Showing papers in "Journal of Finance in 1990"
TL;DR: In this article, the authors examined the returns earned by subscribing to initial public offerings of equity (IPOs), and they showed that IPOs with more informed investor capital require higher returns, and that prestigious underwriters are associated with IPOs that have lower returns.
Abstract: This paper examined the returns earned by subscribing to initial public offerings of equity (IPOs). Rock (1986) suggests that IPO returns are required by uninformed investors as compensation for the risk of trading against superior information. We show that IPOs with more informed investor capital require higher returns. The marketing underwriter's reputation reveals the expected level of “informed” activity. Prestigious underwriters are associated with lower risk offerings. With less risk there is less incentive to acquire information and fewer informed investors. Consequently, prestigious underwriters are associated with IPOs that have lower returns.
2,682 citations
TL;DR: In this article, the authors present new empirical evidence of predictability of individual stock returns, including negative first-order serial correlation in monthly stock returns and significant positive serial correlation at longer lags, and the twelve-month serial correlation is particularly strong.
Abstract: This paper presents new empirical evidence of predictability of individual stock returns. The negative first-order serial correlation in monthly stock returns is highly significant. Furthermore, significant positive serial correlation is found at longer lags, and the twelve-month serial correlation is particularly strong. Using the observed systematic behavior of stock returns, one-step-ahead return forecasts are made and ten portfolios are formed from the forecasts. The difference between the abnormal returns on the extreme decile portfolios over the period 1934–1987 is 2.49 percent per month.
2,539 citations
TL;DR: In this article, a dynamic theory of "customer relationships" in bank loan markets is presented, based on a traditional view of bank lending behavior, first spelled out by Hodgman and Kane and Malkiel (1965) and later elaborated upon by Wood (1975).
Abstract: Customer relationships arise between banks and firms because, in the process of lending, a bank learns more than others about its own customers. This information asymmetry allows lenders to capture some of the rents generated by their older customers; competition thus drives banks to lend to new firms at interest rates which initially generate expected losses. As a result, the allocation of capital is shifted toward lower quality and inexperienced firms. This inefficiency is eliminated if complete contingent contracts are written or, when this is costly, if banks can make nonbinding commitments that, in equilibrium, are backed by reputation. THIS PAPER DERIVES A dynamic theory of "customer relationships" in bank loan markets. The theory builds on a traditional view of bank lending behavior, first spelled out by Hodgman (1961) and Kane and Malkiel (1965) and later elaborated upon by Wood (1975). According to this view, an essential factor underlying a bank's loan pricing policy is its impact on the bank's stock of loyal customers, as well as on those customers' deposits. Rather than take relationships as a given, we examine the implications of the view expressed, for example, by Fama (1985), that they arise because of "inside information" generated by the history of bankfirm interactions. In our theory, customer relationships arise endogenously as a consequence of the asymmetric evolution of information sets. In contrast with most theories of pricing under asymmetric information, though, the key informational asymmetry postulated here is that which arises between agents on the same side of the market. We exploit the presumption, made by Kane and Malkiel (1965) and Fama (1985), that a bank which actually lends to a firm learns more about that borrower's characteristics than do other banks. A fundamental consequence of this asymmetric evolution of information is the potential creation of ex post, or temporary, monopoly power. If it is relatively costly for banks and firms to write multiperiod contingent contracts, this ex post monopoly power has undesirable effects on the allocation of capital. Even though banks earn zero expected profit over the lifespan of the average customer relationship, they are not disciplined by the market to offer
2,064 citations
TL;DR: In this article, the authors present a possibly empirically important exception to this argument, based on the prevalence of positive feedback investors in financial markets, who buy securities when prices rise and sell when prices fall.
Abstract: Analyses of rational speculation usually presume that it dampens fluctuations caused by "noise" traders. This is not necessarily the case if noise traders follow positivefeedback strategies-buy when prices rise and sell when prices fall. It may pay to jump on the bandwagon and purchase ahead of noise demand. If rational speculators' early buying triggers positive-feedback trading, then an increase in the number of forwardlooking speculators can increase volatility about fundamentals. This model is consistent with a number of empirical observations about the correlation of asset returns, the overreaction of prices to news, price bubbles, and expectations. WHAT EFFECT DO RATIONAL speculators have on asset prices? The standard answer, dating back at least to Friedman (1953), is that rational speculators must stabilize asset prices. Speculators who destabilize asset prices do so by, on average, buying when prices are high and selling when prices are low; such destabilizing speculators are quickly eliminated from the market. By contrast, speculators who earn positive profits do so by trading against the less rational investors who move prices away from fundamentals. Such speculators rationally counter the deviations of prices from fundamentals and so stabilize them. Recent work on noise trading and market efficiency has accepted this argument (Figlewski, 1979; Kyle, 1985; Campbell and Kyle, 1988; DeLong, Shleifer, Summers, and Waldmann, 1987). In this work, risk aversion keeps rational speculators from taking large arbitrage positions, so noise traders can affect prices. Nonetheless, the effect of rational speculators' trades is to move prices in the direction of, even if not all the way to, fundamentals. Rational speculators buck noisedriven price movements and so dampen, but do not eliminate, them. In this paper we present a possibly empirically important exception to this argument, based on the prevalence of positive feedback investors in financial markets. Positive feedback investors are those who buy securities when prices rise and sell when prices fall. Many forms of behavior common in financial markets can be described as positive feedback trading. It can result from extrapolative expectations about prices, or trend chasing. It can also result from stoploss orders, which effectively prompt selling in response to price declines. A
1,825 citations
TL;DR: In this article, the authors present evidence that some types of bidders systematically overpay in acquisitions, thereby reducing the wealth of their shareholders as opposed to just revealing bad news about their firm.
