Showing papers in "Journal of Finance in 1997"
TL;DR: Using a sample free of survivor bias, this paper showed that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual fund's mean and risk-adjusted returns.
Abstract: Using a sample free of survivor bias, I demonstrate that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds' mean and risk-adjusted returns Hendricks, Patel and Zeckhauser's (1993) "hot hands" result is mostly driven by the one-year momentum effect of Jegadeesh and Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds The results do not support the existence of skilled or informed mutual fund portfolio managers PERSISTENCE IN MUTUAL FUND performance does not reflect superior stock-picking skill Rather, common factors in stock returns and persistent differences in mutual fund expenses and transaction costs explain almost all of the predictability in mutual fund returns Only the strong, persistent underperformance by the worst-return mutual funds remains anomalous Mutual fund persistence is well documented in the finance literature, but not well explained Hendricks, Patel, and Zeckhauser (1993), Goetzmann and Ibbotson (1994), Brown and Goetzmann (1995), and Wermers (1996) find evidence of persistence in mutual fund performance over short-term horizons of one to three years, and attribute the persistence to "hot hands" or common investment strategies Grinblatt and Titman (1992), Elton, Gruber, Das, and Hlavka (1993), and Elton, Gruber, Das, and Blake (1996) document mutual fund return predictability over longer horizons of five to ten years, and attribute this to manager differential information or stock-picking talent Contrary evidence comes from Jensen (1969), who does not find that good subsequent performance follows good past performance Carhart (1992) shows that persistence in expense ratios drives much of the long-term persistence in mutual fund performance My analysis indicates that Jegadeesh and Titman's (1993) one-year momentum in stock returns accounts for Hendricks, Patel, and Zeckhauser's (1993) hot hands effect in mutual fund performance However, funds that earn higher
13,218 citations
TL;DR: Corporate Governance as mentioned in this paper surveys research on corporate governance, with special attention to the importance of legal protection of investors and of ownership concentration in corporate governance systems around the world, and shows that most advanced market economies have solved the problem of corporate governance at least reasonably well, in that they have assured the flows of enormous amounts of capital to firms, and actual repatriation of profits to the providers of finance.
Abstract: This article surveys research on corporate governance, with special attention to the importance of legal protection of investors and of ownership concentration in corporate governance systems around the world. CORPORATE GOVERNANCE DEALS WITH the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. How do the suppliers of finance get managers to return some of the profits to them? How do they make sure that managers do not steal the capital they supply or invest it in bad projects? How do suppliers of finance control managers? At first glance, it is not entirely obvious why the suppliers of capital get anything back. After all, they part with their money, and have little to contribute to the enterprise afterward. The professional managers or entrepreneurs who run the firms might as well abscond with the money. Although they sometimes do, usually they do not. Most advanced market economies have solved the problem of corporate governance at least reasonably well, in that they have assured the flows of enormous amounts of capital to firms, and actual repatriation of profits to the providers of finance. But this does not imply that they have solved the corporate governance problem perfectly, or that the corporate governance mechanisms cannot be improved. In fact, the subject of corporate governance is of enormous practical impor
10,954 citations
TL;DR: The authors showed that countries with poorer investor protections, measured by both the character of legal rules and the quality of law enforcement, have smaller and narrower capital markets than those with stronger investor protections.
Abstract: Using a sample of 49 countries, we show that countries with poorer investor protections, measured by both the character of legal rules and the quality of law enforcement, have smaller and narrower capital markets. These findings apply to both equity and debt markets. In particular, French civil law countries have both the weakest investor protections and the least developed capital markets, especially as compared to common law countries.
10,005 citations
TL;DR: In this paper, the authors argue that the textbook description of arbitrage does not describe realistic arbitrage trades, and moreover the discrepancies become particularly important when arbitrageurs manage other people's money.
Abstract: Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital, and is typically risky. Moreover, professional arbitrage is conducted by a relatively small number of highly specialized investors using other people's capital. Such professional arbitrage has a number of interesting implications for security pricing, including the possibility that arbitrage becomes ineffective in extreme circumstances, when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them. ONE OF THE FUNDAMENTAL concepts in finance is arbitrage, defined as "the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices" (Sharpe and Alexander (1990)). Theoretically speaking, such arbitrage requires no capital and entails no risk. When an arbitrageur buys a cheaper security and sells a more expensive one, his net future cash flows are zero for sure, and he gets his profits up front. Arbitrage plays a critical role in the analysis of securities markets, because its effect is to bring prices to fundamental values and to keep markets efficient. For this reason, it is extremely important to understand how well this textbook description of arbitrage approximates reality. This article argues that the textbook description does not describe realistic arbitrage trades, and, moreover, the discrepancies become particularly important when arbitrageurs manage other people's money. Even the simplest realistic arbitrages are more complex than the textbook definition suggests. Consider the simple case of two Bund futures contracts to deliver DM250,000 in face value of German bonds at time T, one traded in London on LIFFE and the other in Frankfurt on DTB. Suppose for the moment, counter factually, that these contracts are exactly the same. Suppose finally that at some point in time t the first contract sells for DM240,000 and the second for DM245,000. An arbitrageur in this situation would sell a futures contract in Frankfurt and buy one in London, recognizing that at time T he is perfectly hedged. To do so, at time t, he would have to put up some good faith money, namely DM3,000 in London and DM3,500 in Frankfurt, leading to a
3,358 citations
TL;DR: In this paper, the authors developed and applied new measures of portfolio performance which use benchmarks based on the characteristics of stocks held by the portfolios that are evaluated, and applied these measures to a new database of mutual fund holdings covering over 2500 equity funds from 1975 to 1994.
