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Showing papers in "Journal of Finance in 2000"


Journal ArticleDOI
TL;DR: In this article, the authors formalize this intuition with an asset pricing model that incorporates conditional skewness and show that the low expected return momentum portfolios have higher skewnness than high expected return portfolios.
Abstract: If asset returns have systematic skewness, expected returns should include rewards for accepting this risk. We formalize this intuition with an asset pricing model that incorporates conditional skewness. Our results show that conditional skewness helps explain the cross-sectional variation of expected returns across assets and is significant even when factors based on size and book-to-market are included. Systematic skewness is economically important and commands a risk premium, on average, of 3.60 percent per year. Our results suggest that the momentum effect is related to systematic skewness. The low expected return momentum portfolios have higher skewness than high expected return portfolios.

2,628 citations


Journal ArticleDOI
TL;DR: In this article, the authors argue that overconfidence can explain high trading levels and the resulting poor performance of individual investors, and that trading is hazardous to the wealth of the average household.
Abstract: Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.

2,439 citations


Journal ArticleDOI
TL;DR: In this article, two agency models of dividends are proposed: the outcome model and the substitute model, which predicts that stronger minority shareholders rights should be associated with higher dividend payouts; the second model predicts the opposite.
Abstract: This paper outlines and tests two agency models of dividends. According to the "outcome model," dividends are paid because minority shareholders pressure corporate insiders to disgorge cash. According to the "substitute model," insiders interested in issuing equity in the future pay dividends to establish a reputation for decent treatment of minority shareholders. The first model predicts that stronger minority shareholder rights should be associated with higher dividend payouts; the second model predicts the opposite. Tests on a cross section of 4,000 companies from 33 countries with different levels of minority shareholder rights support the outcome agency model of dividends.

2,212 citations


Journal ArticleDOI
TL;DR: In this article, the authors provide measures of absolute and relative equity agency costs for corporations under different ownership and management structures, and find that agency costs are significantly higher when an outsider rather than an insider manages the firm; they are inversely related to the manager's ownership share; and they increase with the number of non-manager shareholders.
Abstract: We provide measures of absolute and relative equity agency costs for corporations under different ownership and management structures. Our base case is Jensen and Meckling’s ~1976! zero agency-cost firm, where the manager is the firm’s sole shareholder. We utilize a sample of 1,708 small corporations from the FRB0NSSBF database and find that agency costs ~i! are significantly higher when an outsider rather than an insider manages the firm; ~ii! are inversely related to the manager’s ownership share; ~iii! increase with the number of nonmanager shareholders, and ~iv! to a lesser extent, are lower with greater monitoring by banks. THE SOCIAL AND PRIVATE COSTS OF AN AGENT’S ACTIONS due to incomplete alignment of the agent’s and owner’s interests were brought to attention by the seminal contributions of Jensen and Meckling ~1976! on agency costs. Agency theory has also brought the roles of managerial decision rights and various external and internal monitoring and bonding mechanisms to the forefront of theoretical discussions and empirical research. Great strides have been made in demonstrating empirically the role of agency costs in financial decisions, such as in explaining the choices of capital structure, maturity structure, dividend policy, and executive compensation. However, the actual measurement of the principal variable of interest, agency costs, in both absolute and relative terms, has lagged behind. To measure absolute agency costs, a zero agency-cost base case must be observed to serve as the reference point of comparison for all other cases of ownership and management structures. In the original Jensen and Meckling agency theory, the zero agency-cost base case is, by definition, the firm owned solely by a single owner-manager. When management owns less than 100 percent of the firm’s equity, shareholders incur agency costs resulting from management’s shirking and perquisite consumption. Because of limitations imposed by personal wealth constraints, exchange regulations on the minimum numbers of shareholders, and other considerations, no publicly traded firm is entirely owned by management. Thus, Jensen and Meckling’s zero agency cost base case cannot be found among the usual sample of publicly

2,004 citations


Journal ArticleDOI
TL;DR: In this article, the authors test the gradual information-diffusion model of Hong and Stein ~1999! and establish three key results: once one moves past the very smallest stocks, the profitability of momentum strategies declines sharply with firm size.
Abstract: Various theories have been proposed to explain momentum in stock returns. We test the gradual-information-diffusion model of Hong and Stein ~1999! and establish three key results. First, once one moves past the very smallest stocks, the profitability of momentum strategies declines sharply with firm size. Second, holding size fixed, momentum strategies work better among stocks with low analyst coverage. Finally, the effect of analyst coverage is greater for stocks that are past losers than for past winners. These findings are consistent with the hypothesis that firm-specific information, especially negative information, diffuses only gradually across the investing public.