Abstract: In a sample of 326 US acquisitions between 1975 and 1987, three types of acquisitions have systematically lower and predominantly negative announcement period returns to bidding firms. The returns to bidding shareholders are lower when their firm diversifies, when it buys a rapidly growing target, and when its managers performed poorly before the acquisition. These results suggest that managerial objectives may drive acquisitions that reduce bidding firms' values. THERE IS NOW CONSIDERABLE evidence that making acquisitions is a mixed blessing for shareholders of acquiring companies. Average returns to bidding shareholders from making acquisitions are at best slightly positive, and significantly negative in some studies (Bradley, Desai and Kim 1988, Roll 1986). Some have suggested that negative bidder returns are purely a consequence of stock financing of acquisitions that leads to a release of adverse information about acquiring firms (Asquith, Bruner, and Mullins 1987). In this case, negative bidder returns are not evidence of a bad investment. An alternative interpretation of poor bidder performance is that bidding firms overpay for the targets they acquire. In this paper, we present evidence that some types of bidders systematically overpay. There are at least two reasons why bidding firms' managers might overpay in acquisitions, thereby truly reducing the wealth of their shareholders as opposed to just revealing bad news about their firm. According to Roll (1986), managers of bidding firms are infected by hubris, and so overpay for targets because they overestimate their own ability to run them. Another view of overpayment is that managers of bidding firms pursue personal objectives other than maximization of shareholder value. To the extent that acquisitions serve these objectives, managers of bidding firms are willing to pay more for targets than they are worth to bidding firms' shareholders. Our view is that when a firm makes an acquisition or any other investment, its manager considers both his personal benefits from the investment and the consequences for the market value of the firm. Some investments are particularly attractive from the former perspective: they contribute to long term growth of the firm, enable the manager to diversify the risk on his human capital, or
1,617 citations
TL;DR: Fama et al. as discussed by the authors found that 30% of the variance in stock returns can be explained by a combination of shocks to expected cash flows, time-varying expected returns, and expected return shocks.
Abstract: Measuring the total return variation explained by shocks to expected cash flows, timevarying expected returns, and shocks to expected returns is one way to judge the rationality of stock prices. Variables that proxy for expected returns and expectedreturn shocks capture 30% of the variance of annual NYSE value-weighted returns. Growth rates of production, used to proxy for shocks to expected cash flows, explain 43% of the return variance. Whether the combined explanatory power of the variablesabout 58% of the variance of annual returns-is good or bad news about market efficiency is left for the reader to judge. STANDARD VALUATION MODELS POSIT three sources of variation in stock returns: (a) shocks to expected cash flows, (b) predictable return variation due to variation through time in the discount rates that price expected cash flows, and (c) shocks to discount rates. Many studies examine these three sources of return variation. Fama (1981), Geske and Roll (1983), Kaul (1987), Barro (1990), and Shah (1989) find that large fractions (often more than 50%) of annual stock-return variances can be traced to forecasts of variables such as real GNP, industrial production, and investment that are important determinants of the cash flows to firms. There is also evidence that expected returns (and thus the discount rates that price expected cash flows) vary through time (for example, Fama and Schwert (1977), Keim and Stambaugh (1986), Campbell and Shiller (1988), and Fama and French (1988, 1989)). Finally, French, Schwert, and Stambaugh (1987) find that part of the variation in stock returns can be traced to a "discount-rate effect," that is, shocks to expected returns and discount rates that generate opposite shocks to prices. Measuring the total return variation explained by a combination of shocks to expected cash flows, time-varying expected returns, and shocks to expected returns is a logical way to judge the efficiency or rationality of stock prices. Although the three sources of return variation have been studied separately, there is little evidence on their combined explanatory power. Such evidence is a major goal of this paper. The evidence says that variables that measure time-varying expected returns and shocks to expected returns capture about 30% of the variance of annual real returns on the value-weighted portfolio of New York Stock Exchange (NYSE) stocks. Future growth rates of industrial production, used to proxy for shocks to
1,585 citations
TL;DR: In this article, the authors provide a theory of capital structure based on the effect of debt on investors' information about the firm and on their ability to oversee management, arguing that managers are reluctant to relinquish control and unwilling to provide information that could result in such an outcome.
Abstract: This paper provides a theory of capital structure based on the effect of debt on investors' information about the firm and on their ability to oversee management. We postulate that managers are reluctant to relinquish control and unwilling to provide information that could result in such an outcome. Debt is a disciplining device because default allows creditors the option to force the firm into liquidation and generates information useful to investors. We characterize the time path of the debt level and obtain comparative statics results on the debt level, bond yield, probability of default, probability of reorganization, etc. THE PURPOSE OF THIS paper is to provide a theory of capital structure based on the effect of debt on investors' information about the firm and on their ability to oversee management. We contend that, in general, managers do not always behave in the best interests of their investors and therefore need to be disciplined. Debt serves as a disciplining device because default allows creditors the option to force the firm into liquidation. Moreover, debt also generates information that can be used by investors to evaluate major operating decisions including liquidation. The informational consequences of debt are twofold. First, the mere
1,393 citations
TL;DR: In this paper, the authors provide empirical support for the notion that autoregressive conditional heterogeneousness (ARCH) in daily stock return data reflects time dependence in the process generating information flow to the market.