Abstract: This article develops and applies new measures of portfolio performance which use benchmarks based on the characteristics of stocks held by the portfolios that are evaluated. Specifically, the benchmarks are constructed from the returns of 125 passive portfolios that are matched with stocks held in the evaluated portfolio on the basis of the market capitalization, book-to-market, and prior-year return characteristics of those stocks. Based on these benchmarks, "Characteristic Timing" and "Characteristic Selectivity" measures are developed that detect, respectively, whether portfolio managers successfully time their portfolio weightings on these characteristics and whether managers can select stocks that outperform the average stock having the same characteristics. We apply these measures to a new database of mutual fund holdings covering over 2500 equity funds from 1975 to 1994. Our results show that mutual funds, particularly aggressive-growth funds, exhibit some selectivity ability, but that funds exhibit no characteristic timing ability. CURRENTLY, OVER ONE TRILLION dollars are invested in actively managed equity mutual funds. Assuming that the fees and expenses of these funds average about one percent of assets-a conservative estimate that ignores the expenses that funds generate from buying and selling stocks-the total costs generated by this industry exceed $10 billion per year. Although mutual funds provide a number of services, such as check-writing and bookkeeping services, more than half of the expenses of mutual funds arise because of their stock-selection efforts.I This article examines whether mutual funds can systematically pick stocks that allow them to earn back a significant fraction of the fees and expenses that they generate. This question has been asked a number of times before, and has generated a great deal of controversy. Beginning with Jensen (1968),
3,081 citations
TL;DR: In this article, an option pricing model that allows volatility, interest rates and jumps to be stochastic is presented. But it is not known whether and by how much each generalization improves option pricing and hedging.
Abstract: Substantial progress has been made in developing more realistic option pricing models. Empirically, however, it is not known whether and by how much each generalization improves option pricing and hedging. We fill this gap by first deriving an option model that allows volatility, interest rates and jumps to be stochastic. Using S&P 500 options, we examine several alternative models from three perspectives: (1) internal consistency of implied parameters/volatility with relevant timeseries data, (2) out-of-sample pricing, and (3) hedging. Overall, incorporating stochastic volatility and jumps is important for pricing and internal consistency. But for hedging, modeling stochastic volatility alone yields the best performance. IN THE LAST TWO DECADES, option pricing has witnessed an explosion of new
2,777 citations
TL;DR: In this article, the authors compare three models of the stochastic behavior of commodity prices that take into account mean reversion, in terms of their ability to price existing futures contracts, and their implication with respect to the valuation of other financial and real assets.
Abstract: In this article we compare three models of the stochastic behavior of commodity prices that take into account mean reversion, in terms of their ability to price existing futures contracts, and their implication with respect to the valuation of other financial and real assets. The first model is a simple one-factor model 'in which the logarithm of the spot price of the commodity is assumed to follow a mean reverting process. The second model takes into account a second stochastic factor, the convenience yield of the commodity, which is assumed to follow a mean reverting process. Finally, the third model also includes stochastic interest rates. The Kalman filter methodology is used to estimate the parameters of the three models for two commercial commodities, copper and oil, and one precious metal, gold. The analysis reveals strong mean reversion in the commercial commodity prices. Using the estimated parameters, we analyze the implications of the models for the term structure of futures prices and volatilities beyond the observed contracts, and for hedging contracts for future delivery. Finally, we analyze the implications of the models for capital budgeting decisions. THE STOCHASTIC BEHAVIOR OF commodity prices plays a central role in the models for valuing financial contingent claims on the commodity, and in the procedures for evaluating investments to extract or produce the commodity. Earlier studies, by assuming that interest rates and convenience yields are constant allowed for a straight forward extension of the procedures developed for common stock option pricing to the valuation of financial and real commodity contingent claims. The assumption, however, is clearly not very satisfactory since it implies that the volatility of future prices is equal to the volatility of spot prices, and that the distribution of future spot prices under the equivalent martingale measure has a variance that increases without bound as the horizon increases. In an equilibrium setting we would expect that when prices are relatively high, supply will increase since higher cost producers of the commodity will enter the market putting a downward pressure on prices. Conversely, when prices are relatively low, supply will decrease since some of
2,159 citations
TL;DR: In this paper, the authors examine the role of corporate headquarters in allocating scarce resources to competing projects in an internal capital market and examine the process by which internal capital markets channel limited resources to different uses inside a company.
Abstract: This article examines the role of corporate headquarters in allocating scarce resources to competing projects in an internal capital market Unlike a bank, headquarters has control rights that enable it to engage in "winner-picking"-the practice of actively shifting funds from one project to another By doing a good job in the winner-picking dimension, headquarters can create value even when it cannot help at all to relax overall firm-wide credit constraints The model implies that internal capital markets may sometimes function more efficiently when headquarters oversees a small and focused set of projects THIS ARTICLE ANALYZES THE process by which internal capital markets channel limited resources to different uses inside a company In so doing, it seeks to address two related sets of questions First, what is the fundamental economic rationale for creating an internal capital market? That is, under what circumstances can it make sense to combine several technologically distinct projects under one roof, and have them seek funding from corporate headquarters, as opposed to setting them up as stand-alone companies that each raise external financing on their own? Second, given this rationale, what is the optimal size and scope of an internal capital market? Should headquarters be involved in funding a large number of projects, or just a few? And should these projects be unrelated to one another, or in similar lines of business? The answers to both sets of questions flow from the insight that in a credit-constrained setting-where not all positive NPV projects can be financed headquarters can create value by actively reallocating scarce funds across projects For example, the cash flow generated by one division's activities may be taken and spent on investment in another division, where the returns are higher Or alternatively, one division's assets may be used as collateral to raise financing that is then diverted to the other division Simply put, individual projects must compete for the scarce funds, and headquarters' job is to pick the winners and losers in this competition
1,853 citations
TL;DR: In this article, the authors investigate the long-run underperformance of recent initial public offering (IPO) firms in a sample of 934 venture-backed IPOs from 1972-1992 and 3,407 non-venturebacked IPO from 1975-1992.