1,983 citations


Journal ArticleDOI
TL;DR: In this paper, the authors use a new database to perform a comprehensive analysis of the mutual fund industry and find that funds hold stocks that outperform the market by 1.3 percent per year, but their net returns underperform by one percent.
Abstract: We use a new database to perform a comprehensive analysis of the mutual fund industry. We find that funds hold stocks that outperform the market by 1.3 percent per year, but their net returns underperform by one percent. Of the 2.3 percent difference between these results, 0.7 percent is due to the underperformance of nonstock holdings, whereas 1.6 percent is due to expenses and transactions costs. Thus, funds pick stocks well enough to cover their costs. Also, high-turnover funds beat the Vanguard Index 500 fund on a net return basis. Our evidence supports the value of active mutual fund management.

1,875 citations


Journal ArticleDOI
TL;DR: In this paper, the authors analyzed the performance of the affiliates of diversified Indian business groups relative to unaffiliated firms and found that the most diversified business groups outperform the other firms.
Abstract: Emerging markets like India have poorly functioning institutions, leading to severe agency and information problems. Business groups in these markets have the potential both to offer benefits to member firms, and to destroy value. We analyze the performance of affiliates of diversified Indian business groups relative to unaffiliated firms. We find that accounting and stock market measures of firm performance initially decline with group diversification and subsequently increase once group diversification exceeds a certain level. Unlike U.S. conglomerates' lines of business, and similar to the affiliates of U.S. LBO associations, affiliates of the most diversified business groups outperform unaffiliated firms.

1,847 citations


Journal ArticleDOI
TL;DR: The authors examined the forecasting ability of the affine class of term structure models, where the cross-sectional and time-series characteristics of the term structure are linked in an internally consistent way.
Abstract: The standard class of affine models produces poor forecasts of future Treasury yields. Better forecasts are generated by assuming that yields follow random walks. The failure of these models is driven by one of their key features: Compensation for risk is a multiple of the variance of the risk. Thus risk compensation cannot vary independently of interest rate volatility. I also describe a broader class of models. These “essentially affine” models retain the tractability of standard models, but allow compensation for interest rate risk to vary independently of interest rate volatility. This additional f lexibility proves useful in forecasting future yields. CAN WE USE F INANCE THEORY to tell us something about the empirical behavior of Treasury yields that we do not already know? In particular, can we sharpen our ability to predict future yields? A long-established fact about Treasury yields is that the current term structure contains information about future term structures. For example, long-maturity bond yields tend to fall over time when the slope of the yield curve is steeper than usual. These predictive relations are based exclusively on the time-series behavior of yields. To rule out arbitrage, the cross-sectional and time-series characteristics of the term structure are linked in an internally consistent way. In principle, imposing these restrictions should allow us to exploit more of the information in the current term structure, and thus improve forecasts. But in practice, existing no-arbitrage models impose other restrictions for the sake of tractability; thus their value as forecasting tools is a priori unclear. I examine the forecasting ability of the affine class of term structure models. By “affine,” I refer to models where zero-coupon bond yields, their physical dynamics, and their equivalent martingale dynamics are all affine functions of an underlying state vector. A variety of nonaffine models have been developed, but the tractability and apparent richness of the affine class has led the finance profession to focus most of its attention on such models. Although forecasting future yields is important in its own right, a model that is consistent with finance theory and produces accurate forecasts can make a deeper contribution to finance. It should allow us to address a key

1,601 citations


Journal ArticleDOI
TL;DR: In this article, a cross-sectional time-series model is proposed to assess the impact of market liberalization in emerging equity markets on the cost of capital, volatility, beta, and correlation with world market returns.
Abstract: We propose a cross-sectional time-series model to assess the impact of market lib- eralizations in emerging equity markets on the cost of capital, volatility, beta, and correlation with world market returns. Liberalizations are defined by regulatory changes, the introduction of depositary receipts and country funds, and structural breaks in equity capital flows to the emerging markets. We control for other eco- nomic events that might confound the impact of foreign speculators on local equity markets. Across a range of specifications, the cost of capital always decreases after a capital market liberalization with the effect varying between 5 and 75 basis points. THROUGHOUT HISTORY AND IN MANY MARKET ECONOMIES, the speculator has been characterized as both a villain and a savior. Indeed, the reputation of the speculator generally depends on the country where he does business. In well- functioning advanced capital markets, such as the United States, the specu- lator is viewed as an integral part of the free-market system. In developing capital markets, the speculator, and in particular the international specula- tor, is looked upon with many reservations. Recently, many so-called "emerging" markets have opened up their capital markets to foreign investors, creating an ideal laboratory for examining the impact of increased foreign portfolio investment in developing equity mar- kets. Our main focus is the impact on expected equity returns-the cost of equity capital. However, we also examine the effects of increased foreign