Abstract: This paper provides empirical support for the notion that Autoregressive Conditional HeterQskedasticity (ARCH) in daily stock return data reflects time dependence in the process generating information flow to the market. Daily trading volume, used as a proxy for information arrival time, is shown to have significant explanatory power regarding the variance of daily returns, which is an implication of the assumption that daily returns are subordinated to intraday equilibrium returns. Furthermore, ARCH effects tend to disappear when volume is included in the variance equation. THE AUTOREGRESSIVE CONDITIQNAL HETEROSKEDASTICITY (ARCH) process of Engle (1982) has been shown to provide a good fit for many financial return time series,1 ARCH imposes an autoregressive structure on conditional variance, allQwing volatility shocks to persist over time. This persistence captures the propensity of returns of like magnitude to clu~ter in time and can explain the well documented nonnormality and nonstability of empirical asset return distributions. (See especially Fama (1965).) An appealing explanation for the presence of ARCH is based upon the hypothesis that daily returns are generated by a maiture of distributions, in which the rate of daily information arrival is the stochastic mixing variable. As suggested by Diebold (1986), Gallant, Hsieh, and Tauchen (1988), and Stock (1987, 1988), ARCH might capture the time series properties (e.g., serial correlation) of this mixing variable. HQwever, this linkage has not been broadly documented with the datia. The objective of this study is to examine the validity of this explanation for daily stock returns. The empirical strategy exploits the implication of the mixture model that the variance of daily price increments is heteroskedastic-specifically, positively related to the rate of daily information arrival. Using daily trading volume as a proxy for the mixing variable, we show that, for a sample of 20 common stocks, ARCH effects vanish when volume is included as an explanatory variable in the conditional variance equation.
1,223 citations
TL;DR: In this article, the authors developed and empirically tested a two-factor model for pricing financial and real assets contingent on the price of oil and applied it to determine the present values of one barrel of oil deliverable in one to ten years time.
Abstract: This paper develops and empirically tests a two-factor model for pricing financial and real assets contingent on the price of oil. The factors are the spot price of oil and the instantaneous convenience yield. The parameters of the model are estimated using weekly oil futures contract prices from January 1984 to November 1988, and the model's performance is assessed out of sample by valuing futures contracts over the period November 1988 to May 1989. Finally, the model is applied to determine the present values of one barrel of oil deliverable in one to ten years time.
1,094 citations
TL;DR: This paper investigated the relationship between bank ownership structure and risk taking and found that stockholder controlled banks exhibit significantly higher risk taking behavior than managerially controlled banks during the 1979-1982 period of relative deregulation.
Abstract: This paper investigates the relationship between bank ownership structure and risk taking. It is hypothesized that stockholder controlled banks have incentives to take higher risk than managerially controlled banks and that these differences in risk become more pronounced in periods of deregulation. In support of this hypothesis, we show that stockholder controlled banks exhibit significantly higher risk taking behavior than managerially controlled banks during the 1979-1982 period of relative deregulation. IN THIS PAPER WE analyze the relationship between risk taking by banking firms and their ownership structures. In particular, we concentrate on the potential conflict of interest over risk taking between managerially controlled banks (defined as banks whose managers hold a relatively small proportion of the banks' stock and act in their own utility-maximizing interests) and stockholder controlled banks (defined as banks whose managers hold a relatively large proportion of the bank's stock and act in the stockholder's value-maximizing interest). This conflict of interest is important partly because others have already documented an inverse relationship between non-bank firm risk taking and the
1,070 citations
TL;DR: In this article, the authors provide evidence of substantial tax effects on the choice between issuing debt or equity; most studies fail to find significant effects, and the relationship between tax shields and debt policy is clarified.
Abstract: This paper provides clear evidence of substantial tax effects on the choice between issuing debt or equity; most studies fail to find significant effects. The relationship between tax shields and debt policy is clarified. Other papers miss the fact that most tax shields have a negligible effect on the marginal tax rate for most firms. New predictions are strongly supported by an empirical analysis; the method is to study incremental financing decisions using discrete choice analysis. Previous researchers examined debt/equity ratios, but tests based on incremental decisions should have greater power. NEARLY EVERYONE BELIEVES TAXES must be important to financing decision, but little support has been found in empiricial analyses. Myers (1984) wrote, "I know of no study clearly demonstrating that a firm's tax status has predictable, material effects on its debt policy. I think the wait for such a study will be protracted" (p. 588). A similar conclusion is reached by Poterba (1986). Recent studies that fail to find plausible or significant tax effects include Titman and Wessels (1988), Fischer, Heinkel, and Zechner (1989), Ang and Peterson (1986), Long and Malitz (1985), Bradley, Jarrell, and Kim (1984), and Marsh (1982).1 This paper provides clear evidence of substantial tax effects on financing decisions. The research differs from prior studies in two important ways. First, I clarify the relationship between tax shields and the incentive to use debt. Theory predicts that firms with low expected marginal tax rates on their interest deductions are less likely to finance new investments with debt. Tax shields should matter only to the extent that they affect the marginal tax rate on interest deductions. However, although deductions and credits always lower the average tax rate, they only lower the marginal rate if they cause the firm to have no taxable income and thus face a zero marginal rate on interest deductions (tax exhaustion).2 Other papers have ignored the fact that most tax shields have only
TL;DR: Bank debt (deposits) is an example of this type of liquid security which protect relatively uninformed agents, and as discussed by the authors provides a rationale for deposit insurance in this content, implying that a money market mutual fund-based payments system may be an alternative to one based on insured bank deposits.
Abstract: Trading losses associated with information asymmetries can be mitigated by designing securities which split the cash flows of underlying assets. These securities, which can arise endogenously, have values that do not depend on the information known only to informed agents. Bank debt (deposits) is an example of this type of liquid security which protect relatively uninformed agents, and we provide a rationale for deposit insurance in this content. High-grade corporate debt and government bonds are other examples, implying that a money market mutual fund-based payments system may be an alternative to one based on insured bank deposits.
TL;DR: Abuaf et al. as discussed by the authors presented evidence which casts doubt on the random walk hypothesis for the real exchange rate and showed that PPP may hold in the long run after all.