Abstract: We investigate the long-run underperformance of recent initial public offering (IPO) firms in a sample of 934 venture-backed IPOs from 1972-1992 and 3,407 nonventurebacked IPOs from 1975-1992 We find that venture-backed IPOs outperform nonventure-backed IPOs using equal weighted returns Value weighting significantly reduces performance differences and substantially reduces underperformance for nonventure-backed IPOs In tests using several comparable benchmarks and the Fama-French (1993) three factor asset pricing model, venture-backed companies do not significantly underperform, while the smallest nonventure-backed firms do Underperformance, however, is not an IPO effect Similar size and book-to-market firms that have not issued equity perform as poorly as IPOs RITTER (1991) AND LOUGHRAN and Ritter (1995) document severe underperformance of initial public offerings (IPOs) during the past twenty years suggesting that investors may systematically be too optimistic about the prospects of firms that are issuing equity for the first time Recent work has shown that underperformance extends to other countries as well as to seasoned equity offerings We address three primary issues related to the underperformance of new issues First, we examine whether venture capitalists, who specialize in financing promising startup companies and bringing them public, affect the long-run performance of newly public firms We find that venture-backed firms do indeed outperform nonventure-backed IPOs over a five-year period, but only when returns are weighted equally
1,496 citations
TL;DR: Fama and French as discussed by the authors argued that the association between these characteristics and returns arise because the characteristics are proxies for nondiversifiable factor risk, and that the return premia on small capitalization and high book-to-market stocks does not arise because of the comovements of these stocks with pervasive factors.
Abstract: Firm sizes and book-to-market ratios are both highly correlated with the average returns of common stocks. Fama and French (1993) argue that the association between these characteristics and returns arise because the characteristics are proxies for nondiversifiable factor risk. In contrast, the evidence in this article indicates that the return premia on small capitalization and high book-to-market stocks does not arise because of the comovements of these stocks with pervasive factors. It is the characteristics rather than the covariance structure of returns that appear to explain the cross-sectional variation in stock returns. THERE IS NOW CONSIDERABLE evidence that the cross-sectional pattern of stock returns can be explained by characteristics such as size, leverage, past returns, dividend-yield, earnings-to-price ratios, and book-to-market ratios.' Fama and French (1992, 1996) examine all of these variables simultaneously and conclude that, with the exception of the momentum strategy described by Jegadeesh and Titman (1993), the cross-sectional variation in expected returns can be explained by only two of these characteristics, size and book-to-market. Beta, the traditional Capital Asset Pricing Model (CAPM) measure of risk, explains almost none of the cross-sectional dispersion in expected returns once size is taken into account.2
1,462 citations
TL;DR: In this article, the authors examined the relationship between post-acquisition returns and the mode of acquisition and form of payment and found that shareholders who hold on to the acquirer stock received as payment in stock mergers do not earn significantly positive excess returns.
Abstract: Using 947 acquisitions during 1970-1989, this article finds a relationship between the postacquisition returns and the mode of acquisition and form of payment. During a five-year period following the acquisition, on average, firms that complete7 stock mergers earn significantly negative excess returns of -25.0 percent whereas firms that complete cash tender offers earn significantly positive excess returns of 61.7 percent. Over the combined preacquisition and postacquisition period, target shareholders who hold on to the acquirer stock received as payment in stock mergers do not earn significantly positive excess returns. In the top quartile of target to acquirer size ratio, they earn negative excess returns. CORPORATE ACQUISITIONS ARE IMPORTANT events. An examination of delistings from the Center for Research in Security Prices (CRSP) tapes shows that over half a trillion dollars worth of equity in publicly-traded firms was acquired by other publicly-traded firms during 1970-1989. Many researchers have addressed the question of wealth gains from acquisitions. They typically find three patterns: (i) target shareholders earn significantly positive abnormal returns from all acquisitions, (ii) acquiring shareholders earn little or no abnormal returns from tender offers, and (iii) acquiring shareholders earn negative abnormal returns from mergers.1 The evidence is usually based on returns computed over a preacquisition period starting immediately before the announcement date and ending on or before the effective date. This assumes that prices fully adjust to the likely efficiency gains from acquisitions. A few studies also examine the assumption of market efficiency by measuring abnormal returns after the acquisition effective date. These findings are mixed. Franks, Harris, and Titman (1991) find no evidence of significant abnormal returns over a three-year period after the last bid date. However,
TL;DR: In this paper, the authors developed a model of international equity portfolio investment flows based on differences in informational endowments between foreign and domestic investors, and showed that when domestic investors possess a cumulative information advantage over foreign investors about their domestic market, investors tend to purchase foreign assets in periods when the return on foreign assets is high and to sell when the returning is low.