1,558 citations


Journal ArticleDOI
John R. Graham1
TL;DR: In this article, the authors integrate under firm-specific benefit functions to estimate that the capitalized tax benefit of debt equals 97 percent of firm value (or as low as 43 percent, net of personal taxes) The typical firm could double tax benefits by issuing debt until the marginal tax benefit begins to decline.
Abstract: I integrate under firm-specific benefit functions to estimate that the capitalized tax benefit of debt equals 97 percent of firm value (or as low as 43 percent, net of personal taxes) The typical firm could double tax benefits by issuing debt until the marginal tax benefit begins to decline I infer how aggressively a firm uses debt by observing the shape of its tax benefit function Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively Product market factors, growth options, low asset collateral, and planning for future expenditures lead to conservative debt usage Conservative debt policy is persistent

1,510 citations


Journal ArticleDOI
TL;DR: This article showed that as interbank competition increases, banks make more relationship loans, but each has lower added value for borrowers, while capital market competition reduces relationship lending and bank lending shrinks.
Abstract: How will banks evolve as competition increases from other banks and from the capital market? Will banks become more like capital market underwriters and offer passive transaction loans or return to their roots as relationship lending experts? These are the questions we address. Our key result is that as interbank competition increases, banks make more relationship loans, but each has lower added value for borrowers. Capital market competition reduces relationship lending ~and bank lending shrinks!, but each relationship loan has greater added value for borrowers. In both cases, welfare increases for some borrowers but not necessarily for all. RAPID CHANGES IN F INANCIAL SERVICES ARE threatening commercial banks. In the United States, mutual funds such as Fidelity and Merrill Lynch compete for banks’ core deposits. Investment banks, armed with a variety of financial market innovations, challenge banks’ traditional lending products. Banks also find themselves in greater competition with one another as globalization and deregulation weaken geographic boundaries and encourage crossborder ~Europe! and interstate ~U.S.! banking. These developments raise numerous fundamental questions. Will the relationship-oriented European bank system survive competitive pressures in this changing environment? Will U.S. banks focus more on “relationship banking” 1 —whereby banks invest in building relationships with borrowers—or on “transaction banking,” which involves “arm’s length” transactions rather

Journal ArticleDOI
TL;DR: In this paper, the authors focus on research and development (R&D) as a potential source of insider gains and find that insider gains in R&D-intensive firms are substantially larger than insider gains without R&DI.
Abstract: Although researchers have documented gains from insider trading, the sources of private information leading to information asymmetry and insider gains have not been comprehensively investigated. We focus on research and development (R&D)—an increasingly important yet poorly disclosed productive input—as a potential source of insider gains. Our findings, for the period from 1985 to 1997 indicate that insider gains in R&D-intensive firms are substantially larger than insider gains in firms without R&D. Insiders also take advantage of information on planned changes in R&D budgets. R&D is thus a major contributor to information asymmetry and insider gains, raising issues concerning management compensation, incentives, and disclosure policies.

Journal ArticleDOI
TL;DR: In this article, a stock market liberalization is defined as a decision by a country's government to allow foreigners to purchase shares in that country's stock market, and it is shown that the stock market's aggregate equity price index experiences abnormal returns of 3.3 percent per month in real dollar terms during an eight-month window leading up to the implementation of its initial stock market.
Abstract: A stock market liberalization is a decision by a country's government to allow foreigners to purchase shares in that country's stock market. On average, a country's aggregate equity price index experiences abnormal returns of 3.3 percent per month in real dollar terms during an eight-month window leading up to the implementation of its initial stock market liberalization. This result is consistent with the prediction of standard international asset pricing models that stock market liberalization may reduce the liberalizing country's cost of equity capital by allowing for risk sharing between domestic and foreign agents. A stock market liberalization is a decision by a country's government to allow foreigners to purchase shares in that country's stock market. Standard international asset pricing models (JAPMs) predict that stock market liberalization may reduce the liberalizing country's cost of equity capital by allowing for risk sharing between domestic and foreign agents (Stapleton and Subrahmanyan (1977), Errunza and Losq (1985), Eun and Janakiramanan (1986), Alexander, Eun, and Janakiramanan (1987), and Stulz (1999a, 1999b)). This prediction has two important empirical implications for those emerging countries that liberalized their stock markets in the late 1980s and early 1990s. First, if stock market liberalization reduces the aggregate cost of equity capital then, holding expected future cash flows constant, we should observe an increase in a country's equity price index when the market learns that a stock market liberalization is going to occur. The second implication is

