Showing papers in "Journal of Finance in 1993"
TL;DR: In this article, the authors show that strategies that buy stocks that have performed well in the past and sell stocks that had performed poorly in past years generate significant positive returns over 3- to 12-month holding periods.
Abstract: This paper documents that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. We find that the profitability of these strategies are not due to their systematic risk or to delayed stock price reactions to common factors. However, part of the abnormal returns generated in the first year after portfolio formation dissipates in the following two years. A similar pattern of returns around the earnings announcements of past winners and losers is also documented
10,806 citations
TL;DR: In this article, a modified GARCH-M model was used to find a negative relation between conditional expected monthly return and conditional variance of monthly return, using seasonal patterns in volatility and nominal interest rates to predict conditional variance.
Abstract: We find support for a negative relation between conditional expected monthly return and conditional variance of monthly return, using a GARCH-M model modified by allowing (1) seasonal patterns in volatility, (2) positive and negative innovations to returns having different impacts on conditional volatility, and (3) nominal interest rates to predict conditional variance. Using the modified GARCH-M model, we also show that monthly conditional volatility may not be as persistent as was thought. Positive unanticipated returns appear to result in a downward revision of the conditional volatility whereas negative unanticipated returns result in an upward revision of conditional volatility. THE TRADEOFF BETWEEN RISK and return has long been an important topic in asset valuation research. Most of this research has examined the tradeoff between risk and return among different securities within a given time period. The intertemporal relation between risk and return has been examined by several authors-Fama and Schwert (1977), French, Schwert, and Stambaugh (1987), Harvey (1989), Campbell and Hentschel (1992), Nelson (1991), and Chan, Karolyi, and Stulz (1992), to name a few. This paper extends that research.
7,837 citations
TL;DR: The last two decades indicate corporate internal control systems have failed to deal effectively with these changes, especially slow growth and the requirement for exit as mentioned in this paper, which is a major challenge for Western firms and political systems as these forces continue to work their way through the worldwide economy.
Abstract: Since 1973 technological, political, regulatory, and economic forces have been changing the worldwide economy in a fashion comparable to the changes experienced during the nineteenth century Industrial Revolution. As in the nineteenth century, we are experiencing declining costs, increasing average (but decreasing marginal) productivity of labor, reduced growth rates of labor income, excess capacity, and the requirement for downsizing and exit. The last two decades indicate corporate internal control systems have failed to deal effectively with these changes, especially slow growth and the requirement for exit. The next several decades pose a major challenge for Western firms and political systems as these forces continue to work their way through the worldwide economy.
7,121 citations
TL;DR: This paper defined the news impact curve which measures how new information is incorporated into volatility estimates and compared various ARCH models including a partially nonparametric one with daily Japanese stock return data.
Abstract: This paper defines the news impact curve which measures how new information is incorporated into volatility estimates. Various new and existing ARCH models including a partially nonparametric one are compared and estimated with daily Japanese stock return data. New diagnostic tests are presented which emphasize the asymmetry of the volatility response to news. Our results suggest that the model by Glosten, Jagannathan, and Runkle is the best parametric model. The EGARCH also can capture most of the asymmetry; however, there is evidence that the variability of the conditional variance implied by the EGARCH is too high.
3,151 citations
TL;DR: In this paper, a general framework for analyzing corporate risk management policies is developed, and the authors argue that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities.
Abstract: This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving “nonlinear” instruments like options.
2,485 citations
TL;DR: The authors found that firms which hedge face more convex tax functions, have less coverage of fixed claims, are larger, have more growth options in their investment opportunity set, and employ fewer hedging substitutes.
Abstract: Finance theory indicates that hedging increases firm value by reducing expected taxes, expected costs of financial distress, or other agency costs. This paper provides evidence on these hypotheses using survey data on firm's use of forwards, futures, swaps, and options combined with COMPUTSTAT data on firm characteristics. Of 169 firms in the sample, 104 firms use hedging instruments in 1986. The data suggest that firms which hedge face more convex tax functions, have less coverage of fixed claims, are larger, have more growth options in their investment opportunity set, and employ fewer hedging substitutes.
1,396 citations
TL;DR: The relative performance of no-load, growth-oriented mutual funds persists in the near term, with the strongest evidence for a one-year evaluation horizon as mentioned in this paper, and the difference in risk-adjusted performance between the top and bottom octile portfolios is six to eight percent per year.