Abstract: This article develops a model of international equity portfolio investment flows based on differences in informational endowments between foreign and domestic investors. It is shown that when domestic investors possess a cumulative information advantage over foreign investors about their domestic market, investors tend to purchase foreign assets in periods when the return on foreign assets is high and to sell when the return is low. The implications of the model are tested using data on United States (U.S.) equity portfolio flows. DESPITE THE APPARENT advantages of the international diversification of equity portfolios, demonstrated by Grubel (1968), Levy and Sarnat (1970) and Solnik (1974), and despite the general relaxation of controls on foreign portfolio investments by developed countries that took place in the early 1980s, French and Poterba (1991), Cooper and Kaplanis (1994) and Tesar and Werner (1995) show that there continues to exist a strong domestic bias in national equity portfolios. Explanations that have been offered for this bias include both barriers to capital flows created by higher costs of transacting in foreign securities, withholding taxes, and political risk, as well as other factors such as the failure of purchasing power parity (PPP), information asymmetries, and regulation. Equilibrium models of international asset pricing that explain the domestic bias in terms of tax and transaction cost barriers to international capital flows have been developed by Black (1974) and Stulz (1981). However, higher transaction costs on foreign transactions could be expected to lead to lower turnover rates on the overseas components of portfolios than on the domestic components, yet Tesar and Werner (1995) find just the opposite: portfolio turnover rates are higher on foreign than on domestic portfolios. Similarly, while withholding taxes on foreign investment income can be expected to cause a home bias in the composition of investment portfolios to the extent that these taxes cannot be offset against domestic taxes, Cooper and Kaplanis (1994) and French and Poterba (1991) find that the expected return differentials that are required to explain the observed degree of home bias exceed what can reason
TL;DR: The authors found that the level of diversification is negatively related to managerial equity ownership and to the equity ownership of outside blockholders, and that decreases in diversification are associated with external corporate control threats, financial distress, and management turnover.
Abstract: We provide evidence on the agency cost explanation for corporate diversification. We find that the level of diversification is negatively related to managerial equity ownership and to the equity ownership of outside blockholders. In addition, we report that decreases in diversification are associated with external corporate control threats, financial distress, and management turnover. These findings suggest that agency problems are responsible for firms maintaining value-reducing diversification strategies and that the recent trend toward increased corporate focus is attributable to market disciplinary forces.
TL;DR: This article found that leverage increases in the aftermath of entrenchment-reducing shocks to managerial security, including unsuccessful tender offers, involuntary CEO replacements, and the addition to the board of major stockholders.
Abstract: We study associations between managerial entrenchment and firms' capital structures, with results generally suggesting that entrenched CEOs seek to avoid debt. In a cross-sectional analysis, we find that leverage levels are lower when CEOs do not face pressure from either ownership and compensation incentives or active monitoring. In an analysis of leverage changes, we find that leverage increases in the aftermath of entrenchment-reducing shocks to managerial security, including unsuccessful tender offers, involuntary CEO replacements, and the addition to the board of major stockholders.
TL;DR: In this article, the authors show that the omitted delisting returns are large and that the delisting bias in the stock return data base maintained by the Center for Research in Security Prices (CRSP) is discussed.
Abstract: I document a delisting bias in the stock return data base maintained by the Center for Research in Security Prices (CRSP). I find that delists for bankruptcy and other negative reasons are generally surprises and that correct delisting returns are not available for most of the stocks that have been delisted for negative reasons since 1962. Using over-the-counter price data, I show that the omitted delisting returns are large. Implications of the bias are discussed. ACADEMIC RESEARCHERS, INVESTMENT PROFESSIONALS, and government analysts all use the stock return data base maintained by the Center for Research in Security Prices (CRSP). Their studies typically form portfolios based on publicly available information and then use CRSP data to calculate portfolio returns. The accuracy of the CRSP data and the feasibility of the portfolio strategies that they investigate are critical to the validity of these studies. Exchanges sometimes delist, or cease trading, stocks before investors are able to sell them.1 To correct for surprise delists, CRSP calculates delisting returns. The CRSP Stock File Guide (1994) explains: (The delisting return) is the return of the security after it is delisted. It is calculated by comparing a value after delisting against the price on the security's last trading date. The value after delisting can include a delisting price or the amount from a final distribution. It is commonly believed that CRSP collects delisting returns whenever they are unanticipated. But the CRSP files are missing thousands of delisting returns.2 Despite the fact that most delists for bankruptcy, insufficient capital, and other performance-related reasons are unannounced, no delisting return
TL;DR: This article found that the operating performance of issuing firms shows substantial improvement prior to the offering, but then deteriorates following a sharp run-up in the year prior to an offering, and that the multiples at the time of the offering do not reflect an expectation of deteriorating performance.
Abstract: Recent studies have documented that firms conducting seasoned equity offerings have inordinately low stock returns during the five years after the offering, following a sharp run-up in the year prior to the offering. This article documents that the operating performance of issuing firms shows substantial improvement prior to the offering, but then deteriorates. The multiples at the time of the offering, however, do not reflect an expectation of deteriorating performance. Issuing firms are disproportionately high-growth firms, but issuers have much lower subsequent stock returns than nonissuers with the same growth rate. SEVERAL RECENT EMPIRICAL STUDIES have documented the poor stock market performance of firms conducting seasoned equity offerings (SEOs) in the United States and other countries.1 Loughran and Ritter (1995) report that the average raw return for issuing firms is only 7 percent per year during the five years after the offering, compared to 15 percent per year for nonissuing firms of the same market capitalization. These low postissue returns follow extremely high returns in the year prior to the offering: 72 percent on average.2 This article links the stock price performance of these issuing firms to their operating performance, and in so doing, addresses four questions: 1) Does the postissue operating performance of issuers deteriorate relative to comparable nonissuing firms? 2) Are the patterns for large issuers different from those for small issuers? 3) Do the capital expenditure decisions of issuers suggest that the managers are just as overoptimistic as investors are? 4) Given that issuing firms tend to be rapidly growing, and rapidly growing firms display strong
TL;DR: This paper examined the use of currency derivatives in order to differentiate among existing theories of hedging hehavior and found that firms with greater growth opportunities and tighter financial constraints are more likely to use currency derivatives.