Journal ArticleDOI
TL;DR: In this article, the authors show that if divisions are similar in the level of their resources and opportunities, funds will be transferred from divisions with poor opportunities to divisions with good opportunities, leading to more inefficient investment and less valuable firms.
Abstract: We model the distortions that internal power struggles can generate in the allocation of resources between divisions of a diversified firm. The model predicts that if divisions are similar in the level of their resources and opportunities, funds will be transferred from divisions with poor opportunities to divisions with good opportunities. When diversity in resources and opportunities increases, however, resources can f low toward the most inefficient division, leading to more inefficient investment and less valuable firms. We test these predictions on a panel of diversified U.S. firms during the period from 1980 to 1993 and find evidence consistent with them. THE FUNDAMENTAL QUESTION IN THE THEORY of the firm, raised by Coase ~1937! more than 60 years ago, is how decisions taken inside a hierarchy differ from those taken in the marketplace. Coase suggested that decisions within a hierarchy are determined by power considerations rather than relative prices. If this is indeed the case, why, and when, does the hierarchy dominate the market? A major obstacle to progress in this area has been the lack of data. Data on internal decisions made by firms are generally proprietary. Even when they are available to researchers, it is difficult to find a comparable group of decisions taken in the market. A notable exception is the capital allocation decision in diversified firms. Since 1978, public U.S. companies have been forced to disclose their data on sales, profitability, and investments by major lines of business ~segments!. An analysis of a small sample of multisegment firms reveals that segments correspond, by and large, to distinct internal

Journal ArticleDOI
TL;DR: In this article, the authors develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market.
Abstract: We develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division managers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of “socialism” in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.

Journal ArticleDOI
TL;DR: In this paper, the authors investigate the usefulness of trading volume in predicting cross-sectional returns for various price momentum portfolios and find that firms with high ~low! past turnover ratios exhibit many glamour ~value! characteristics, earn lower ~higher! future returns, and have consistently more negative ~positive! earnings surprises over the next eight quarters.
Abstract: This study shows that past trading volume provides an important link between “momentum” and “value” strategies. Specifically, we find that firms with high ~low! past turnover ratios exhibit many glamour ~value! characteristics, earn lower ~higher! future returns, and have consistently more negative ~positive! earnings surprises over the next eight quarters. Past trading volume also predicts both the magnitude and persistence of price momentum. Specifically, price momentum effects reverse over the next five years, and high ~low! volume winners ~losers! experience faster reversals. Collectively, our findings show that past volume helps to reconcile intermediate-horizon “underreaction” and long-horizon “overreaction” effects. FINANCIAL ACADEMICS AND PRACTITIONERS have long recognized that past trading volume may provide valuable information about a security. However, there is little agreement on how volume information should be handled and interpreted. Even less is known about how past trading volume interacts with past returns in the prediction of future stock returns. Stock returns and trading volume are jointly determined by the same market dynamics, and are inextricably linked in theory ~e.g., Blume, Easley, and O’Hara ~1994!!. Yet prior empirical studies have generally accorded them separate treatment. In this study, we investigate the usefulness of trading volume in predicting cross-sectional returns for various price momentum portfolios. The study is organized into two parts. In the first part, we document the interaction between past returns and past trading volume in predicting future returns

Journal ArticleDOI
TL;DR: In this paper, the authors show that entrepreneurial income risk has a significant impact on portfolio choice and asset prices, and they find that households with high and variable business income hold less wealth in stocks than other similarly wealthy households, although they constitute a significant fraction of the stockholding population.
Abstract: Using cross-sectional data from the SCF and Tax Model, we show that entrepreneurial income risk has a significant inf luence on portfolio choice and asset prices. We find that households with high and variable business income hold less wealth in stocks than other similarly wealthy households, although they constitute a significant fraction of the stockholding population. Similarly for nonentrepreneurs, holding stock in the firm where one works reduces the portfolio share of other common stocks. Finally, we show that adding proprietary income to a linear asset pricing model improves its performance over a similar model that includes only wage income. IN CONSTRUCTING INVESTMENT PORTFOLIOS, it appears that many if not most households fail to behave in a manner consistent with simple economic theory. Even among relatively wealthy households, the share of financial assets held in different asset classes varies widely, and there is evidence that among those who hold common stock, there is often little diversification ~e.g., King and Leape ~1987!, Blume and Zeldes ~1994!!. We begin this paper with an empirical investigation into some of the risk factors and demographic variables that might explain these cross-sectional differences in portfolio composition. A number of previous studies focus on the level and variability of wage income growth as one of the largest sources of undiversifiable income risk. Here we present evidence that, for the subset of the population that has significant stockholdings, income from entrepreneurial ventures ~which we refer to as proprietary business income) represents a large source of undiversifiable risk that is more highly correlated with common stock returns. These findings motivate the investigation in the second part of the paper of a linear asset pricing model that incorporates proprietary income from pri