Abstract: The relative performance of no-load, growth-oriented mutual funds persists in the near term, with the strongest evidence for a one-year evaluation horizon. Portfolios of recent poor performers do significantly worse than standard benchmarks; those of recent top performers do better, though not significantly so. The difference in risk-adjusted performance between the top and bottom octile portfolios is six to eight percent per year. These results are not attributable to known anomalies or survivorship bias. Investigations with a different (previously used) data set and with some post-1988 data confirm the finding of persistence.
1,212 citations
TL;DR: This article examined the impact of scheduled macroeconomic news announcements on interest rate and foreign exchange futures markets and found that these announcements are responsible for most of the observed time-of-day and day-ofthe-week volatility patterns in these markets.
Abstract: We examine the impact of scheduled macroeconomic news announcements on interest rate and foreign exchange futures markets. We find these announcements are responsible for most of the observed time-of-day and day-of-the-week volatility patterns in these markets. While the bulk of the price adjustment to a major announcement occurs within the first minute, volatility remains substantially higher than normal for roughly fifteen minutes and slightly elevated for several hours. Nonetheless, these subsequent price adjustments are basically independent of the first minute's return. We identify those announcements with the greatest impact on these markets. WE EXAMINE THE IMPACT on interest rate and foreign exchange markets of scheduled macroeconomic news releases such as the employment report, the consumer price index (CPI), and the producer price index (PPI). Many market participants believe that such announcements have a major impact on financial markets. Indeed, a small industry devoted to predicting the figures to be released in upcoming releases has evolved in recent years. With the exception of the weekly money supply figures, however, the impact of such announcements on financial markets has received scant attention.1 This is doubly surprising given the considerable research interest in market volatility since these news releases are a potential source of much of this volatility. Consider, for instance, Figure 1. As shown there, prices in interest rate and foreign exchange futures markets are much more volatile between 8:30 and 8:35 A.M. eastern time (ET) than during any other five-minute trading period including
1,050 citations
TL;DR: In this paper, the authors studied the relationship between top-management compensation and the design and mix of external claims issued by a firm and derived the optimal management compensation for the cases when the external claims are equity and risky debt, and (2) equity and convertible debt.
Abstract: The interrelationship between top-management compensation and the design and mix of external claims issued by a firm is studied. The optimal managerial compensation structures depend on not only the agency relationship between shareholders and management, but also the conflicts of interests which arise in the other contracting relationships for which the firm serves as a nexus. We analyze in detail the optimal management compensation for the cases when the external claims are (1) equity and risky debt, and (2) equity and convertible debt. In addition to the role of aligning managerial incentives with shareholder interests, managerial compensation in a levered firm also serves as a precommitment device to minimize the agency costs of debt. The optimal management compensation derived has low pay-performance sensitivity. With convertible debt, instead of straight debt, the corresponding optimal managerial compensation has high pay-to-performance sensitivity. A negative relationship between pay-performance sensitivity and leverage is derived. Our results provide a reconciliation of the puzzling evidence of Jensen and Murphy (1990) with agency theory. Other testable implications include (1) a relationship between the risk premium in corporate bond yields and top-management compensation structures, and (2) the announcement effect of adoption of executive stock option plans on bond prices. The model yields implications for management compensation in banks and Federal Deposit Insurance reform. Our results explain the dynamics of top-management compensation in firms going through financial distress and reorganization.
889 citations
TL;DR: In this paper, a model with adverse selection where information sharing between lenders arises endogenously is presented, and it is shown that lenders' incentives to share information about borrowers are positively related to the mobility and heterogeneity of borrowers, to the size of the credit market and to advances in information technology.