Abstract: This paper re-examines the evidence on Purchasing Power Parity (PPP) in the long run. Previous studies have generally been unable to reject the hypothesis that the real exchange rate follows a random walk. If true, this implies that PPP does not hold. In contrast, this paper casts serious doubt on this random walk hypothesis. The results follow from more powerful estimation techniques, applied in a multilateral framework. Deviations from PPP, while substantial in the short run, appear to take about three years to be reduced in half. LONG-RUN PURCHASING POWER PARITY (PPP) is a fundamental building block of most models of exchange rate determination. Dynamic exchange rate models, as in Dornbusch (1976) and Mussa (1982), usually rely on PPP as a long-run equilibrium condition for the exchange rate. Yet the PPP doctrine has not fared well in recent tests.1 In particular, Roll (1979) and Adler and Lehmann (1983) have been unable to reject the hypothesis that the real exchange rate follows a random walk. If true, the random walk hypothesis has the disturbing implication that shocks to the real exchange rate are never reversed, which clearly implies that there is no tendency for PPP to hold in the long run. This paper presents evidence which casts doubt on the random walk hypothesis for the real exchange rate. In our opinion, the negative results obtained in previous empirical research2 reflect the poor power of the tests rather than evidence against PPP. In other words, the methodology employed so far will fail to reject the random walk assumption even in situations where the real exchange rate exhibits slow reversals to PPP values. This is why Hakkio (1986) concludes that, "although the hypothesis that the exchange rate follows a random walk cannot be rejected, not much weight should be put on this conclusion." This paper shows that PPP may hold in the long run after all. The stronger conclusions of this study can be traced to the use of more powerful tests, primarily the statistics advocated by Dickey and Fuller (1979), employed in a multivariate setting. We find that using a system of univariate autoregressions constraining * Salomon Brothers and Graduate School of Business, Columbia University, respectively. This material is related to Abuaf's Ph.D. dissertation at the University of Chicago. The suggestions of the referees led to numerous improvements in the paper. The views expressed here do not necessarily reflect those of Salomon Brothers. 'See for instance Frenkel (1981), Cumby and Obstfeld (1984), and Hakkio (1984). 2Exceptions are Cumby and Obstfeld (1984) and Cumby and Huizinga (1988), who report that expected exchange rate changes are biased predictors of relative inflation rates. This implies that real
TL;DR: Fama as discussed by the authors analyzed the relation between real stock returns and real activity from 18891988 to 1989 and found that stock returns are highly correlated with future production growth rates for 1953-1987, and the degree of correlation increases with the length of the holding period.
Abstract: This paper analyzes the relation between real stock returns and real activity from 18891988. It replicates Fama's (1990) results for the 1953-1987 period using an additional 65 years of data. It also compares two measures of industrial production in the tests: (1) the series produced by Babson for 1889-1918, spliced with the Federal Reserve Board index of industrial production for 1919-1988, and (2) the new Miron and Romer (1989) index spliced with the Federal Reserve Board index in 1941. Fama's findings are robust for a much longer period-future production growth rates explain a large fraction of the variation in stock returns. The new Miron-Romer measure of industrial production is less closely related to stock price movements than the older Babson and Federal Reserve Board measures. FAMA (1990) SHOWS THAT MONTHLY, quarterly, and annual stock returns are highly correlated with future production growth rates for 1953-1987. Moreover, the degree of correlation increases with the length of the holding period. He argues that the relation between current stock returns and future production growth reflects information about future cash flows that is impounded in stock prices. Fama uses multiple regression tests to control for variation in expected stock returns that is reflected in dividend yields on stocks D(t)/V(t), default spreads on corporate bonds DEF(t), and term spreads on bonds TERM(t). Finally, he analyzes the effects of shocks to expected returns on stock returns. Combining these sources of variation in stock returns, he explains up to 59 percent of the variation in annual stock returns from 1953-1987. Nevertheless, as Fama (1990, pp. 18-19) notes, One could also argue, however, that the regressions overstate explanatory power. The variables used to explain returns are chosen largely on the basis of goodness-of-fit rather than the directives of a well-developed theory.... It is possible that with fresh data, the explanatory power of the variables used here would be lower than that measured for 1953-87.
TL;DR: In this article, an information-theoretic, infinite horizon model of the firm's equity issue decision under adverse selection is presented. And the model predicts that equity issues on average are preceded by an abnormal positive return on the stock, although for some firms the issue is preceded by a loss.
Abstract: This paper presents an information-theoretic, infinite horizon model of the equity issue decision. The model predicts that (a) equity issues on average are preceded by an abnormal positive return on the stock, although for some firms the issue is preceded by a loss; (b) equity issues on average are preceded by an abnormal rise in the market; and (c) the stock price drops at the announcement of an issue. The model provides a measure of the welfare cost of asymmetric information; the welfare loss may be small even if the price drop at issue announcement is large. THE ADVERSE SELECTION PROBLEM when firms issue new securities has been the focus of much recent work in corporate finance. Seasoned equity issues have received particular attention, in part because there are striking stock price patterns around the time of equity issues and considerable variation over time in the number of issues. In this paper we present a dynamic, infinite horizon model of the firm's equity issue decision under adverse selection. The model can simultaneously account for each of the following empirical observations about equity issues:' * Stock prices of issuing firms on average exhibit a large and extended positive
TL;DR: In this paper, the authors investigated the effect on bank equity values of the Comptroller of the Currency's announcement that some banks were "too big to fail" and that for those banks total deposit insurance would be provided.