Journal ArticleDOI
TL;DR: In this article, the authors examine how the evidence of predictability in asset returns affects optimal portfolio choice for investors with long horizons and find that even after incorporating parameter uncertainty, there is enough predictability to make investors allocate substantially more to stocks, the longer their horizon.
Abstract: We examine how the evidence of predictability in asset returns affects optimal portfolio choice for investors with long horizons. Particular attention is paid to estimation risk, or uncertainty about the true values of model parameters. We find that even after incorporating parameter uncertainty, there is enough predictability in returns to make investors allocate substantially more to stocks, the longer their horizon. Moreover, the weak statistical significance of the evidence for predictability makes it important to take estimation risk into account; a long-horizon investor who ignores it may overallocate to stocks by a sizeable amount.

Journal ArticleDOI
TL;DR: In this article, a bank's capital structure affects its liquidity creation and credit-creation functions in addition to its stability, and the consequent trade-offs imply an optimal bank capital structure.
Abstract: Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance. DOES BANK CAPITAL STRUCTURE MATTER, and if so, how should it be set? Most work on the subject extrapolates an answer from prior work on the capital structure of industrial firms. But bank assets and functions are not the same as those of industrial firms. In fact, one strand of the banking literature suggests banks have a role precisely because they do not suffer the asymmetric information costs of issuance faced by industrial firms (see Gorton and Pennacchi (1990)). Therefore, to really understand the determinants of bank capital structure, we should start by modeling the essential functions banks perform, and then ask what role capital plays. Using this approach, we can see that a bank's capital structure affects its liquiditycreation and credit-creation functions in addition to its stability. The consequent trade-offs imply an optimal bank capital structure. Because customers rely to different extents on liquidity and credit, bank capital structure also determines the nature of the bank's clientele. Our approach will help us better understand the impact of regulations such as minimum capital requirements, and also help suggest the consequences of different recapitalization policies in a banking crisis. We start by describing the functions a bank performs. Consider a world where a number of entrepreneurs each has a project in need of funding. Each entrepreneur has specific abilities vis 'a vis his project so that the cash flows he can generate exceed what anyone else can generate from it. An entrepreneur cannot commit his human capital to the project, except on a

Journal ArticleDOI
TL;DR: The authors argue that corporate finance theory, empirical research, practical applications, and policy recommendations are deeply rooted in an underlying theory of the firm, and they also argue that although the existing theories have delivered very important and useful insights, they seem to be quite ineffective in helping us cope with the new type of firms that is emerging.
Abstract: In this paper I argue that corporate finance theory, empirical research, practical applications, and policy recommendations are deeply rooted in an underlying theory of the firm. I also argue that although the existing theories have delivered very important and useful insights, they seem to be quite ineffective in helping us cope with the new type of firms that is emerging. I outline the characteristics that a new theory of the firm should satisfy and how such a theory could change the way we do corporate finance, both theoretically and empirically. FOR A RELATIVELY YOUNG RESEARCHER like myself, there is a very strong tendency to look at the history of corporate finance and be overwhelmed by the giants of the recent past. A field that 40 years ago was little more than a collection of cookbook recipes that ref lected practitioners’ common sense is today a bona fide discipline, taught not only to future practitioners but also to doctoral students, both in business schools and in economic departments—a discipline whose ideas are now inf luencing other areas of economics, such as industrial organization, monetary policy, and asset pricing. The quality and the impact of the contributions that were made to the field during the last 40 years, and in particular in the period from the late 1970s to the late 1980s, justify the widespread feeling that the “golden age” of corporate finance is behind us. Two excellent recent surveys of the main areas of corporate finance reinforce this sense: the capital structure survey by Harris and Raviv ~1991! and the corporate governance survey by Shleifer and Vishny ~1997!. Both are very lucid categorizations of the existing literature. This lucidity is the product not only of the ability of their authors but also of the ripeness of the moment. Both surveys follow a period of intense activity in the field, and in a certain sense, they close it. It is especially noteworthy that, 10 years later, the survey by Harris and Raviv ~1991! would not necessitate any dramatic rewriting. Although there have certainly been important contributions afterward, they have been mostly empirical, and they have not undermined the conceptual framework underlying Harris and Raviv’s analyses.