Abstract: We present a model with adverse selection where information sharing between lenders arises endogenously. Lenders' incentives to share information about borrowers are positively related to the mobility and heterogeneity of borrowers, to the size of the credit market, and to advances in information technology; such incentives are instead reduced by the fear of competition from potential entrants. In addition, information sharing increases the volume of lending when adverse selection is so severe that safe borrowers drop out of the market. These predictions are supported by international and historical evidence in the context of the consumer credit market. A LARGE BODY OF literature on credit markets has shown that asymmetric information may prevent the efficient allocation of lending, leading to credit rationing (e.g., Jaffee and Russell (1976), Stiglitz and Weiss (1981)) or to a wedge between lending and borrowing rates (e.g., King 1986)). In this literature informational asymmetries are taken to be exogenous: lenders fail to observe some relevant characteristic or action of potential borrowers and have no way of learning about it. In some countries, however, lenders can improve their knowledge about new customers by exchanging information with other lenders through information brokers, generally known as "credit bureaus." The latter collect, file, and distribute the information voluntarily supplied by their members, and operate on the principle of reciprocity: lenders who do not provide data are denied access to the bureau's files. In other countries, instead, these institutions do not exist. The literature offers no guide to identify the factors that lead to endogenous communication between lenders. This paper is an attempt to fill the gap. Information sharing is important for a number of reasons: it may increase the degree of competitiveness within credit markets (Vives (1990)), improve
867 citations
TL;DR: This article used a vector autoregressive model to decompose stock and 10-year bond returns into changes in expectations of future stock dividends, inflation, short-term real interest rates, and excess stock and bond returns.
Abstract: This paper uses a vector autoregressive model to decompose excess stock and 10-year bond returns into changes in expectations of future stock dividends, inflation, short-term real interest rates, and excess stock and bond returns. In monthly postwar U.S. data, stock and bond returns are driven largely by news about future excess stock returns and inflation, respectively. Real interest rates have little impact on returns, although they do affect the short-term nominal interest rate and the slope of the term structure. These findings help to explain the low correlation between excess stock and bond returns.
TL;DR: In this paper, the authors examined patterns in stock market trading volume, trading costs, and return volatility using New York Stock Exchange data from 1988 and found that trading volume is low and adverse selection costs are high on Monday, consistent with the predictions of Foster and Viswanathan (1990) model.
Abstract: Patterns in stock market trading volume, trading costs, and return volatility are examined using New York Stock Exchange data from 1988. Intraday test results indicate that, for actively traded firms trading volume, adverse selection costs, and return volatility are higher in the first half-hour of the day. This evidence is inconsistent with the Admati and Pfleiderer (1988) model which predicts that trading costs are low when volume and return volatility are high. Interday test results show that, for actively traded firms, trading volume is low and adverse selection costs are high on Monday, which is consistent with the predictions of the Foster and Viswanathan (1990) model. ACADEMICS, INVESTORS, AND REGULATORS alike are now intensively focused upon understanding the volatility of asset returns and its relation to trading volume. This interest was undoubtedly piqued by the market break of October 1987-a time during which volatility and trading volume reached unprecedented levels. But, even beforehand, researchers observed regular differences in the return process for various hours of the day and days of the week. Research concerning temporal patterns in stock market volatility and volume falls in two groups-studies that document observed patterns and studies that develop models to predict patterns. Among the studies in the first group are Oldfield and Rogalski (1980), French and Roll (1986), Stoll and Whaley (1990), Harris (1986), and Wood, McInish, and Ord (1985), who report evidence on seasonalities in daily and weekly return variances. Among the regularities that have been documented using interday data is that volatility is higher when the market is open than when it is closed. Oldfield and Rogalski (1980), French and Roll (1986), and Stoll and Whaley (1990), for example, point out significant differences in return volatility between trading
TL;DR: This paper found that despite selling at substantial discounts, private placements of equity are associated with positive abnormal returns and that discounts reflect information costs borne by private investors and abnormal returns reflect favorable information about firm value.
Abstract: Despite selling at substantial discounts, private placements of equity are associated with positive abnormal returns. We find evidence that discounts reflect information costs borne by private investors and abnormal returns reflect favorable information about firm value. Results are consistent with the role of private placements as a solution to the Myers and Majluf underinvestment problem and with the use of private placements to signal undervaluation. We also find some evidence of anticipated monitoring benefits from private sales of equity. For the smaller firms that comprise our sample, information effects appear to be relatively more important than ownership effects.
TL;DR: In this article, the authors focus on the possibility that small sample bias could be playing an important role in the inference that stock returns are predictable from fundamentals and in estimates of the degree of predictability.