Abstract: This paper investigates the effect on bank equity values of the Comptroller of the Currency's announcement that some banks were "too big to fail" and that for those banks total deposit insurance would be provided. Using an event study methodology, we find positive wealth effects accruing to TBTF banks, with corresponding negative effects accruing to non-included banks. We demonstrate that the magnitude of these effects differed with bank solvency and size. We also show that the policy to which the market reacted was that suggested by the Wall Street Journal and not that actually intended by the Comptroller. THE ROLE OF DEPOSIT insurance has become a topic of increasing debate. Advocates argue that by removing the incentive to "run", deposit insurance protects individual financial institutions from instability in the intermediation process, thereby providing stability to the financial system as a whole.1 The recent rise in bank failures and the concomitant crises in the S&L industry, however, demonstrate that this stability is not guaranteed. Moreover, critics note that deposit insurance may introduce incentive problems and wealth effects into the financial system, both of which can impede the effective functioning of any deposit insurance system. These problems have prompted concern about the structure of the current deposit insurance system and have led to numerous proposals regarding its restructuring.2 This paper investigates one aspect of this debate by analyzing the effect on bank equity values of the policy decision to insure completely some banks but not others. Specifically, in September 1984 the Comptroller of the Currency testified before Congress that some banks were simply "too big to fail" (TBTF) and that for those banks total deposit insurance would be provided. While not explicitly naming the banks, the Comptroller admitted that this policy would apply to the eleven largest banks. Using an event study methodology, we analyze
TL;DR: In this article, the authors document regularities in trading patterns of individual and institutional investors related to the day of the week and find a relative increase in trading activity by individuals on Mondays.
Abstract: In this paper, we document regularities in trading patterns of individual and institutional investors related to the day of the week. We find a relative increase in trading activity by individuals on Mondays. In addition, there is a tendency for individuals to increase the number of sell transactions relative to buy transactions, which might explain at least part of the weekend effect.
TL;DR: Haugen and Senbet as discussed by the authors found that a significant positive stock and a negative bond market reaction is associated with the approval of an executive stock option plan, which is consistent with the notion that executive stock options may induce a wealth transfer from bondholders to stockholders.
Abstract: Executive stock option plans have asymmetric payoffs that could induce managers to take on more risk. Evidence from traded call options and stock return data supports this notion. Implicit share price variance, computed from the Black-Scholes option pricing model, and stock return variance increase after the approval of an executive stock option plan. The event is accompanied by a significant positive stock and a negative bond market reaction. This evidence is consistent with the notion that executive stock options may induce a wealth transfer from bondholders to stockholders. MANAGERIAL STOCK OPTIONS HAVE been proposed as a method that ameliorates the agency problems that exist between managers and shareholders (Haugen and Senbet (1981)). The typical stock option plan grants the executive the option to purchase a number of shares of common stock at a stated exercise price that is normally equivalent to the market value of the stock on the date of the grant. These options differ from listed options in that there is usually a minimum holding period required before the options can be exercised. In addition, the options are long-term in nature (typically ten years) and are strictly nonmarketable. Since Jensen and Meckling (1976), it has been widely held that agency costs are reduced by relating an executive's compensation to firm performance (e.g., Beck and Zorn (1982) and Haugen and Senbet (1981)). The empirical evidence indicates that proposed changes in long-range managerial compensation plans (option, restricted stock, performance, stock appreciation rights, and phantom stock) are met with positive share price reactions (e.g., Brickley, Bhagat, and Lease (1985)). The positive share price reaction to the announcement of executive stock option plans is consistent with the contention that these plans improve managerial incentives. Improved incentives are the reason most often cited by firms seeking shareholder approval for the adoption of stock option plans. A study by Masson (1971) found that firms with compensation packages that emphasize stock market performance (and de-emphasize other firm performance measures) outperform firms without such an arrangement. Murphy (1985) also finds that
TL;DR: In this paper, the authors investigated the relationship between price changes and trading volume of options and stocks for a sample of firms whose options traded on the CBOE during the first quarter of 1986 and found that the stock market lead the option market by as much as fifteen minutes.
Abstract: This study investigates intraday relations between price changes and trading volume of options and stocks for a sample of firms whose options traded on the CBOE during the first quarter of 1986. After purging the price change series of the effects of bid/ask spreads, multivariate time-series analysis is used to estimate the lead/lag relation between the price changes in the option and stock markets. The results indicate that price changes in the stock market lead the option market by as much as fifteen minutes. The analysis of trading volume indicates that the stock market lead may be even longer. THE INTENSE TRADING ACTIVITY in and, in fact, the very existence of organized stock option markets attest to the economic benefits that these financial contracts provide. Reduced transaction costs and increased financial leverage are two reasons why trading in the stock option market may be more attractive than trading in the market for the underlying stock. In addition, these cheaper and more flexible trading opportunities attract new and differently informed investors to the marketplace. The resulting increase in trading activity, together with the inextricable arbitrage linkage between stock and option prices, imply an increase in market efficiency. This study investigates empirically the intraday price change and trading volume relations between stocks and options for a sample of firms whose options were actively traded on the Chicago Board Options Exchange during the first quarter of 1986. In particular, intraday call option price changes are translated into implied stock price changes using the American call option pricing model. These intraday implied stock price changes are then compared with the actual stock price changes to identify which, if either, market leads the other. In perfectly functioning capital markets, there should be complete simultaneity between the series, that is, new information disseminating into the marketplace should be reflected in the prices and the trading activity of both securities simultaneously. Institutional factors, however, may make the stock option market more attractive to information traders. This may cause price changes and trading activity due to new information to be observed in the option market first, followed by price
TL;DR: In this article, the authors studied the dividend policy adjustments of 80 NYSE firms to protracted financial distress as evidenced by multiple losses during 1980-1985 and found that almost all the firms reduced dividends, and more than half faced binding debt covenants in years they did so.