Journal ArticleDOI
TL;DR: The authors characterizes all continuous price processes that are consistent with current option prices and shows how arbitrary volatility processes can be adjusted to fit current option price exactly, just as interest rate processes can also be adjusted exactly to fit bond prices exactly.
Abstract: This paper characterizes all continuous price processes that are consistent with current option prices. This extends Derman and Kani (1994), Dupire (1994, 1997), and Rubinstein (1994), who only consider processes with deterministic volatility. Our characterization implies a volatility forecast that does not require a specific model, only current option prices. We show how arbitrary volatility processes can be adjusted to fit current option prices exactly, just as interest rate processes can be adjusted to fit bond prices exactly. The procedure works with many volatility models, is fast to calibrate, and can price exotic options efficiently using familiar lattice techniques.

Journal ArticleDOI
TL;DR: In this paper, the authors focus on the optimal dynamic investment policy for a risk averse manager paid with a call option on the assets he controls, and focus on how the option compensation impacts the manager's appetite for risk when he cannot hedge the option position.
Abstract: This paper solves the dynamic investment problem of a risk averse manager compensated with a call option on the assets he controls. Under the manager’s optimal policy, the option ends up either deep in or deep out of the money. As the asset value goes to zero, volatility goes to infinity. However, the option compensation does not strictly lead to greater risk seeking. Sometimes, the manager’s optimal volatility is less with the option than it would be if he were trading his own account. Furthermore, giving the manager more options causes him to reduce volatility. MANAGERS WITH CONVEX COMPENSATION SCHEMES play an important role in financial markets. This paper solves for the optimal dynamic investment policy for a risk averse manager paid with a call option on the assets he controls. The paper focuses on how the option compensation impacts the manager’s appetite for risk when he cannot hedge the option position. On one hand, the convexity of the option makes the manager shun payoffs that are likely to be near the money. Under the optimal policy, the manager either significantly outperforms his benchmark or else incurs severe losses. Furthermore, in examples of optimal trading strategies, asset volatility goes to infinity as asset value goes to zero. Yet option compensation does not strictly lead to greater risk seeking. As asset value grows large, or if the evaluation date is far away, the manager moderates asset risk. For example, if the manager has constant relative risk aversion ~CRRA!, asset volatility converges to the Merton constant as asset value goes to infinity. In some situations, the manager actually chooses a lower asset volatility than he would if he were investing on his own, because the leverage inherent in his option magnifies his exposure to the asset volatility. In addition, with all constant or decreasing absolute risk averse utility functions from the hyperbolic absolute risk averse ~HARA! class, giving the manager more options causes him to reduce asset volatility. In the CRRA case, for example, the manager targets a fixed volatility for his personal

Journal ArticleDOI
TL;DR: In a frictionless world without taxes or transaction costs, dividends and share repurchases are equivalent as discussed by the authors, which is consistent with some documented regularities, specifically both the presence and stickiness of dividends, and offers novel empirical implications, e.g., a prediction that it is the tax difference between institutions and retail investors that determines dividend payments, not the absolute tax payments.
Abstract: This paper explains why some firms prefer to pay dividends rather than repurchase shares. When institutional investors are relatively less taxed than individual investors, dividends induce “ownership clientele” effects. Firms paying dividends attract relatively more institutions, which have a relative advantage in detecting high firm quality and in ensuring firms are well managed. The theory is consistent with some documented regularities, specifically both the presence and stickiness of dividends, and offers novel empirical implications, e.g., a prediction that it is the tax difference between institutions and retail investors that determines dividend payments, not the absolute tax payments. ALTHOUGH A NUMBER OF THEORIES have been put forward in the literature to explain their pervasive presence, 1 dividends remain one of the thorniest puzzles in corporate finance. In a frictionless world without taxes or transaction costs, dividends and share repurchases are equivalent. If dividends are taxed more heavily than capital gains, as is the case in the United States and many other countries, share repurchases are apparently superior to dividends. Nevertheless, dividends continue to be a substantial proportion of earnings—and personal dividend taxes continue to be a substantial source of income for the I.R.S. For the 1973 to 1983 period, dividends for the largest 1,000 firms in the United States averaged 44 percent of earnings whereas repurchases averaged only 6 percent ~see Allen and Michaely ~1995!!. Although, as Bagwell and Shoven ~1989! have stressed, repurchases increased significantly in 1984 and have remained high, repurchases were not a substitute for dividends. From 1984 to 1988, repurchases increased from 6 percent to 38 percent of earnings, but dividends still increased from 44 percent to 51 percent. The I.R.S. Statistics of Income publication documents that taxable dividends in adjusted gross income amounted to $82 billion in about