Abstract: We examine the use of currency derivatives in order to differentiate among existing theories of hedging hehavior. Firms with greater growth opportunities and tighter financial constraints are more likely to use currency derivatives. This result suggests that firms might use derivatives to reduce cash flow variation that might otherwise preclude firms from investing in valuahle growth opportunities. Firms with extensive foreign exchange-rate exposure and economies of scale in hedging activities are also more likely to use currency derivatives. Finally, the source of foreign exchange-rate exposure is an important factor in the choice among types of currency derivatives. LAKGE U.S. CORPORATIONS INCREASINGLY tum to derivatives to reduce tbeir exposures to a variety of risks. Tbe motives for tbis bebavior are not well understood, and tbe empirical evidence on tbe cbaracteristics of derivatives users is limited. However, tbeoretical researcb provides several explanations for optimal bedging that result from difTerent types of capital market imperfections. To distinguish among tbese explanations, we examine tbe use of currency derivatives for a sample of firms tbat bave ex ante exposure to foreign excbange-rate risk. We also consider bow tbe magnitude of tbis exposure affects tbe level of benefits tbat can be realized from reducing risk and tbe costs associated witb risk reduction. Our sample represents 372 of tbe Fortune 500 nonfinancial firms in 1990. All of our sample firms bave potential exposure to foreign currency risk from foreign operations, foreign-denominated debt, or a bigb concentration of foreign competitors in tbeir industries. Approximately 41 percent of tbese firms use currency swaps, forwards, futures, options, or combinations of tbese instruments. We find tbat firms witb greater growtb opportunities and tighter financial constraints are more likely to use currency derivatives. Tbis result is consistent with tbe notion that firms use derivatives to reduce the variation in
TL;DR: The authors examined the capital expenditures of non-oil subsidiaries of oil companies and found that a decrease in cash flow or collateral value decreases investment, holding fixed the profitability of investment, and the finance costs of different parts of the same corporation are interdependent.
Abstract: Using data from the 1986 oil price decrease, I examine the capital expenditures of nonoil subsidiaries of oil companies. I test the joint hypothesis that 1) a decrease in cash/collateral decreases investment, holding fixed the profitability of investment, and 2) the finance costs of different parts of the same corporation are interdependent. The results support this joint hypothesis: oil companies significantly reduced their nonoil investment compared to the median industry investment. The 1986 decline in investment was concentrated in nonoil units that were subsidized by the rest of the company in 1985. SUPPOSE THAT A COMPANY'S cash flow or collateral value falls, but the profitability of its investment opportunities stays constant (or rises). Would this company reduce its investment? In this article I try to answer this question by examining how different parts of the same firm reacted to the 1986 oil price decline, which reduced the cash flow and collateral value of oil firms. Using the COMPUSTAT database, I identify a group of firms that have corporate segments both in the oil extraction industry and in nonoil industries, where "non-oil" is defined as an industry with profits that are not (positively) correlated with the price of oil. I then test the hypothesis: do large cash flow/ collateral value decreases to a corporation's oil segment decrease investment in its nonoil segment? I focus on the 1986 oil shock, in which oil prices fell by 50 percent, because this dramatic economic event seems unambiguously exogenous to any individual firm. Looking within firms, rather than across firms, I test the joint hypothesis that 1) the oil shock affected the costs of finance for oil segments, and 2) the cost of finance in the oil segment affected the cost of finance in the nonoil segment of the company. This joint hypothesis would be true if both external capital markets were imperfect (so that financial slack matters for investment) and if internal capital markets allocated capital within firms (so that the different parts of the firm are interdependent). It is of interest both to macroeconomics, because investment is an important part of the business
TL;DR: In this article, the authors investigate the idea that changes in dividends have information content about the future earnings of the firm and find only limited support for it and conclude that the size of the dividend increase does not predict future earnings.
Abstract: Many dividend theories imply that changes in dividends have information content about the future earnings of the firm. We investigate this implication and find only limited support for it. Firms that increase dividends in year 0 have experienced significant earnings increases in years -1 and 0, but show no subsequent unexpected earnings growth. Also, the size of the dividend increase does not predict future earnings. Firms that cut dividends in year 0 have experienced a reduction in earnings in year 0 and in year -1, but these firms go on to show significant increases in earnings in year 1. However, consistent with Lintner's model on dividend policy, firms that increase dividends are less likely than nonchanging firms to experience a drop in future earnings. Thus, their increase in concurrent earnings can be said to be somewhat "permanent." In spite of the lack of future earnings growth, firms that increase dividends have significant (though modest) positive excess returns for the following three years. THE IDEA THAT CHANGES in dividends have information content is an old one. Lintner's (1956) famous investigation of dividend policy stresses that firms only increase dividends when management believes that earnings have permanently increased, meaning that a dividend increase implies a rightward shift in (management's perceived) distribution of earnings. A bit later, Miller and Modigliani (1961) explicitly suggest that dividends can convey information about future cash flows when markets are incomplete. Indeed, as demonstrated by Miller and Rock (1985), through the sources and uses of funds identity, the dividend decision could reveal information about current earnings
TL;DR: The authors developed a multi-factor econometric model of the term structure of interest-rate swap yields, which accommodates the possibility of counterparty default, and any differences in the liquidities of the Treasury and Swap markets.