Abstract: This paper studies the dividend policy adjustments of 80 NYSE firms to protracted financial distress as evidenced by multiple losses during 1980-1985. Almost all sample firms reduced dividends, and more than half apparently faced binding debt covenants in years they did so. Absent binding debt covenants, dividends are cut more often than omitted, suggesting that managerial reluctance is to the omission and not simply the reduction of dividends. Moreover, managers of firms with long dividend histories appear particularly reluctant to omit dividends. Finally, some dividend reductions seem strategically motivated, e.g., designed to enhance the firm's bargaining position with organized labor. THIS PAPER STUDIES THE dividend policy adjustments of 80 NYSE firms to protracted financial distress as evidenced by multiple losses during 1980-1985. The prospect of such financial distress, while generally viewed as a first-order determinant of optimal capital structure, has heretofore been largely ignored in analyses of dividend policy. The lack of attention to the dividend-distress link is perhaps traceable to the belief that managers generally adopt conservative payout policies so that future dividend reductions will simply not be necessary. It is probably also attributable to the general perception that debt covenants rarely affect dividend policy in publicly held firms because any nominally binding covenants are readily waived by lenders. Our most striking finding is that more than half the sample apparently faced binding debt covenants in years they reduced dividends. This finding lends credence to the agency view that covenants significantly affect the dividend policies of even the largest publicly held firms. However, many sample firms reduced dividends when covenants were far from binding, so that agency considerations are clearly not the exclusive determinant of the dividend reductions in our sample. We also find that, absent binding covenants, dividends are cut more often than omitted, suggesting that managerial reluctance is to the omission and not simply the reduction of dividends. Moreover, managers of firms with long dividend histories apparently view dividend omissions as particularly unattractive, perhaps because they would mark themselves as the first managers in many years whose policies generated insufficient cash to pay dividends.
TL;DR: In this paper, the authors report anomalous price behavior around repurchase tender offers and find that repurchasing companies experience economically and statistically significant abnormal returns in the two years after the repurchase, mainly caused by the behavior of the small firms in the sample.
Abstract: This paper reports anomalous price behavior around repurchase tender offers. Buying shares before the expiration date of a repurchase tender offer and tendering to the firm produces, on average, abnormal returns of more than 9 percent over a period shorter than one week. In addition, we find that repurchasing companies experience economically and statistically significant abnormal returns in the two years after the repurchase. The upward price drift is mainly caused by the behavior of the small firms in the sample.
TL;DR: In this article, the authors examined the performance of a sample of fifteen U.S.-based internationally diversified mutual funds between 1982 and 1988 and found no evidence that the funds, either individually or as a whole, provided investors with performance that surpassed that of a broad, international equity index over this sample period.
Abstract: In this paper, we examine the performance of a sample of fifteen U.S.-based internationally diversified mutual funds between 1982 and 1988. Two performance measures are used, the Jensen measure and the positive period weighting measure proposed by Grinblatt and Titman. We find no evidence that the funds, either individually or as a whole, provide investors with performance that surpasses that of a broad, international equity index over this sample period. IT IS WIDELY RECOGNIZED that international diversification may produce significant reductions in systematic risk. One way for investors to achieve such diversification without investing in costly information acquisition is through internationally diversified mutual funds. In addition to providing diversification, do fund managers possess information that provides superior returns for an uninformed investor? While considerable evidence on the behavior of mutual fund returns now exists, there is surprisingly little evidence about the performance of internationally diversified funds.' This paper attempts to remedy that deficiency by providing empirical evidence on the performance of a sample of U.S.-based internationally diversified mutual funds. Two measures of performance are utilized in this paper. The first is the widely used Jensen (1968, 1969) measure, which uses the security market line to evaluate fund performance. The second is Grinblatt and Titman's (1989b) positive period weighting measure. While popular, the Jensen measure is subject to well known limitations, the most important of which is the possibility that errors in inference may arise when the fund manager is a market timer. In particular, the Jensen measure may indicate poor performance when the manager possesses and utilizes superior timing information. The performance measure suggested by Grinblatt and Titman (1989b) is not subject to these problems but has other limitations. The plan of the paper is as follows. Section I briefly discusses Grinblatt and Titman's performance measure and compares it with Jensen's measure. In order to obtain valid inference with either measure, the benchmark used to evaluate fund performance must be mean-variance efficient from the point of view of the
TL;DR: In this paper, the authors report on 72 firms which went public since 1983 but previously underwent a full or divisional LBO, and the evidence is consistent with the hypothesis that the change in the governance structure of these firms towards more concentrated residual claims created a new organizational structure which is more efficient than its predecessor.
Abstract: This paper is a report on 72 firms which went public since 1983 but previously underwent a full or divisional LBO. Accounting measures of performance reveal significant improvements in profitability which resulted mainly from these firms' ability to reduce costs. Firms experience dramatic increases in leverage at the LBO, but the leverage ratios are gradually reduced. The evidence is consistent with the hypothesis that the change in the governance structure of these firms towards more concentrated residual claims created a new organizational structure which is more efficient than its predecessor. GOING-PRIVATE TRANSACTIONS, OR leveraged buyouts (LBOs), have become an important method of corporate restructuring. In a typical going-private transaction, incumbent management acquires all outstanding publicly-traded shares of a corporation and merges the assets of the firm with a newly organized, privatelyheld shell corporation that it controls. Outside equity participants or buyout specialists often share equity ownership in the new private entity with management and help arrange financing for the buyout with lending institutions (DeAngelo, DeAngelo, and Rice (1984)). A variation on the going-private transaction is the divisional management buyout. In a divisional buyout, a division or subsidiary of a public corporation is acquired from the parent company by divisional executives and/or parent company managers (Hite and Vetsuypens
TL;DR: In this paper, the authors test the hypothesis that corporate insiders who value control will prefer to finance investments by cash or debt rather than by issuing new stock which dilutes their holdings and increases the risk of losing control.