Journal ArticleDOI
TL;DR: In this article, a systematic and automatic approach to technical pattern recognition using nonparametric kernel regression was proposed, and applied to a large number of U.S. stocks from 1962 to 1996 to evaluate the effectiveness of technical analysis.
Abstract: Technical analysis, also known as "charting," has been a part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis. One of the main obstacles is the highly subjective nature of technical analysis-the presence of geometric shapes in historical price charts is often in the eyes of the beholder. In this paper, we propose a systematic and automatic approach to technical pattern recognition using nonparametric kernel regression, and we apply this method to a large number of U.S. stocks from 1962 to 1996 to evaluate the effectiveness of technical analysis. By comparing the unconditional empirical distribution of daily stock returns to the conditional distribution-conditioned on specific technical indicators such as head-and-shoulders or double-bottoms-we find that over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value.

Journal ArticleDOI
TL;DR: The share of equity issues in total new equity and debt issues is a strong predictor of U.S. stock market returns between 1928 and 1997 as discussed by the authors, and firms issue relatively more equity than debt just before periods of low market returns.
Abstract: The share of equity issues in total new equity and debt issues is a strong predictor of U.S. stock market returns between 1928 and 1997. In particular, firms issue relatively more equity than debt just before periods of low market returns. The equity share in new issues has stable predictive power in both halves of the sample period and after controlling for other known predictors. We do not find support for efficient market explanations of the results. Instead, the fact that the equity share sometimes predicts significantly negative market returns suggests inefficiency and that firms time the market component of their returns when issuing securities. IN THEIR CLASSIC PROOF of the irrelevance of financing policy, Modigliani and Miller ~1958! implicitly assume market efficiency. If the stock market is inefficient, however, financing policy becomes relevant in obvious ways. When equity prices are too high, existing shareholders benefit by issuing overvalued equity. When equity prices are too low, issuing debt is preferable. Consistent with this timing hypothesis, firms issuing equity have poor subsequent performance. Stigler ~1964!, Ritter ~1991!, Loughran and Ritter ~1995!, and Speiss and Aff leck-Graves ~1995! find low average returns after both initial and seasoned offerings. 1 These studies focus exclusively on issuer returns relative to some benchmark—the first term in the decomposition Ri 5 ~Ri 2 Rb! 1 Rb. The benchmark is typically the market portfolio or

Journal ArticleDOI
TL;DR: In this paper, the authors examine several features of the IPO underwriting business that result in a market structure where spreads are high and offer a few ideas about this pattern, but the convergence remains puzzling.
Abstract: Gross spreads received by underwriters on initial public offerings ~IPOs! in the United States are much higher than in other countries. Furthermore, in recent years more than 90 percent of deals raising $20‐80 million have spreads of exactly seven percent, three times the proportion of a decade earlier. Investment bankers readily admit that the IPO business is very profitable, and that they avoid competing on fees because they “don’t want to turn it into a commodity business.” We examine several features of the IPO underwriting business that result in a market structure where spreads are high. IT IS WIDELY ACCEPTED THAT there are fixed costs associated with issuing securities, leading to economies of scale in the costs of issuing debt, equity, and hybrid securities. For initial public offerings ~IPOs! of moderate size, however, no economies of scale are evident when one examines the commissions paid to investment bankers, also known as the gross spreads or underwriting discounts. In the period from 1995 to 1998, for the 1,111 IPOs raising between $20 and $80 million in the United States, more than 90 percent of issuers paid gross spreads of exactly seven percent. This clustering of spreads at seven percent has not always been present. There is much more clustering at seven percent now than a decade ago, although the average spread on IPOs has not changed during this period. In the 1985 to 1987 period, only about one-quarter of moderate size IPOs had spreads of exactly seven percent, in contrast to the more than 90 percent incidence that has prevailed in recent years. We offer a few ideas about this pattern, but the convergence remains puzzling. Spreads on IPOs outside of the United States, such as in Australia, Japan, Hong Kong, or Europe, are approximately half the level of those in the United States. Spreads within the United States for bond, convertible bond, and seasoned equity offerings do not show pronounced clustering on one number.1