Abstract: Predictive regressions are subject to two small sample biases: the coefficient estimate is biased if the predictor is endogenous, and asymptotic standard errors in the case of overlapping periods are biased downward. Both biases work in the direction of making t-ratios too large so that standard inference may indicate predictability even if none is present. Using annual returns since 1872 and monthly returns since 1927 we estimate empirical distributions by randomizing residuals in the VAR representation of the variables. The estimated biases are large enough to affect inference in practice, and should be accounted for when studying predictability. THE PROPOSITION THAT STOCK returns are not predictable was until very recently regarded as one of the most (some would say the only) firmly established empirical results in economics. The extent to which the nonpredictability result has been overturned in the last few years is reflected in the opening sentence of a recent paper by Fama and French (1988): "There is much evidence that stock returns are predictable." Indeed, a recent series of papers including Keim and Stambaugh (1986), Campbell and Shiller (1988), Fama and French (1988) and Cutler, Poterba, and Summers (1991) report that "fundamentals" such as dividend yield and price-earnings ratio explain 25% or more of the variation in stock returns measured over intervals of several years. Further, Balvers, Cosimano, and McDonald (1990), Schwert (1990), and Fama (1990) present evidence that economic indicators such as industrial production also have predictive power for stock returns. This paper focuses on the possibility that small sample bias could be playing an important role in the inference that stock returns are predictable from fundamentals and in estimates of the degree of predictability. A t-ratio will be misleading if either the regression coefficient is biased or if the standard error is biased. Small sample bias in asymptotic standard errors in
TL;DR: The authors showed that the returns to the typical long-term contrarian strategy implemented in previous studies are upwardly biased because they are calculated by cumulating single-period (monthly) returns over long intervals.
Abstract: We show that the returns to the typical long-term contrarian strategy implemented in previous studies are upwardly biased because they are calculated by cumulating single-period (monthly) returns over long intervals. The cumulation process not only cumulates "true" returns but also the upward bias in single-period returns induced by measurement errors. We also show that the remaining "true" returns to loser or winner firms have no relation to overreaction. This study has important implications for event studies that use cumulative returns to assess the impact of information events. RECENT RESEARCH HAS UNCOVERED substantial predictability in both shortterm (Conrad and Kaul (1988, 1989) and Lo and MacKinlay (1988)) and long-term (Fama and French (1988) and Poterba and Summers (1988)) stock returns. An increasingly popular interpretation of return predictability emphasized by a number of researchers is that the stock market consistently overreacts to new information. The "stock market overreaction" hypothesis asserts that stock prices take temporary swings away from their fundamental values due to waves of optimism and pessimism (see, for example, DeBondt and Thaler (1985, 1987), Lehmann (1990), and Shefrin and Statman (1985)). Compelling evidence in favor of long-term overreaction was first provided by DeBondt and Thaler (1985). They show that losers and winners, determined by their performance relative to the aggregate stock market over the past three to five years, consistently outperform and underperform the market in subsequent three- to five-year periods. For example, they find that the arbitrage (zero investment) portfolio of losers and winners earns an
TL;DR: The authors examine the reaction of common stock returns to bond rating changes and find that downgrades associated with deteriorating financial prospects convey new negative information to the capital market, but downgrades due to changes in firms' leverage do not.
Abstract: We examine the reaction of common stock returns to bond rating changes. While recent studies find a significant negative stock response to downgrades, we argue that this reaction should not be expected for all downgrades because: (1) some rating changes are anticipated by market participants and (2) downgrades because of an anticipated move to transfer wealth from bondholders to stockholders should be good news for stockholders. We find that downgrades associated with deteriorating financial prospects convey new negative information to the capital market, but that downgrades due to changes in firms' leverage do not.
TL;DR: This paper investigated the determinants of leveraged buyout activity by comparing firms that have implemented LBOs to those that have not and found that firms that initiate LBO can be characterized as having a combination of unfavorable investment opportunities (low Tobin's q) and relatively high cash flow.
