, Gregory Brown, and René M. Stulz
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    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.

  • 2009-06 -- Macroeconomic Conditions and the Structure of Securities

    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
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    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.

  • 2009-07 -- When are Analyst Recommendation Changes Influential?

    When are Analyst Recommendation Changes Influential? (revised 05/10)
    Roger K. Loh and René M. Stulz
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    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.

  • 2009-08 -- Does Governance Travel Around the World? Evidence from Institutional Investors

    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
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    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.

  • 2009-09 -- The Role of the Securitization Process in the Expansion of Subprime Credit

    The Role of the Securitization Process in the Expansion of Subprime Credit
    Taylor D. Nadauld
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    We analyze the structure and attributes of subprime mortgage-backed securitization deals originated between 1997 and 2007. Our data set allows us to link loan-level data for over 6.7 million subprime loans to the securitization deals into which the loans were sold. We show that the securitization process, including the assignment of credit ratings, provided incentives for securitizing banks to purchase loans of poor credit quality in areas with high rates of house price appreciation. Increased demand from the secondary mortgage market for these types of loans appears to have facilitated easier credit in the primary mortgage market. To test this hypothesis, we identify an event which represents an external shock to the relative demand for subprime mortgages in the secondary market. We show that following the SEC’s adoption of rules reducing capital requirements on certain broker dealers in 2004, five large deal underwriters disproportionately increased their purchasing activity relative to competing underwriters in ZIP codes with the highest realized rates of house price appreciation but lower average credit quality. We show that these loans subsequently defaulted at marginally higher rates. Finally, using the event as an instrument, we demonstrate a causal link between the demand for mortgages in the secondary mortgage market and the supply of subprime credit in the primary mortgage market.

  • 2009-10 -- A Theory Of Risk Capital

    A Theory Of Risk Capital
    Isil Erel, Stewart C. Myers, and James A. Read, Jr.
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    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.

  • 2009-11 -- Determinants of Cross-Border Mergers and Acquisitions

    Determinants of Cross-Border Mergers and Acquisitions
    (revised March 2011)
    Isil Erel, Rose C. Liao, and Michael S. Weisbach
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    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.

  • 2009-12 -- Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation

    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
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    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.

  • 2009-13 -- Bank CEO Incentives and the Credit Crisis

    Bank CEO Incentives and the Credit Crisis (revised 08/10)(revised 03/10)(revised 12/09)
    Rüdiger Fahlenbrach and René M. Stulz
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    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.

  • 2009-14 -- Do Investment Banks Have Skill? Performance Persistence of M&A Advisors

    Do Investment Banks Have Skill? Performance Persistence of M&A Advisors
    Jack Bao and Alex Edmans
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    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.

  • 2009-15 -- When Constraints Bind

    When Constraints Bind
    Karl B. Diether and Ingrid M. Werner
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    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.

  • 2009-16 -- Credit Default Swaps and the Credit Crisis

    Credit Default Swaps and the Credit Crisis
    René M. Stulz
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    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.

  • 2009-17 -- Expected Returns and Volatility of Fama-French Factors

    Expected Returns and Volatility of Fama-French Factors
    Fousseni Chabi-Yo
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    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.

  • 2009-18 -- Default Risk, Idiosyncratic Coskewness and Equity Returns

    Default Risk, Idiosyncratic Coskewness and Equity Returns
    Fousseni Chabi-Yo and Jun Yang
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    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).

  • 2009-19 -- Changing the Nexus: The Evolution and Renegotiation of Venture Capital Contracts

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

  • 2009-20 -- The Effects of Stock Lending on Security Prices: An Experiment

    The Effects of Stock Lending on Security Prices: An Experiment (revised 08/10)
    Steven N. Kaplan, Tobias J. Moskowitz and Berk A. Sensoy
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    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.

  • 2009-21 -- The State of Corporate Governance Research

    The State of Corporate Governance Research
    Lucian A. Bebchuk and Michael S. Weisbach
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    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.