Journal ArticleDOI
TL;DR: In this article, Chan, Hamao, and Lakonishok showed that the relationship between average return and book-to-market equity is as strong for 1929 to 1963 as for the subsequent period studied in previous papers.
Abstract: The value premium in U.S. stock returns is robust. The positive relation between average return and book-to-market equity is as strong for 1929 to 1963 as for the subsequent period studied in previous papers. A three-factor risk model explains the value premium better than the hypothesis that the book-to-market characteristic is compensated irrespective of risk loadings. FIRMS WITH HIGH RATIOS OF BOOK VALUE to the market value of common equity have higher average returns than firms with low book-to-market ratios ~Rosenberg, Reid, and Lanstein ~1985!!. Because the capital asset pricing model ~CAPM! of Sharpe ~1964! and Lintner ~1965! does not explain this pattern in average returns, it is typically called an anomaly. There are four common explanations for the book-to-market ~BE0ME! anomaly. One says that the positive relation between BE0ME and average return ~the so-called value premium! is a chance result unlikely to be observed out of sample ~Black ~1993!, MacKinlay ~1995!!. Out-of-sample evidence is, however, provided by Chan, Hamao, and Lakonishok ~1991!, Capaul, Rowley, and Sharpe ~1993!, and Fama and French ~1998!. They document strong relations between average return and BE0ME in markets outside the United States. Using a rather small sample of firms, Davis ~1994! finds that the relation between average return and BE0ME observed in recent U.S. returns extends back to 1941. We extend Davis’ data back to 1926, and we expand the coverage to all NYSE industrial firms. We find that the value premium in pre-1963 returns is close to that observed for the subsequent period in earlier work. These results argue against the sample-specific explanation for the value premium. The second story for the value premium is that it is not an anomaly at all. The higher average returns on high BE0ME stocks are compensation for risk in a multifactor version of Merton’s ~1973! intertemporal capital asset pricing model ~ICAPM! or Ross’s ~1976! arbitrage pricing theory ~APT!. Consistent with this view, Fama and French ~1993! document covariation in returns

Journal ArticleDOI
TL;DR: This article studied the hedging policies of oil and gas producers between 1992 and 1994 and found that the extent of hedging is related to financing costs: In particular, companies with greater financial leverage manage price risks more extensively, while larger companies and companies whose production is located in regions where prices have a high correlation with the prices on which exchangetraded derivatives are based are more likely to manage risks.
Abstract: This paper studies the hedging policies of oil and gas producers between 1992 and 1994. My evidence shows that the extent of hedging is related to financing costs: In particular, companies with greater financial leverage manage price risks more extensively. My evidence also shows that the likelihood of hedging is related to economies of scale in hedging costs and to the basis risk associated with hedging instruments. Larger companies and companies whose production is located primarily in regions where prices have a high correlation with the prices on which exchangetraded derivatives are based are more likely to manage risks. DESPITE THE PREVALENCE OF CORPORATE RISK MANAGEMENT and the effort that has been devoted to developing theoretical rationales for hedging, there are no widely accepted explanations for risk management as a corporate policy. Important questions remain regarding the determinants of the extent to which a company hedges, the impact of risk management on a firm's value, and the interaction between a firm's hedging policy and its other policy decisions. To address some of these questions, I examine the risk management activities of 100 oil and gas producers for 1992 to 1994. In particular, I investigate whether the fraction of production an oil and gas producer hedges against price fluctuations is related to its financing policy, tax status, compensation policy, ownership structure, and operating characteristics. I document a wide variation in hedging policies among oil and gas producers. My tests find that this variation is associated with several differences in the firms' characteristics. The fraction of production hedged is positively related to the differences in financial leverage, measured as the ratio of total debt to total assets, and it is greater for oil and gas producers

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TL;DR: In this paper, a theory of the optimal number of banking relationships is developed and tested using matched bank-firm data, and the empirical evidence supports the predictions of the model.
Abstract: A theory of the optimal number of banking relationships is developed and tested using matched bank-firm data. According to the theory, relationship banks may be unable to continue funding profitable projects owing to internal problems and a firm may thus have to refinance from nonrelationship banks. The latter, however, face an adverse selection problem, as they do not know the quality of the project, and may refuse to lend. In these circumstances, multiple banking can reduce the probability of an early liquidation of the project. The empirical evidence supports the predictions of the model.

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TL;DR: The authors examined whether hostile takeovers can be distinguished from friendly takeovers, empirically, based on accounting and stock performance data, and found that most deals described as hostile in the press are not distinguishable from friendly deals in economic terms, except that hostile transactions involve publicity as part of the bargaining process.
Abstract: This paper examines whether hostile takeovers can be distinguished from friendly takeovers, empirically, based on accounting and stock performance data. Much has been made of this distinction in both the popular and the academic literature, where gains from hostile takeovers result from replacing incumbent managers and gains from friendly takeovers result from strategic synergies. Alternatively, hostility could reflect strategic choices made by the bidder or the target. Empirical tests show that most deals described as hostile in the press are not distinguishable from friendly deals in economic terms, except that hostile transactions involve publicity as part of the bargaining process.