Abstract: This paper investigates the determinants of leveraged buyout (LBO) activity by comparing firms that have implemented LBOs to those that have not. Consistent with the free cash flow theory, we find that firms that initiate LBOs can be characterized as having a combination of unfavorable investment opportunities (low Tobin's q) and relatively high cash flow. LBO firms also tend to be more diversified than firms which do not undertake LBOs. In addition, firms with high expected costs of financial distress (e.g., those with high research and development expenditures) are less likely to do LBOs. THE AMERICAN CORPORATE SECTOR experienced a dramatic increase in leveraged buyout activity in the 1980s. Between 1979 and 1989 there were over 2,000 leveraged buyouts (LBOs) valued in excess of $250 billion.1 These transactions have been the source of considerable controversy, perhaps because a number of individuals have become very wealthy as a result of LBOs while others have lost their jobs. Two central questions that have arisen in the debate about LBOs are: 1. Do LBOs create wealth, or do they merely redistribute wealth? 2. Does the debt taken on in LBOs cause problems in periods of economic distress? Proponents of LBOs (e.g., Jensen (1986, 1989)) argue that the transactions create wealth by improving managerial incentives and forcing disgorgement of excess free cash flow that would otherwise be invested unwisely. Jensen also addresses the second question, and argues that the costs of financial distress in LBOs are not large. Critics of LBOs argue that most of the gains to equityholders arise because of tax savings (see Lowenstein (1985)) and the expropriation of nonequity stakeholders (e.g., employees and bondholders) and have expressed concern about the effect of financial distress on the ability of LBO firms to remain competitive in the event of an economic downturn.
TL;DR: In this paper, the authors examined the empirical predictions of a real option-pricing model using a large sample of market prices and found that the option model has explanatory power for predicting transactions prices over and above the intrinsic value.
Abstract: This research is the first to examine the empirical predictions of a real option-pricing model using a large sample of market prices. We find empirical support for a model that incorporates the option to wait to develop land. The option model has explanatory power for predicting transactions prices over and above the intrinsic value. Market prices reflect a premium for the option to wait to invest that has a mean value of 6% in our sample. We also estimate implied standard deviations for individual commercial property prices ranging from 18 to 28% per year. DESPITE EXTENSIVE TESTING OF option-pricing models for financial assets, virtually no research has addressed the empirical implications of option-based valuation models for real assets.' This research is the first effort that examines the empirical predictions of a real option-pricing model using a large sample of market prices. Real options that have been valued in the academic literature include capital investments and natural resources, as well as urban land. The model we consider incorporates the option to wait to invest in the valuation of urban land. This paper provides empirical information about the option-based value of land, relative to its intrinsic value and its market price. Using data on 2700 land transactions in Seattle, we find a mean option (time) premium of 6% of the theoretical land value. This premium ranges from 1% to 30% in various subsamples. We define the "option premium" as the difference between the intrinsic value and the option model value, divided by the option model value.2 We also find that the option model has explana
TL;DR: In this paper, the authors studied senior management compensation policy in 77 publicly traded firms that filed for bankruptcy or privately restructured their debt during 1981 to 1987, and found that almost one third of all CEOs are replaced, and those who keep their jobs often experience large salary and bonus reductions.
Abstract: This paper studies senior management compensation policy in 77 publicly traded firms that filed for bankruptcy or privately restructured their debt during 1981 to 1987. Almost one-third of all CEOs are replaced, and those who keep their jobs often experience large salary and bonus reductions. Newly appointed CEOs with ties to previous management are typically paid 35% less than the CEOs they replace. In contrast, outside replacement CEOs are typically paid 36% more than their predecessors, and are often compensated with stock options. On average, CEO wealth is significantly related to shareholder wealth after firms renegotiate their debt contracts. However, managers' compensation is sometimes explicitly tied to the value of creditors' claims.
TL;DR: In this article, the authors present empirical evidence that trading in options contributes to both transactional and informational efficiency of the stock market by reducing the effect of constraints on short sales, and they also find significant effects on option prices, related to the short interest in the underlying stock.
Abstract: This paper presents empirical evidence that trading in options contributes to both transactional and informational efficiency of the stock market by reducing the effect of constraints on short sales. The significantly higher average level of short interest exhibited by optionable stocks supports the argument that options facilitate short selling. We also find significant effects on option prices, related to the short interest in the underlying stock. We then present evidence that options also increase information efficiency. Earlier work, that is replicated and extended here, has suggested that short sale constraints cause stock prices to underweight negative information. Options appear to reduce that effect.
TL;DR: In this paper, the authors present an information-theoretic model of IPO pricing in which insiders sell stock in both the IPO and the secondary market, have private information about their firm's prospects, and outsiders may engage in costly information production about the firm.
Abstract: This paper presents an information-theoretic model of IPO pricing in which insiders sell stock in both the IPO and the secondary market, have private information about their firm's prospects, and outsiders may engage in costly information production about the firm. High-value firms, knowing they are going to pool with low-value firms, induce outsiders to engage in information production by underpricing, which compensates outsiders for the cost of producing information. The information is reflected in the secondary market price of equity, giving a higher expected stock price for high-value firms.