  • 2009-22 -- Investor Abilities and Financial Contracting: Evidence from Venture Capital

    Investor Abilities and Financial Contracting: Evidence from Venture Capital
    Ola Bengtsson and Berk A. Sensoy
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    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.

  • 2009-23 -- Learning to Cope: Voluntary Financial Education Programs and Loan Performance During a Housing Crisis

    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
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    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 home ownership.

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  • 2009-24 -- Economic Nationalism in Mergers and Acquisitions

    Economic Nationalism in Mergers and Acquisitions  (revised 9/11), (revised 06/10)
    Serdar Dinc and Isil Erel
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    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.

2008

  • 2008-01 -- How much do banks use credit derivatives to hedge loans?

    How much do banks use credit derivatives to hedge loans?
    Bernadette Minton, René M. Stulz, and Rohan Williamson
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    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.

  • 2008-02 -- Investor inattention and the underreaction to stock recommendations

    Investor inattention and the underreaction to stock recommendations
    Roger Loh
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    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.

  • 2008-03 - Diversification, Productivity, and Financial Constraints: Empirical Evidence from the US Electric Utility Industry?

    Diversification, Productivity, and Financial Constraints: Empirical Evidence from the US Electric Utility Industry?
    Mika Goto, Angie Low, and Anil K. Makhija
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    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 over-investment 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.

  • 2008-04 -- The Changing Nature of Chapter 11

    The Changing Nature of Chapter 11
    Sreedhar T. Bharath, Venky Panchapegesan, and Ingrid Werner
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    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.

  • 2008-05 -- Shareholder Rights, Boards, and CEO Compensation

    Shareholder Rights, Boards, and CEO Compensation
    Rüdiger Fahlenbrach
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    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.

  • 2008-06 -- Off but Not Gone: A Study of Nasdaq Delistings

    Off but Not Gone: A Study of Nasdaq Delistings
    Jeffrey H. Harris Venkatesh Panchapegesan, and Ingrid Werner
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    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.

  • 2008-07 -- Commodity price exposure and ownership clienteles

    Commodity price exposure and ownership clienteles
    Phil Davies, Bernadette Minton, and Catherine Schrand
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    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.

  • 2008-08 -- Hedge fund contagion and liquidity

    Hedge fund contagion and liquidity
    Nicole M. Boyson, Christof W. Stahel, and René M. Stulz
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    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.

  • 2008-09 -- Estimating the Effects of Large Shareholders Using a Geographic Instrument

    Estimating the Effects of Large Shareholders Using a Geographic Instrument (revised 04/09)
    Bo Becker, Henrik Cronqvist, and Rüdiger Fahlenbrach
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    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.

  • 2008-10 -- Why do firms appoint CEOs as outside directors?

    Why do firms appoint CEOs as outside directors?
    Rüdiger Fahlenbrach, Angie Low, and René M. Stulz
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    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.

  • 2008-11 -- What Determines the Structure of Corporate Debt Issues?

    What Determines the Structure of Corporate Debt Issues?
    Brandon Julio, Woojin Kim, and Michael S. Weisbach
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    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.

  • 2008-12 -- Thriving in the midst of financial distress? An analysis of firms exposed to asbestos litigation

    Thriving in the midst of financial distress? An analysis of firms exposed to asbestos litigation
    Jérôme Ph. A. Taillard
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    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.

  • 2008-13 -- Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization

    Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization
    René M. Stulz
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    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.

  • 2008-14 -- Why Do Foreign Firms Leave U.S. Equity Markets? An Analysis of Deregistrations Under SEC Exchange Act Rule 12h-6

    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
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    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.

  • 2008-15 -- Why are Buyouts Levered? The Financial Structure of Private Equity Funds

    Why are Buyouts Levered? The Financial Structure of Private Equity Funds
    Ulf Axelson, Per Strömberg, and Michael S. Weisbach
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    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.