Abstract: We test the proposition that corporate control considerations motivate the means of investment financing-cash (and debt) or stock. Corporate insiders who value control will prefer financing investments by cash or debt rather than by issuing new stock which dilutes their holdings and increases the risk of losing control. Our empirical results support this hypothesis: in corporate acquisitions, the larger the managerial ownership fraction of the acquiring firm the more likely the use of cash financing. Also, the previously observed negative bidders' abnormal returns associated with stock financing are mainly in acquisitions made by firms with low managerial ownership. Do FIRMS HAVE SYSTEMATIC preferences for the means of financing investments? In Modigliani and Miller's (1958) (M&M's) perfect market, no-tax world, the means by which investments are financed are irrelevant for the total value of the firm. Miller (1977) extended this irrelevance proposition to a case where taxes exist. However, casual observation suggests that firms are not indifferent to the means of financing. For example, many firms prefer to finance investments from internal sources or by debt rather than by issuing new equity. An explanation for such systematic financing preferences and the consequent capital structure of firms is, therefore, called for. Indeed, a number of such explanations have been advanced. For example, DeAngelo and Masulis (1980) showed that in Miller's (1977) framework the means of financing is not irrelevant if firms have different expected marginal effective tax rates due to differences in fixed charges. It has also been argued that financing preferences may result from agency costs associated with debt (e.g., Barnea, Haugen, and Senbet (1981) or from asymmetry of information between managers and outside investors (Myers and Majluf (1984)). Recently, Harris and Raviv (1988) and Stulz (1988) advanced a new argument for the existence of financing preferences that centers around managers' incentive to maintain control over the corporation. Specifically, by increasing debt and using the proceeds to retire equity held by the public, owners-managers increase the probability of maintaining control and reaping the benefits associated with it, since the substitution of debt for outsiders' equity decreases the fraction of
TL;DR: In this article, an empirical regularity in the pattern of daily stock index returns surrounding holidays was examined, showing that stocks advance with disproportionate frequency and show high mean returns averaging nine to fourteen times the mean return for the remaining days of the year.
Abstract: On the trading day prior to holidays, stocks advance with disproportionate frequency and show high mean returns averaging nine to fourteen times the mean return for the remaining days of the year. Over one third of the total return accruing to the market portfolio over the 1963-1982 period was earned on the eight trading days which each year fall before holiday market closings. Examination of hourly pre-holiday stock returns reveals high returns throughout the day. Pre-holiday stock returns in the post-test 1983-1986 period are also examined. THIS PAPER EXPLORES A seeming empirical regularity in the pattern of daily stock index returns surrounding holidays: The trading day prior to holidays on average exhibits high positive returns. Over one-third of the return earned by the market over the twenty year test period accrued on the eight trading days which annually fall before holidays. Intimations of the pre-holiday strength have appeared in the academic literature. In an examination of the frequency of Dow Jones Industrial Average advances on days surrounding weekends during the 1901 to 1932 period Fields (1934) finds a disproportionate frequency of advances on trading days preceding long holiday weekends. Roll (1983a) finds high returns accruing to small firms on the trading day prior to New Year's Day. Lakonishok and Smidt (1984) note that "prices also rise in all deciles (of market capitalization) on the last trading day before Christmas" and conclude that "the high Christmas returns of large companies might be considered (another) ... mystery." A number of stock market advisors have also noted the pre-holiday strength. Merrill (1966) finds a disproportionate frequency of Dow Jones Industrial Average advances on days preceding holidays during the 1897 to 1965 period, and Fosback (1976) has noted high preholiday returns in SP further, hourly returns and closing bid/ask data are examined to determine when high returns accrue on preholidays. Tests are also conducted showing that pre-holiday strength is not
TL;DR: In this paper, a single factor model of heteroskedasticity for portfolio returns is proposed and a constant correlation model is used to estimate timevarying monthly variances for size-ranked portfolios.
Abstract: We use predictions of aggregate stock return variances from daily data to estimate timevarying monthly variances for size-ranked portfolios. We propose and estimate a single factor model of heteroskedasticity for portfolio returns. This model implies time-varying betas. Implications of heteroskedasticity and time-varying betas for tests of the capital asset pricing model (CAPM) are then documented. Accounting for heteroskedasticity increases the evidence that risk-adjusted returns are related to firm size. We also estimate a constant correlation model. Portfolio volatilities predicted by this model are similar to those predicted by more complex multivariate generalized-autoregressiveconditional-heteroskedasticity (GARCH) procedures. MANY RESEARCHERS HAVE NOTED that the variance of aggregate stock returns changes over time. For example, French, Schwert, and Stambaugh (1987) use daily returns to the Standard & Poor's (S&P) composite portfolio to estimate monthly volatility from 1928 to 1984. They estimate that the standard deviation of aggregate monthly returns was about four times larger in the 1929-1933 period than in the 1953-1970 period. This paper (i) investigates the relation between aggregate volatility and the variance of monthly returns to disaggregated portfolios of stocks and (ii) examines the effect of portfolio heteroskedasticity on some common empirical tests in finance. We start with a model which implies that the conditional covariance is a quadratic function of the conditional market standard deviation,
TL;DR: The authors found that stock price changes at stock dividend and split announcements are significantly correlated with split factors, holding other factors constant, and with earnings forecast errors, suggesting that management's choice of split factor signals private information about future earnings and that investors revise their beliefs about firm value accordingly.