TL;DR: In this article, the authors developed a dynamic model of market-making incorporating inventory and information effects, where the marketmaker is both a dealer and an investor, quoting prices that induce mean reversion in inventory toward targets determined by portfolio considerations.
Abstract: The authors develop a dynamic model of market-making incorporating inventory and information effects. The marketmaker is both a dealer and an investor, quoting prices that induce mean reversion in inventory toward targets determined by portfolio considerations. The authors test the model with inventory data from a New York Stock Exchange specialist. Specialist inventories exhibit slow mean reversion, with a half-life of over forty-nine days, suggesting weak inventory effects. However, after controlling for shifts in desired inventories, the half-life falls to seven and three-tenths days. Further, quote revisions are negatively related to specialist trades and are positively related to the information conveyed by order imbalances. Copyright 1993 by American Finance Association.
TL;DR: In this paper, the authors examine the value of bank durability to borrowing firms and conclude that borrowers incur significant costs in response to unanticipated reductions in bank durability and thus are bank stakeholders.
Abstract: We examine the value of bank durability to borrowing firms. The analysis is based on theoretical models of the asset services view of intermediation which imply that private information and associated relationship-specific activities are intrinsic to bank lending. We analyze share price effects on firms with lending relationships with Continental Illinois Bank during its de facto failure and subsequent FDIC rescue. We find the bank's impending insolvency had negative effects and the FDIC rescue positive effects on client firm share prices. We conclude that borrowers incur significant costs in response to unanticipated reductions in bank durability and thus are bank stakeholders. WE ANALYZE THE VALUE of bank durability to borrowing firms within the context of the asset services view of intermediation and contracting theory. We examine excess returns for firms with publicly documented lending relationships with the Continental Illinois Bank during the period of its de facto failure and rescue by the FDIC in 1984.1 At that time, Continental Illinois was the seventh largest domestic bank holding company and had a large corporate client base. This was the last government rescue of a major bank prior to the "too big to fail" doctrine, initiated several months afterwards. We find client firm value is correlated with unexpected changes in bank durability, indicating that borrowers have a valuable stake in lending relationships. The effects of bank failure on client firms are related to the extent to which borrowers obtain relationship-based cost advantages from bank lending. Financial market efficiency implies that share prices will capitalize any losses borrowers incur as a result of bank failure. We find client firms of Continental Illinois incur average excess returns of -4.2% during the bank's impending insolvency. In response to the government rescue announcement, which revived the bank's durability, client firms gain 2.0% on average. These effects
TL;DR: In this paper, the authors examine managerial investment decisions in the presence of imperfect information and short-term managerial objectives and identify how the direction of the distortion depends upon the type of informational imperfection present, and demonstrate that imperfect information, together with an emphasis on a firm's short-run valuation, may lead not only to underinvestment, but also to overinvestment in long-run projects.
Abstract: We examine managerial investment decisions in the presence of imperfect information and short-term managerial objectives. Prior research has argued that such an environment induces managers to underinvest in long-run projects. We show that short-term objectives and imperfect information may also lead to overinvestment, and we identify how the direction of the distortion depends upon the type of informational imperfection present. When investors cannot observe the level of investment in the long-run project, suboptimal investment will be induced. When investors can observe investment but not its productivity, however, overinvestment will occur. THERE HAS BEEN IN recent years substantial public debate on the question of whether the long-run investment decisions of the managers of publicly traded companies may be distorted by market pressures. Recent work by economists has tried to identify the potential source and nature of such distortions.' Research has naturally focused on situations that are characterized by (i) short-term managerial objectives the managers are concerned not only with the firm's long-run stock price but also with the firm's short-run stock price (due to incentive schemes or the fear of losing control), and (ii) imperfect information the market has less information than the firm's managers about the firm's long-run projects. The results of this research have indicated that in some situations, short-term objectives and imperfect information may lead to underinvestment in long-run projects. This paper seeks to extend prior work on the effects of short-term objectives and imperfect information on long-run investment decisions. We demonstrate that imperfect information, together with an emphasis on a firm's short-run valuation, may lead not only to underinvestment, but also to overinvestment in long-run projects. The direction of the distortion depends
TL;DR: In this paper, a transaction-level empirical analysis of the trading activities of New York Stock Exchange specialists is presented, which suggests that trades in which the specialist participates have a higher immediate impact on the quotes than trades with no specialist participation.