  • 2008-16 -- Corporate Financial and Investment Policies when Future Financing is not Frictionless

    Corporate Financial and Investment Policies when Future Financing is not Frictionless
    Heitor Almeida, Murillo Campello, and Michael S. Weisbach
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    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.

  • 2008-17 -- Information Disclosure and Corporate Governance

    Information Disclosure and Corporate Governance (revised 08/09)(revised 06/10)(revised01/30/11)
    Benjamin E. Hermalin and Michael S. Weisbach
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    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.

  • 2008-18 -- Risk Management Failures: What Are They and When Do They Happen?

    Risk Management Failures: What Are They and When Do They Happen?
    René M. Stulz
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    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.

  • 2008-19 -- Estimating Affine Multifactor Term Structure Models Using Closed-Form Likelihood Expansions

    Estimating Affine Multifactor Term Structure Models Using Closed-Form Likelihood Expansions (revised 05/09)(revised 07/09)
    Robert Kimmel
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    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.

  • 2008-20 -- Does Mandatory Loan Review Affect Mortgage Contract Choice and Performance?

    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
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    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.

  • 2008-21 -- The Role of Boards of Directors in Corporate Governance: A Conceptual Framework & Survey

    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
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    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.

  • 2008-22 -- Investor Demand for Industry Factor Price Exposure

    Investor Demand for Industry Factor Price Exposure (revised 06/10)
    Phil Davies, Bernadette Minton, and Catherine Schrand
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    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.

  • 2008-23 -- Discussion of ‘A Lobbying Approach to Evaluating the Sarbanes-Oxley Act of 2002’

    Discussion of ‘A Lobbying Approach to Evaluating the Sarbanes-Oxley Act of 2002’
    G. Andrew Karolyi
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    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.

  • 2008-24 -- Changing Times: The Pricing Problem in Non-Linear Models

    Changing Times: The Pricing Problem in Non-Linear Models
    Robert Kimmel
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    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.

  • 2008-25 -- Pricing Kernels with Coskewness and Volatility Risk

    Pricing Kernels with Coskewness and Volatility Risk (revised 03/09)
    Fousseni Chabi-Yo
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    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.

2007

  • 2007-01 -- Does Corporate Culture Matter for Firm Policies?

    Does Corporate Culture Matter for Firm Policies?
    Henrik Cronqvist, Angie Low, and Mattias Nilsson
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    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.

  • 2007-02 -- A Note on the Dai-Singleton Canonical Representation of Affine Term Structure Models

    A Note on the Dai-Singleton Canonical Representation of Affine Term Structure Models (revised 09/08)
    Patrick Cheridito, Damir Filipovic, and Robert L. Kimmel
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    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.

  • 2007-03 -- Hedge Funds: Past, Present, and Future

    Hedge Funds: Past, Present, and Future
    René M. Stulz
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    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.

  • 2007-04 -- Former CEO Directors: Lingering CEOs or Valuable Resources?

    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
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    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.

  • 2007-05 -- The Impact of Shareholder Power on Bondholders: Evidence from Mergers and Acquisitions

    The Impact of Shareholder Power on Bondholders: Evidence from Mergers and Acquisitions
    Angie Low, Anil K. Makhija, and Anthony B. Sanders
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    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.

  • 2007-06 -- Complex Times: Asset Pricing and Conditional Moments under Non-Affine Diffusions

    Complex Times: Asset Pricing and Conditional Moments under Non-Affine Diffusions (revised 08/08)
    Robert L. Kimmel
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    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.

  • 2007-07 -- Do Entrenched Managers Pay Their Workers More?

    Do Entrenched Managers Pay Their Workers More?
    Henrik Cronqvist, Fredrik Heyman, Mattias Nilsson, Helena Svaleryd, and Jonas Vlachos
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    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.

  • 2007-08 -- Why do private acquirers pay so little compared to public acquirers?

    Why do private acquirers pay so little compared to public acquirers?
    Leonce Bargeron, Frederik Schlingemann, René M. Stulz, and Chad Zutter
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    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.