Abstract: This article develops a multi-factor econometric model of the term structure of interest-rate swap yields. The model accommodates the possibility of counterparty default, and any differences in the liquidities of the Treasury and Swap markets. By parameterizing a model of swap rates directly, we are able to compute model-based estimates of the defaultable zero-coupon bond rates implicit in the swap market without having to specify a priori the dependence of these rates on default hazard or recovery rates. The time series analysis of spreads between zero-coupon swap and treasury yields reveals that both credit and liquidity factors were important sources of variation in swap spreads over the past decade. ALTHOUGH PLAIN VANILLA FIXED-for-floating interest-rate swaps comprise a major segment of the fixed-income derivative market, notably few econometric models for pricing swaps have been developed in the literature. Perhaps the primary reasons for this are: (i) swap contracts embody default risk and hence equilibrium or arbitrage-free term structure models developed for default-free government bond markets are not directly applicable to the swap market; (ii) empirical modeling of the default event underlying credit spreads on defaultable bonds and swaps has met with limited success at explaining the timeseries properties of spreads; and (iii) swap spreads are likely to depend on other factors such as liquidity that are not directly related to default events. Also, until recently, data have not been widely available. In this article we develop a multifactor econometric model of the term structure of U.S. fixedfor-floating interest-rate swap yields that accommodates many of the institutional features of swap markets. Specifically, using results in Duffie and Singleton (1996), we show that the fixed payment rate of a swap, assuming that the floating rate is London Interbank Offering Rate (LIBOR), can be expressed in terms of present values of net cash flows of the swap contract
TL;DR: In this paper, the authors examined how stock return data respond to monetary policy shocks and found that expansionary policy increases ex-post stock returns, while exposure to monetary policies increases an asset's ex-ante return.
Abstract: Financial economists have long debated whether monetary policy is neutral. This article addresses this question by examining how stock return data respond to monetary policy shocks. Monetary policy is measured by innovations in the federal funds rate and nonborrowed reserves, by narrative indicators, and by an event study of Federal Reserve policy changes. In every case the evidence indicates that expansionary policy increases ex-post stock returns. Results from estimating a multi-factor model also indicate that exposure to monetary policy increases an asset's ex-ante return.
TL;DR: In this article, the authors analyzed the timing of stock option awards to CEOs of major U.S. companies and found that the timing coincides with favorable movements in company stock prices.
Abstract: This article analyzes the timing of CEO stock option awards, as a method of investigating corporate managers' influence over the terms of their own compensation. In a sample of 620 stock option awards to CEOs of Fortune 500 companies between 1992 and 1994, I find that the timing of awards coincides with favorable movements in company stock prices. Patterns of companies' quarterly earnings announcements are consistent with an interpretation that CEOs receive stock option awards shortly before favorable corporate news. I evaluate and reject several alternative explanations of the results, including insider trading and the manipulation of news announcement dates. MANY EXECUTIVE COMPENSATION STUDIES find links between the introduction of long-term incentive plans and changes in company performance. Leading examples include Larcker (1983) (accounting-based performance plans) and DeFusco, Johnson, and Zorn (1990) (stock options). However, most evidence in such studies is consistent with two interpretations. Incentive compensation might motivate managers to make superior decisions. Alternatively, managers might have influence over the terms of their own compensation and use this power to obtain more performance-based pay in advance of anticipated stock price increases. Until recently, the limited public data about executive compensation has permitted little research that could distinguish between these alternative hypotheses. Using the dates of stock option awards received by CEOs of major U.S. companies, this article investigates the hypothesis that managers influence the terms of their own compensation. U.S. public corporations began reporting this information in late 1992 pursuant to reformed Securities and Exchange Commission (SEC) regulations for executive compensation disclosure (SEC (1992)). Since nearly all executive stock options are granted with fixed exercise prices equal to the stock price on the date of award, opportunistic timing of
TL;DR: In this paper, the conditional capital asset pricing model (CAPM) for the world's eight largest equity markets using a parsimonious generalized autoregressive conditional heteroskedasticity (GARCH) parameterization was tested.
Abstract: We test the conditional capital asset pricing model (CAPM) for the world's eight largest equity markets using a parsimonious generalized autoregressive conditional heteroskedasticity (GARCH) parameterization. Our methodology can be applied simultaneously to many assets and, at the same time, accommodate general dynamics of the conditional moments. The evidence supports most of the pricing restrictions of the model, but some of the variation in risk-adjusted excess returns remains predictable during periods of high interest rates. Our estimates indicate that, although severe market declines are contagious, the expected gains from international diversification for a U.S. investor average 2.11 percent per year and have not significantly declined over the last two decades.
TL;DR: In this article, the authors examine data on analyst following for a sample of initial public offerings completed between 1975 and 1987 to see how they relate to three well-documented IPO anomalies.