Abstract: This paper provides evidence that firms signal their private information about future earnings by their choice of split factor. Split factors are increasing in earnings forecast errors, after controlling for differences in pre-split price and firm size. Furthermore, price changes at stock dividend and split announcements are significantly correlated with split factors, holding other factors constant, and with earnings forecast errors. These correlations suggest that management's choice of split factor signals private information about future earnings and that investors revise their beliefs about firm value accordingly. The analysis also suggests, however, that announcement returns are significantly correlated with split factors after controlling for earnings forecast errors. This suggests that earnings forecast errors measure management's private information about future earnings with error, that split factors signal other valuation-relevant attributes, or that a'signaling explanation is incomplete. RESEARCHERS HAVE LONG PUZZLED over the role of stock splits and stock dividends. A stock dividend or split increases the number of equity shares outstanding but has no effect on shareholders' proportional ownership of shares. It is therefore puzzling that firms engage in these transactions, and even more so that stock prices rise on average when these transactions are announced, as Grinblatt, Masulis, and Titman (1984) document. The significant positive announcement effects led Grinblatt, Masulis, and Titman (hereafter GMT) to hypothesize that firms signal information about their future earnings or equity values through their split decisions. To date, this hypothesis has met with limited support. GMT conclude that "the announcement returns cannot be explained by forecasts of imminent increases in cash dividends" because they observe similar stock price behavior in firms that do not pay dividends. Our study provides further evidence on the signaling hypothesis by testing whether stock dividends and splits convey information about future earnings, and by testing whether the split factor itself is the signal. The notion that the split factor may act as a signal has institutional as well as theoretical support. Practitioners have long contended that the purpose of stock splits is to move a firm's share price into an "optimal trading range." Baker and Gallagher (1980), who surveyed chief financial officers of firms that split their shares, report that 94% of their sample indicated their stock splits moved their
TL;DR: In this article, the authors examine the profitability of insider trading in firms whose securities trade in the OTC/NASDAQ market and provide evidence on the determinants of insiders' profits.
Abstract: In this paper, we examine the profitability of insider trading in firms whose securities trade in the OTC/NASDAQ market. Although the evidence suggests timing and forecasting ability on the part of insiders, high transaction costs (especially bid-ask spreads) appear to eliminate the potential for positive abnormal returns from active trading. By implication, outside investors who mimic the trading of insiders are also precluded from earning abnormal profits. In addition, we provide evidence on the determinants of insiders' profits. The data suggest that insiders closer to the firm trade on more valuable information than insiders removed from the firm.
TL;DR: In this paper, the authors present a general equilibrium theory relating returns on financial assets to macroeconomic fluctuations in a context that is consistent with efficient markets in that no excess-profit opportunities are available.
Abstract: An intertemporal general equilibrium model relates financial asset returns to movements in aggregate output. The model is a standard neoclassical growth model with serial correlation in aggregate output. Changes in aggregate output lead to attempts by agents to smooth consumption, which affects the required rate of return on financial assets. Since aggregate output is serially correlated and hence predictable, the theory suggests that stock returns can be predicted based on rational forecasts of output. The empirical results confirm that stock returns are a predictable function of aggregate output and also support the accompanying implications of the model. A RAPIDLY GROWING BODY of research documents forecastable components in security returns. The extent of predictability is a function of the return horizon, with predictable variation in aggregate returns ranging from around 3 percent for shorter horizons to above 25 percent for longer horizons. One of the most successful attempts in predicting security returns is Fama and French (1988b). Other papers demonstrating predictability are, for example, Fama and Schwert (1977), Keim and Stambaugh (1986), Campbell (1987), French, Schwert, and Stambaugh (1987), Campbell and Shiller (1988), and Lo and MacKinlay (1988). Potential explanations for the predictability of returns fall, primarily, into two areas: 1) some form of general or limited irrationality, such as fads, speculative bubbles, or noise trading or 2) some form of general equilibrium model that provides for variation in real rates of return over time. Although substantial literature exists debating the "irrational" alternative (see Summers (1986), Poterba and Summers (1988), or West (1988)), we are not aware of work that provides an explanation in the context of a parsimonious and empirically robust general equilibrium model. It is important to emphasize, as Fama and French (1988a), and others have noted, that, in the context of intertemporal models, predictability is not necessarily inconsistent with the concept of market efficiency. The purpose of this paper is to present a general equilibrium theory relating returns on financial assets to macroeconomic fluctuations in a context that is consistent with efficient markets in that no excess-profit opportunities are available. Accordingly, we show that, within an efficient market framework, stock prices need not follow a
TL;DR: In this paper, the authors present evidence that the distribution of target ownership is related to the division of the takeover gain between the target and the bidder for a sample of successful tender offers.
Abstract: This paper presents evidence that the distribution of target ownership is related to the division of the takeover gain between the target and the bidder for a sample of successful tender offers. In the whole sample, the target's gain is negatively related to bidder and institutional ownership. In the sample of multiple-bidder contests, the target's gain increases with managerial ownership and falls with institutional ownership. RECENT PAPERS EMPHASIZE THE importance of the distribution of target share ownership in takeover contests.' Although these papers differ in the issues they address, they share the common idea that large blockholders use their voting rights to further their own interests by influencing the likelihood and outcomes of takeover attempts. This literature suggests that management and non-management blockholders have different incentives in the presence of a takeover attempt. On one hand, managers who value incumbency can use their voting rights to decrease the likelihood of a takeover and increase its cost for the bidder. On the other hand, non-management blockholders are likely to use their voting rights to facilitate takeovers that, if successful, increase the value of their holdings. Blockholders who use their stake to increase the bidder's cost increase the target's share of the takeover gain if the takeover succeeds, whereas those who use their stake to decrease the bidder's cost decrease the target's share. In this paper, we present evidence that the distribution of target ownership is related to the division of the takeover gain (defined as the increase in the combined value of the target and the bidder) for a sample of successful tender bids. The value of managerial incumbency varies widely across firms. Consequently, so does target management's incentive to use its ownership position to resist acquisition attempts. Unopposed offers often occur because management believes the offer to be in the shareholders' best interests or because of retirement plans. Management may also choose not to resist because it has conceded defeat or