  • 2007-09 -- Has New York become less competitive in global markets? Evaluating foreign listing choices over time

    Has New York become less competitive in global markets? Evaluating foreign listing choices over time
    Craig Doidge, G. Andrew Karolyi, and René M. Stulz
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    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.

  • 2007-10 -- The Impact of Competition and Corporate Structure on Productive Efficiency: The Case of the U.S. Electric Utility Industry, 1990-2004

    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
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    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.

  • 2007-11 -- Fairness Opinions in Mergers and Acquisitions

    Fairness Opinions in Mergers and Acquisitions
    Anil K. Makhija and Rajesh P. Narayanan
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    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.

  • 2007-12 -- Managerial ownership dynamics and firm value

    Managerial ownership dynamics and firm value (revised 01/08)
    Rüdiger Fahlenbrach and René M. Stulz
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    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.

  • 2007-13 -- Fundamentals, Market Timing, and Seasoned Equity Offerings

    Fundamentals, Market Timing, and Seasoned Equity Offerings
    Harry DeAngelo, Linda DeAngelo, and René Stulz
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    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.

  • 2007-14 -- Differences in Governance Practice between U.S. and Foreign Firms: Measurement, Causes, and Consequences

    Differences in Governance Practice between U.S. and Foreign Firms: Measurement, Causes, and Consequences
    Reena Aggarwal, Isil Erel, René Stulz, and Rohan Williamson
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    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.

  • 2007-15 -- An Assessment of Terrorism-Related Investing Strategies

    An Assessment of Terrorism-Related Investing Strategies
    G. Andrew Karolyi
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    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.

  • 2007-16 -- Common Patterns in Commonality in Returns, Liquidity, and Turnover around the World

    Common Patterns in Commonality in Returns, Liquidity, and Turnover around the World
    G. Andrew Karolyi, Kuan-Hui Lee, and Mathijs A. van Dijk
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    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.

  • 2007-17 -- Do Funds Need Governance? Evidence from Variable Annuity-Mutual Fund Twins

    Do Funds Need Governance? Evidence from Variable Annuity-Mutual Fund Twins
    Richard Evans and Rüdiger Fahlenbrach
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    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.

  • 2007-18 -- Relationships, Corporate Governance, and Performance: Evidence from Private Placements of Common Stock

    Relationships, Corporate Governance, and Performance: Evidence from Private Placements of Common Stock (revised 05/08)
    Karen H. Wruck and YiLin Wu
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    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.

2006

  • 2006-01 -- Is there hedge fund contagion?

    Is there hedge fund contagion?
    Nicole M. Boyson, Christof W. Stahel, and René M. Stulz
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    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.

  • 2006-02 -- Co-Movements of Index Options and Futures Quotes

    Co-Movements of Index Options and Futures Quotes (revision 2005-10)
    Rüdiger Fahlenbrach and Patrik Sandås
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    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.

  • 2006-03 -- The Accrual Anomaly: Risk or Mispricing?

    The Accrual Anomaly: Risk or Mispricing?
    David Hirshleifer, Kewei Hou, Siew Hong Teoh
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    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.

  • 2006-04 -- Merton Miller

    Merton Miller
    René M. Stulz
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    Merton Miller was at the center of the transformation of academic finance from a descriptive field to a science. His principal contribution to this transformation was the introduction of arbitrage arguments which underlie most theoretical contributions in finance and remain central to the way financial economists analyze finance problems to this day. These arbitrage arguments underlie his and Franco Modigliani's famous irrelevance propositions.

  • 2006-05 -- Price and Volatility Transmission across Borders

    Price and Volatility Transmission across Borders
    Louis Gagnon and G. Andrew Karolyi
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    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.

  • 2006-06 -- The Consequences of Terrorism for Financial Markets: What Do We Know?

    The Consequences of Terrorism for Financial Markets: What Do We Know?
    G. Andrew Karolyi
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    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.