Abstract: We examine data on analyst following for a sample of initial public offerings completed between 1975 and 1987 to see how they relate to three well-documented IPO anomalies. We find that higher underpricing leads to increased analyst following. Analysts are overoptimistic about the earnings potential and long term growth prospects of recent IPOs. More firms complete IPOs when analysts are particularly optimistic about the growth prospects of recent IPOs. In the long run, IPOs have better stock performance when analysts ascribe low growth potential rather than high growth potential. These results suggest that the anomalies may be partially driven by overoptimism. THREE WELL-DOCUMENTED "ANOMALIES" associated with initial public offerings (IPO) are underpricing, hot issue markets, and long-run underperformance. Can data on analyst following or analyst forecast accuracy help us understand these phenomena better? There is an ongoing debate about whether these anomalies are examples of market inefficiency, and if so, whether they are caused by the behavior of irrational investors or whether they reflect institutional constraints. Consider the long run underperformance of initial public offerings documented by Ritter (1991). The immediate question is whether the underperformance persists after precise adjustment for priced risk. If indeed IPOs underperform on a risk adjusted basis, the next question is whether the underperformance is because of institutional constraints -such as short sales restrictions-in the IPO market, or whether it is because of systematic overoptimism on the part of investors. The problem with investigating these issues using data on returns and prices only is that the researcher cannot tell if ex post realized returns for a security are low because the ex ante estimated cash flows were too high (either because of overoptimism on the part of all investors or because short sales constraints prevented the beliefs of pessimistic investors
TL;DR: In this paper, the authors examine the hypothesis that the superior return to so-called value stocks is the result of expectational errors made by investors and find that a significant portion of the return difference between value and glamour stocks is attributable to earnings surprises that are systematically more positive for value stocks.
Abstract: This article examines the hypothesis that the superior return to so-called value stocks is the result of expectational errors made by investors. We study stock price reactions around earnings announcements for value and glamour stocks over a 5-year period after portfolio formation. The announcement returns suggest that a significant portion of the return difference between value and glamour stocks is attributable to earnings surprises that are systematically more positive for value stocks. The evidence is inconsistent with a risk-based explanation for the return differential. MOST FINANCE RESEARCHERS AGREE that simple value strategies based on such ratios as book-to-market, earnings-to-price and cash flow-to-price have produced superior returns over a long period of time.' Interpreting these superior returns, however, has been more controversial. On one side, Fama-French (1992) argue that these superior returns represent compensation for risk along the lines of the Merton (1973) intertemporal capital asset pricing model (ICAPM) where portfolios formed on book-to-market ratios are interpreted as mimicking portfolios whose returns are correlated with relevant state variables representing consumption or production opportunities. On the other side, Lakonishok, Shleifer, and Vishny (LSV, 1994) contend that there is little evidence that high book-to-market and high cash-flow-to-price stocks are riskier based on conventional notions of systematic risk. LSV argue instead that value stocks have been underpriced relative to their risk and return characteristics for various behavioral and institutional reasons. A specific behavioral explanation pursued in more depth by LSV (1994) is that the superior return on value stocks is due to expectational errors made by investors. In particular, investors tend to extrapolate past growth rates too far into the future. Evidence going back to Little (1962) suggests that company
TL;DR: This article developed alternative ways to compare asset pricing models when it is understood that their implied stochastic discount factors do not price all portfolios correctly Unlike comparisons based on x2 statistics associated with null hypotheses that models are correct, their measures of model performance do not reward variability of discount factor proxies.
Abstract: In this article we develop alternative ways to compare asset pricing models when it is understood that their implied stochastic discount factors do not price all portfolios correctly Unlike comparisons based on x2 statistics associated with null hypotheses that models are correct, our measures of model performance do not reward variability of discount factor proxies One of our measures is designed to exploit fully the implications of arbitrage-free pricing of derivative claims We demonstrate empirically the usefulness of our methods in assessing some alternative stochastic factor models that have been proposed in asset pricing literature IN THEORIES OF ASSET PRICING, portfolio payoffs are modeled as bundled contingent claims to a numeraire consumption good When asset markets are frictionless, portfolio prices can be characterized as a linear valuation functional that assigns prices to the portfolio payoffs (eg, see Ross (1978), Harrison and Kreps (1979), Kreps (1981), Chamberlain and Rothschild (1983), Hansen and Richard (1987), and Clark (1993)) These valuation functionals are typically represented as inner products of payoffs with pricing kernels or stochastic
TL;DR: In this paper, the authors present a technique for nonparametrically estimating continuous-time diffusion processes that are observed at discrete intervals, and illustrate the methodology by using daily three and six month Treasury Bill data, from January 1965 to July 1995, to estimate the drift and diffusion of the short rate, and the market price of interest rate risk.
Abstract: This article presents a technique for nonparametrically estimating continuous-time diffusion processes that are observed at discrete intervals. We illustrate the methodology by using daily three and six month Treasury Bill data, from January 1965 to July 1995, to estimate the drift and diffusion of the short rate, and the market price of interest rate risk. While the estimated diffusion is similar to that estimated by Chan, Karolyi, Longstaff, and Sanders (1992), there is evidence of substantial nonlinearity in the drift. This is close to zero for low and medium interest rates, but mean reversion increases sharply at higher interest rates. MODERN ASSET PRICING THEORY allows us to value and hedge a wide array of contingent claims, given a continuous-time model for the dynamics of the underlying state variables.1 Many such models have been developed to describe a range of economic variables, including stock prices (for pricing options and other derivatives) and real investment returns. Given the importance of valuing and hedging the huge institutional holdings of fixed income securities and derivatives, it is not surprising that one of the most common uses of continuous-time models has been in describing the dynamics of the short-term riskless interest rate, rt. Unfortunately, while the theory tells us what to do once we have a model for
TL;DR: Bollerslev et al. as discussed by the authors analyzed a one-year time series of fiveminute Deutschemark-U.S. Dollar exchange rates and showed that the long-memory characteristics constitute an intrinsic feature of the return generating process, rather than the manifestation of occasional structural shifts.
