ARCH modeling in finance: A review of the theory and empirical evidence

We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors’ confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations ~“momentum”!, short-run earnings “drift,” but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy. IN RECENT YEARS A BODY OF evidence on security returns has presented a sharp challenge to the traditional view that securities are rationally priced to ref lect all publicly available information. Some of the more pervasive anomalies can be classified as follows ~Appendix A cites the relevant literature!: 1. Event-based return predictability ~public-event-date average stock returns of the same sign as average subsequent long-run abnormal performance! 2. Short-term momentum ~positive short-term autocorrelation of stock returns, for individual stocks and the market as a whole!

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Investor Psychology and Security Market Under- and Overreactions

This paper shows that revealing public information to reduce information asymmetry can reduce a firm's cost of capital by attracting increased demand from large investors due to increased liquidity of its securities. Large firms will disclose more information since they benefit most. Disclosure also reduces the risk bearing capacity available through market makers. If initial information asymmetry is large, reducing it will increase the current price of the security. However, the maximum current price occurs with some asymmetry of information: further reduction of information asymmetry accentuates the undesirable effects of exit from market making. THIS PAPER STUDIES THE causes and consequences of a security's liquidity, especially the effect of future liquidity on the security's current price-equivalently the effect on its required expected rate of return, its cost of capital. Under conditions that we identify, reducing information asymmetry reduces the cost of capital. Under other (less typical) conditions, this reduced information asymmetry can have the opposite effect. We use public disclosure of information as the means of changing information asymmetry, but the points are more general. Our model is related to those of Kyle (1985), Glosten and Milgrom (1985), and Admati and Pfleiderer (1988). They assume that there is unlimited risk bearing capacity devoted to market making, which implies that changes in future liquidity never influence a security's cost of capital.1 In contrast, we develop a model of trade in an illiquid market with limited risk bearing capacity of risk-averse market makers and examine the effects of private information on the incentives of market makers to provide risk bearing

Disclosure, Liquidity, and the Cost of Capital

We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors' confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations (momentum), short-run earnings drift, but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy. 
Prepublication version available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2017

Presentation Slides for 'Investor Psychology and Security Market Under and Overreactions'

Economic theory suggests that a commitment by a firm to increased levels of disclosure should lower the information asymmetry component of the firm's cost of capital. But while the theory is compelling, so far empirical results relating increased levels of disclosure to measurable economic benefits have been mixed. One explanation for the mixed results among studies using data from firms publicly registered in the United States is that, under current U.S. reporting standards, the disclosure environment is already rich. In this paper, we study German firms that have switched from the German to an international reporting regime (1AS or U.S. GAAP), thereby committing themselves to increased levels of disclosure. We show that proxies for the information asymmetry component of the cost of capital for the switching firmsnamely, the bid-ask spread and trading volume-behave in the predicted direction compared to firms employing the German reporting regime.

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The Economic Consequences of Increased Disclosure

This article develops a theory in which concentrated-trading patterns arise endogenously as a result of the strategic behavior of liquidity traders and informed traders. Our results provide a partial explanation for some of the recent empitical findings concerning the patterns of volume and price variability in intraday transaction data. In the last few years, intraday trading data for a number of securities have become available. Several empirical studies have used these data to identify various patterns in trading volume and in the daily behavior of security prices. This article focuses on two of these patterns; trading volume and the variability of returns. Consider, for example, the data in Table 1 concerning shares of Exxon traded during 1981.1 The U-shaped pattern of the average volume of shares traded-namely, the heavy trading in the beginning and the end of the trading day and the relatively light trading in the middle of the day-is very typical and has been documented in a number of studies. [For example,Jain andJoh (1986) examine hourly data for the aggregate volume on the NYSE, which is reported in the Wall StreetJournal, and find the same pattern.] Both the variance of price changes

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A Theory of Intraday Patterns: Volume and Price Variability

We develop a model in which a large investor has access to a costly monitoring technology affecting securities' expected payoffs. Allocations of shares are determined through trading among risk-averse investors. Despite the free-rider problem associated with monitoring, risk-sharing considerations lead to equilibria in which monitoring takes place. Under certain conditions the equilibrium allocation is Pareto efficient and all agents hold the market portfolio of risky assets independent of the specific monitoring technology. Otherwise distortions in risk sharing may occur, and monitoring activities that reduce the expected payoff on the market portfolio may be undertaken.

https://www.jstor.org/stable/pdfplus/2138781.pdf

Large Shareholder Activism, Risk Sharing, and Financial Market Equilibrium

We derive a role for inside investors, such as venture capitalists, in resolving various agency problems that arise in a multistage financial contracting problem. Absent an inside investor, the choice of securities is unlikely to reveal all private information, and overinvestment may occur. An inside investor, however, always makes optimal investment decisions if and only if he holds a fixed-fraction contract, where he always receives a fixed fraction of the project's payoff and finances that same fraction of future investments. This contract also eliminates any incentives of the venture capitalist to misprice securities issued in later financing rounds. IN THIS ARTICLE WE develop a model of financial contracting with multiple investment decisions and show how conflicts of interest and informational asymmetries can be effectively resolved by an inside investor, i.e., an investor who not only provides capital but also works closely with the firm, monitors it frequently, and is generally very well informed about the firm's prospects and investment opportunities. Venture capitalists are obvious examples of inside investors, and their function has been an important motivation for this article. Banks, especially in Japan and Germany, are also involved in monitoring and can be viewed as playing the role of inside investors. In this article we examine the potential benefits of inside investors in a context where there are no restrictions beyond limited liability on the type of financial contracts that can be written. We address a basic financial contracting problem involving an entrepreneur who has an idea for a project but does not have sufficient capital to fund it. An important assumption is that there are several stages in the project's development and that a decision must be made at each stage whether the project should be continued or abandoned. If the project is continued, the amount of additional capital to be invested must also be determined. We assume that the entrepreneur, as an insider, observes private information about the project's profitability at each stage. This information is not

Robust Financial Contracting and the Role of Venture Capitalists

A Noisy Rational Expectations Equilibrium for Multi-Asset Securities Markets

We examine whether a large shareholder can alleviate conflicts of interest between managers and shareholders through the credible threat of exit on the basis of private information. In our model, the threat of exit often reduces agency costs, but additional private information need not enhance the effectiveness of the mechanism. Moreover, the threat of exit can produce quite different effects depending on whether the agency problem involves desirable or undesirable actions from shareholders’ perspective. Our results are consistent with empirical findings on the interaction between managers and minority large shareholders and have further empirical implications. (JEL D53, D82, G10, G30, G34) The role of active large shareholders in improving corporate performance has been discussed extensively in the last two decades. Although large shareholders (including pension funds, mutual funds, hedge funds, and other investors) hold a substantial and increasing fraction of shares in public companies in the United States, most large shareholders play a limited role in overt forms of shareholder activism such as takeovers, proxy fights, strategic voting, shareholders’ proposals, etc. One likely reason for this is that active shareholders only realize a relatively small fraction of the benefits from their monitoring while bearing the full cost, which can be substantial. In other words, we have a classic “free rider” problem. In addition, legal barriers, agency problems affecting the incentives of the large shareholder, and the fact that many large shareholders are committed to being passive and not investing resources to monitor their portfolio firms

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Anat R. Admati

Papers

A Theory of Intraday Patterns: Volume and Price Variability

Large Shareholder Activism, Risk Sharing, and Financial Market Equilibrium

Robust Financial Contracting and the Role of Venture Capitalists

A Noisy Rational Expectations Equilibrium for Multi-Asset Securities Markets

The "Wall Street Walk" and Shareholder Activism: Exit as a Form of Voice