  • 2006-07 -- How has CEO Turnover Changed? Increasingly Performance Sensitive Boards and Increasingly Uneasy CEOs

    How has CEO Turnover Changed? Increasingly Performance Sensitive Boards and Increasingly Uneasy CEOs
    Steven N. Kaplan and Bernadette A. Minton
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    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.

  • 2006-08 -- Investor Overreaction, Cross-Sectional Dispersion of Firm Valuations, and Expected Stock Returns

    Investor Overreaction, Cross-Sectional Dispersion of Firm Valuations, and Expected Stock Returns
    Danling Jiang
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    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.

  • 2006-09 -- What Factors Drive Global Stock Returns?

    What Factors Drive Global Stock Returns?  (Current Version: January 2011)
    Kewei Hou, G. Andrew Karolyi, and Bong-Chan Kho
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    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.

  • 2006-10 -- The World Price of Liquidity Risk

    The World Price of Liquidity Risk
    Kuan-Hui Lee
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    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.

  • 2006-11 -- Information, Trading Volume, and International Stock Return Comovements: Evidence from Cross-listed Stocks

    Information, Trading Volume, and International Stock Return Comovements: Evidence from Cross-listed Stocks (updated 02/07)
    Louis Gagnon and G. Andrew Karolyi
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    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.

  • 2006-12 -- Financial globalization, governance, and the evolution of the home bias

    Financial globalization, governance, and the evolution of the home bias
    Bong-Chan Kho, René M. Stulz, and Francis E. Warnock
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    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.

  • 2006-13 -- It’s SHO Time! Short-Sale Price-Tests and Market Quality

    It’s SHO Time! Short-Sale Price-Tests and Market Quality (updated 08/07)
    Karl B. Diether, Kuan-Hui Lee, and Ingrid M. Werner
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    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.

  • 2006-14 -- Large Shareholders and Corporate Policies

    Large Shareholders and Corporate Policies
    Henrik Cronqvist and Rüdiger Fahlenbrach
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    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.

  • 2006-15 -- Enterprise Risk Management: Theory and Practice

    Enterprise Risk Management: Theory and Practice
    Brian Nocco and René M. Stulz
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    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.

  • 2006-16 -- Advertising and Portfolio Choice

    Advertising and Portfolio Choice
    Henrik Cronqvist
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    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.

  • 2006-17 -- Why do U.S. firms hold so much more cash than they used to?

    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
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    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.

  • 2006-18 -- Subordinations Levels in Structured Financing

    Subordinations Levels in Structured Financing
    Xudong An, Yongheng Deng, and Anthony B. Sanders
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    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.

  • 2006-19 -- The Effect of Bank Mergers on Loan Prices: Evidence from the U.S.

    The Effect of Bank Mergers on Loan Prices: Evidence from the U.S. (updated 12/07)
    Isil Erel
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    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.

  • 2006-20 -- Managerial Risk-Taking Behavior and Equity-Based Compensation

    Managerial Risk-Taking Behavior and Equity-Based Compensation
    Angie Low
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    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.

  • 2006-21 -- The Economics of Conflicts of Interest in Financial Institutions

    The Economics of Conflicts of Interest in Financial Institutions
    Hamid Mehran and René M. Stulz
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    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.

  • 2006-22 -- List Prices, Sale Prices, and Marketing Time: An Application to U.S. Housing Markets

    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
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    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.

  • 2006-23 -- R2 and Price Inefficiency

    R2 and Price Inefficiency
    Kewei Hou, Lin Peng, and Wei Xiong
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    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.

  • 2006-24 -- Commercial Mortgage-backed Securities (CMBS) Terminations, Regional and Property-Type Risk

    Commercial Mortgage-backed Securities (CMBS) Terminations, Regional and Property-Type Risk
    Yongheng Deng, John M. Quigley, and Anthony B. Sanders
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    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.

  • 2006-25 -- Do U.S. Firms Have the Best Corporate Governance? A Cross-Country Examination of the Relation between Corporate Governance and Shareholder Wealth

    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
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    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.