Abstract: This paper presents a transaction-level empirical analysis of the trading activities of New York Stock Exchange specialists. The main findings of the analysis are the following. Adjustment lags in inventories vary across stocks, and are in some cases as long as one or two months. Decomposition of specialist trading profits by trading horizon shows that the principal source of these profits is short term. An analysis of the dynamic relations among inventories, signed order flow, and quote changes suggests that trades in which the specialist participates have a higher immediate impact on the quotes than trades with no specialist participation. THE IMPORTANCE OF LIQUIDITY in securities markets motivates strong interest in the trading behavior of dealers. Dealers seek to provide liquidity in an ongoing manner and they can influence the short-run dynamics of securities prices through their trading behavior. Not surprisingly, many academic studies examine dealers' trading activities and their role in price determination. Because of the difficulty in obtaining detailed data, most (but not all) of this work is theoretical. Several important empirical issues, therefore, remain unresolved. This paper analyzes inventory adjustment, price determination, and trading profits for one important class of dealers, New York Stock Exchange (NYSE) specialists.'
TL;DR: In this paper, the authors examine both international patterns of intraday trading activity and the time series properties of returns and bid-ask spreads for the deutsche mark-dollar exchange rate in the interbank foreign exchange market.
Abstract: The behavior of quote arrivals and bid-ask spreads is examined for continuously recorded deutsche mark-dollar exchange rate data over time, across locations, and by market participants. A pattern in the intraday spread and intensity of market activity over time is uncovered and related to theories of trading patterns. Models for the conditional mean and variance of returns and bid-ask spreads indicate volatility clustering at high frequencies. The proposition that trading intensity has an independent effect on returns volatility is rejected, but holds for spread volatility. Conditional returns volatility is increasing in the size of the spread. THERE IS A GROWING body of theoretical studies on the pattern of trading activity in financial markets, with implications for the time series behavior of transactions prices and intensity of trading. The empirical literature addressing similar concerns using intraday market data appropriate for such tasks is sparse, particularly in the area of the trading of currencies. The purpose of this paper is to examine both international patterns of intraday trading activity and the time series properties of returns and bid-ask spreads for the deutsche mark-dollar exchange rate in the interbank foreign exchange market. The goal is to provide information useful in the further development of market microstructure models of trading and to compare empirical findings against theoretical results already in existence. The foreign exchange market is in operation twenty-four hours a day, seven
TL;DR: In this article, the authors examine the distribution of test statistics under the null hypothesis of no forecasting ability and find that the empirically observed statistics are well within the 95% bounds of their simulated distributions.
Abstract: This paper reexamines the ability of dividend yields to predict long-horizon stock returns. We use the bootstrap methodology, as well as simulations, to examine the distribution of test statistics under the null hypothesis of no forecasting ability. These experiments are constructed so as to maintain the dynamics of regressions with lagged dependent variables over long horizons. We find that the empirically observed statistics are well within the 95% bounds of their simulated distributions. Overall there is no strong statistical evidence indicating that dividend yields can be used to forecast stock returns. A NUMBER OF RECENT studies appear to provide empirical support for the traditional use of the dividend-price ratio as a measure of expected stock returns. Rozeff (1984), for instance, finds that the ratio of the dividend yield to the short-term interest rate explains a significant fraction of movements in annual stock returns. Fama and French (1988) use a regression framework to show that the dividend yield predicts a significant proportion of multiple year returns to the NYSE index. They further observe that the explanatory power of the dividend yield increases in the time horizon of the returns; over four-year horizons, R2's range from a low of 19% to an astonishingly high value of 64%. Similar results are reported by Flood, Hodrick, and Kaplan (1987) and Campbell and Shiller (1988). The apparent predictability of market returns from past values of dividend yields is regarded by Rozeff (1984) as support for the rejection of the random walk model of stock prices, and by Fama and French (1988) as support for the cyclical behavior of expected returns. Flood, Hodrick, and Kaplan (1987) interpret their results as support for time-varying expected returns to stocks. The direct, and somewhat disturbing, implication of most of these studies is that significant components of long-term stock returns may be predictable using combinations of past returns and macroeconomic variables. There are a number of reasons, however, why these results should be regarded with caution. Given the persistent patterns of dividend payments, movements in dividend yields are essentially dominated by movements in prices. Therefore, the forecasting regressions suffer from biases due to the
TL;DR: This paper developed a test statistic to determine the number of factors in an approximate factor model of asset returns, which does not require that diversifiable components of returns be uncorrelated across assets.