Abstract: Recent empirical evidence suggests that the interdaily volatility clustering for most speculative returns are best characterized by a slowly mean-reverting fractionally integrated process. Meanwhile, much shorter lived volatility dynamics are typically observed with high frequency intradaily returns. The present article demonstrates, that by interpreting the volatility as a mixture of numerous heterogeneous short-run information arrivals, the observed volatility process may exhibit long-run dependence. As such, the long-memory characteristics constitute an intrinsic feature of the return generating process, rather than the manifestation of occasional structural shifts. These ideas are confirmed by our analysis of a one-year time series of fiveminute Deutschemark-U.S. Dollar exchange rates. Among the most puzzling issues is the behavior of volatility. While the general properties of volatility remain elusive, perhaps the most intriguing feature revealed by empirical work on volatility is its long persistence. Such behavior has sparked a search, almost akin to that for the Holy Grail, for the perfect GARCH model, but the underlying question of why such volatility persistence endures remains unanswered. We conjecture that the ability to analyze higher frequency data may be particularly useful in pursuing this issue. (Goodhart and O'Hara (1997)) THE PRONOUNCED VOLATILITY CLUSTERING is arguably one of the most striking features of financial price series recorded at daily or weekly intervals, and a large body of literature seeking to characterize this aspect of speculative returns has emerged over the past decade.1 At the same time, convincing theoretical explanations for the underlying sources of long-run persistence in volatility remain elusive. The recent advent of comprehensive high-frequency * Andersen is from the J.L. Kellogg Graduate School of Management of Northwestern University. Bollerslev is from the University of Virginia and is a research associate at the National Bureau of Economic Research. We gratefully acknowledge the financial support provided by a research grant from the Institute for Quantitative Research in Finance (the Q-Group). Special thanks are due to Olsen and Associates for making the intradaily exchange rate quotes and Reuter's News Tape available. We have received valuable comments from Wake Epps, Clive W.J. Granger, Stephen F. Gray, J. Huston McCulloch, as well as seminar participants at the December 1996 Triangle Econometrics Workshop, the 1997 AFA Meetings in New Orleans, Academia Sinica, the Wharton School, USC, and Georgetown and York universities. We remain fully responsible for the content. 1 See Bollerslev, Chou, and Kroner (1992) for a survey of this literature using ARCH type
TL;DR: In this paper, the authors examined the survival of overconfident beliefs in a model of speculative trading with asymmetric information, and they showed that overconfidence may strictly dominate rationality since a trader may not only generate higher expected profit and utility than his rational opponent, but also higher than if he were also rational.
Abstract: In a duopoly model of informed speculation, we show that overconfidence may strictly dominate rationality since an overconfident trader may not only generate higher expected profit and utility than his rational opponent, but also higher than if he were also rational. This occurs because overconfidence acts like a commitment device in a standard Cournot duopoly. As a result, for some parameter values the Nash equilibrium of a two-fund game is a Prisoner's Dilemma in which both funds hire overconfident managers. Thus, overconfidence can persist and survive in the long run. THE RATIONAL EXPECTATIONS HYPOTHESIS implies that economic agents make decisions as though they know a correct probability distribution of the underlying uncertainty. According to the traditional view (Alchian (1950) and Friedman (1953)), the rational expectations hypothesis is empirically plausible because rational beliefs are better able to survive the market test than irrational beliefs. Yet, the empirical literature on judgment under uncertainty provides extensive evidence that people tend to exhibit overconfidence in judgment, i.e., people's subjective probability distributions are too tight (Alpert and Raiffa (1959), and Lichtenstein, Fischhoff, and Phillips (1982)). This article examines the survival of overconfident beliefs in a model of speculative trading with asymmetric information. The model is based on a duopoly version of the trading model in Kyle (1984, 1985). Two risk-neutral informed traders have different noisy signals of the unobserved liquidation value. We relax the rational expectations assumption that traders have common priors on the joint probability distribution of each private signal and the liquidation value. We generalize this approach by allowing traders to have different distributions of the private signals. The different distributions may be due to cognitive errors (Kahneman, Slovic, and Tversky (1982)). In this
TL;DR: In this paper, a unified model that gives closed form solutions for caps and floors written on interest rates as well as puts and calls written on zero-coupon bonds was derived.
Abstract: We derive a unified model that gives closed form solutions for caps and floors written on interest rates as well as puts and calls written on zero-coupon bonds. The crucial assumption is that simple interest rates over a fixed finite period that matches the contract, which we want to price, are log-normally distributed. Moreover, this assumption is shown to be consistent with the Heath-Jarrow-Morton model for a specific choice of volatility. CLOSED FORM SOLUTIONS FOR interest rate derivatives, in particular caps, floors, and bond options, have been obtained by a number of authors for Markovian term structure models with normally distributed interest rates or alternatively log-normally distributed bond prices (see, for example, Jamshidian (1989, 1991a); Heath, Jarrow, and Morton (1992); Brace and Musiela (1994); Geman, El Karoui, and Rochet (1995)). These models support Black-Scholes type formulas most frequently used by practitioners for pricing bond options and swaptions. Unfortunately, these models imply negative interest rates with positive probabilities, and hence they are not arbitrage free in an economy with opportunities for riskless and costless storage of money. Briys, Crouhy, and Schobel (1991) apply the Gaussian framework to derive closed form solutions for caps, floors, and European zero-coupon bond options. To exclude the influence of negative forward rates on the pricing of zero-coupon bond options, they introduce an additional boundary condition. As shown by Rady and Sandmann (1994) these pricing formulas are only supported by a term structure model with an absorbing boundary for the forward rate at zero, where the absorbing probability is not negligible, which for a term structure model is a quite problematic assumption.