Abstract: An important issue in applications of multifactor models of asset returns is the
appropriate number of factors. Most extant tests for the number of factors are valid
only for strict factor models, in which diversifiable returns are uncorrelated across
assets. In this paper we develop a test statistic to determine the number of factors
in an approximate factor model of asset returns, which does not require that
diversifiable components of returns be uncorrelated across assets. We find evidence
for one to six pervasive factors in the cross-section of New York Stock Exchange and
American Stock Exchange stock returns.
TL;DR: In this article, the authors compare centralized and fragmented markets, such as floor and telephone markets, and compare the expected spread is shown to be equal in both markets, ceteris paribus.
Abstract: This paper compares centralized and fragmented markets, such as floor and telephone markets. Risk-averse agents compete for one market order. In centralized markets, these agents are market makers or limit order traders. They are assumed to observe the quotes of their competitors. In fragmented markets they are dealers. They can only assess the positions of their competitors. We analyze differences in bidding strategies reflecting differences in market structures. The equilibrium number of dealers is shown to be increasing in the frequency of trades and the volatility of the value of the asset. The expected spread is shown to be equal in both markets, ceteris paribus. But the spread is more volatile in centralized than in fragmented markets. THIS PAPER ANALYZES FRAGMENTED markets and compares them to centralized markets. Telephone dealer markets such as NASDAQ, SEAQ, the foreign exchange market, and the Treasury bonds market are fragmented. Examples of centralized markets are the stock and futures exchanges, such as the NYSE or the CBOT. In the latter, all the orders are addressed to the same location so that market participants can observe all the quotes and trades and take them into account in their strategies. In the former, deals are the outcome of bilateral negotiations that other market participants cannot observe. Consequently information about market conditions is more readily available in centralized markets than in fragmented markets. This difference in market structures affects the behavior of the agents who provide liquidity to the market. Suppliers of liquidity, i.e., market makers, dealers, or limit order traders can be seen as bidders in the auction for the order flow from market order traders. The bids are the ask and bid quotes. There are two determinants of the quotes. First, they depend on the agents' private valuations of the asset. In the present paper, the agents are assumed to have the same information about the final value of the asset, but they are
TL;DR: In this paper, the Lucas (1978) general equilibrium theory of asset pricing is modified to incorporate heterogeneous agents and incomplete markets, and the model features two types of agents who differ up to a nontradable, idiosyncratic component in their endowment processes.
Abstract: The representative agent theory of asset pricing is modified to incorporate heterogeneous agents and incomplete markets. The model features two types of agents who differ up to a nontradable, idiosyncratic component in their endowment processes. Numerical solutions indicate that individuals are able to diversify a substantial portion of their idiosyncratic income risk through riskless borrowing and lending alone. Restrictions on the variability of intertemporal marginal rates of substitution (Hansen and Jagannathan (1991)) are used to argue that incomplete markets, as modeled here, cannot account for the properties of asset returns that are anomalous from the perspective of representative agent theory. A LARGE LITERATURE IN financial economics has investigated the extent to which variants of the Lucas (1978) general equilibrium theory of asset pricing can account for the joint behavior of aggregate U.S. consumption and asset returns. By and large, this literature has concluded that a theory based upon frictionless Arrow-Debreu markets and/or a representative agent makes strongly counterfactual predictions regarding even the simple (unconditional) properties of this relationship. Mehra and Prescott (1985), for instance, show that the theory drastically underpredicts the average excess rate of return on U.S. stocks-the so-called "equity premium puzzle." Weil (1989) points out, as did Mehra and Prescott, that the magnitude of the average risk-free rate is far below that predicted by the theory: this has been dubbed the "risk-free rate puzzle." Numerous authors, including Grossman, Melino, and Shiller (1987) and Backus, Gregory, and Zin (1989), show that the theory cannot account for term premia inherent in the yield curve. Hodrick (1987) surveys a large literature which documents the theory's shortcomings in accounting for excess expected returns in foreign exchange markets. The notion that the representative agent model cannot account for excess returns across a wide array of asset markets can be made more precise by using tools developed by Hansen and Jagannathan (1991) and Shiller (1982).