Showing papers in "Journal of Finance in 2004"

Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

Abstract: We model consumption and dividend growth rates as containing (1) a small longrun predictable component, and (2) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin’s (1989) preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better long-run growth prospects raise equity prices. The model can justify the equity premium, the risk-free rate, and the volatility of the market return, risk-free rate, and the price‐ dividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time-varying.

Information and the Cost of Capital

Abstract: We investigate the role of information in affecting a firm's cost of capital. We show that differences in the composition of information between public and private information affect the cost of capital, with investors demanding a higher return to hold stocks with greater private information. This higher return arises because informed investors are better able to shift their portfolio to incorporate new information, and uninformed investors are thus disadvantaged. In equilibrium, the quantity and quality of information affect asset prices. We show firms can influence their cost of capital by choosing features like accounting treatments, analyst coverage, and market microstructure.

The Cash Flow Sensitivity of Cash

Abstract: We model a firm’s demand for liquidity to develop a new test of the effect of financial constraints on corporate policies. The effect of financial constraints is captured by the firm’s propensity to save cash out of cash flows (the cash flow sensitivity of cash). We hypothesize that constrained firms should have a positive cash flow sensitivity of cash, while unconstrained firms’ cash savings should not be systematically related to cash flows. We empirically estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971 to 2000 period and find robust support for our theory. TWO IMPORTANT AREAS OF RESEARCH in corporate finance are the effects of financial constraints on firm behavior and the manner in which firms perform financial management. These two issues, although often studied separately, are fundamentally linked. As originally proposed by Keynes (1936), a major advantage of a liquid balance sheet is that it allows firms to undertake valuable projects when they arise. However, Keynes also argued that the importance of balance sheet liquidity is influenced by the extent to which firms have access to external capital markets (p. 196). If a firm has unrestricted access to external capital— that is, if a firm is financially unconstrained—there is no need to safeguard against future investment needs and corporate liquidity becomes irrelevant. In contrast, when the firm faces financing frictions, liquidity management may become a key issue for corporate policy. Despite the link between financial constraints and corporate liquidity demand, the literature that examines the effects of financial constraints on firm behavior has traditionally focused on corporate investment demand. 1 In an influential paper, Fazzari, Hubbard, and Petersen (1988) propose that when firms face financing constraints, investment spending will vary with the availability of internal funds, rather than just with the availability of positive net present

Private Benefits of Control: An International Comparison

Abstract: We estimate private benefits of control in 39 countries using 393 controlling blocks sales. On average the value of control is 14 percent, but in some countries can be as low as ‐4 percent, in others as high a +65 percent. As predicted by theory, higher private benefits of control are associated with less developed capital markets, more concentrated ownership, and more privately negotiated privatizations. We also analyze what institutions are most important in curbing private benefits. We find evidence for both legal and extra-legal mechanisms. In a multivariate analysis, however, media pressure and tax enforcement seem to be the dominating factors. THE BENEFITS OF CONTROL OVER corporate resources play a central role in modern thinking about finance and corporate governance. From a modeling device (Grossman and Hart (1980)) the idea of private benefits of control has become a centerpiece of the recent literature in corporate finance, both theoretical and empirical. In fact, the main focus of the literature on investor protection and its role in the development of financial markets (La Porta, Lopez-de-Salines, and Shleifer (2000)) is on the amount of private benefits that controlling shareholders extract from companies they run. In spite of the importance of this concept, there are remarkably few estimates of how big these private benefits are, even fewer attempts to document empirically what determines their size, and no direct evidence of their impact on financial development. All of the evidence on this latter point is indirect, based on the (reasonable) assumption that better protection of minority shareholders is correlated with higher financial development via its curbing of private benefits of control (La Porta et al. (1997)). The lack of evidence is no accident. By their very nature, private benefits of control are difficult to observe and even more difficult to quantify in a reliable

What Explains the Stock Market's Reaction to Federal Reserve Policy?

Abstract: This paper analyzes the impact of unanticipated changes in the Federal funds target on equity prices, with the aim of both estimating the size of the typical reaction, and understanding the reasons for the market’s response. On average over the May 1989 to December 2001 sample, a “typical” unanticipated 25 basis point rate cut has been associated with a 1.3 percent increase in the S&P 500 composite index. The estimated response varies considerably across industries, with the greatest sensitivity observed in cyclical industries like construction, and the smallest in mining and utilities. Very little of the market’s reaction can be attributed to policy’s effects on the real rate of interest or future dividends, however. Instead, most of the response of the current excess return on equities can be traced to policy’s impact on expected future excess returns. JEL codes: E44, G12.

Is All That Talk Just Noise? The Information Content of Internet Stock Message Boards

Abstract: Financial press reports claim that Internet stock message boards can move markets We study the effect of more than 15 million messages posted on Yahoo! Finance and Raging Bull about the 45 companies in the Dow Jones Industrial Average and the Dow Jones Internet Index Bullishness is measured using computational linguistics methods Wall Street Journal news stories are used as controls We find that stock messages help predict market volatility Their effect on stock returns is statistically significant but economically small Consistent with Harris and Raviv (1993), disagreement among the posted messages is associated with increased trading volume MANY PEOPLE ARE DEVOTING a considerable amount of time and effort creating and reading the messages posted on Internet stock message boards News stories report that the message boards are having a significant impact on financial markets The Securities and Exchange Commission has prosecuted people for Internet messages All this attention to Internet stock messages caused us to wonder whether these messages actually contain financially relevant information 1 We consider three specific issues Does the number of messages posted or the bullishness of these messages help to predict returns? Is disagreement among the messages associated with more trades? Does the level of message posting or the bullishness of the messages help to predict volatility? The first issue is, does the level of message activity or the bullishness of the messages successfully predict subsequent stock returns? This is the natural starting place because a very high proportion of the messages contain explicit assertions that the particular stock is either a good buy or a bad buy Of course, there are a great many previous empirical studies showing how hard it is to predict stock returns by enough to cover transactions costs We find that there is evidence of a small degree of negative predictability even after controlling for bid‐ask bounce When many messages are posted on a given day, there ∗ Both authors are at the Sauder School of Business, University of British Columbia We would

Default Risk in Equity Returns

Abstract: This is the first study that uses Merton’s (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the bookto-market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama‐French (FF) factors SMB and HML contain some default-related information, but this is not the main reason that the FF model can explain the cross section of equity returns. A FIRM DEFAULTS WHEN IT FAILS to service its debt obligations. Therefore, default risk induces lenders to require from borrowers a spread over the risk-free rate of interest. This spread is an increasing function of the probability of default of the individual firm. Although considerable research effort has been put toward modeling default risk for the purpose of valuing corporate debt and derivative products written on it, little attention has been paid to the effects of default risk on equity returns. 1 The effect that default risk may have on equity returns is not obvious, since equity holders are the residual claimants on a firm’s cash flows and there is no promised nominal return in equities. Previous studies that examine the effect of default risk on equities focus on the ability of the default spread to explain or predict returns. The default spread is usually defined as the yield or return differential between long-term

Do Stock Prices and Volatility Jump? Reconciling Evidence from Spot and Option Prices

Abstract: This paper examines the empirical performance of jump diffusion models of stock price dynamics from joint options and stock markets data. The paper introduces a model with discontinuous correlated jumps in stock prices and stock price volatility, and with state-dependent arrival intensity. We discuss how to perform likelihoodbased inference based upon joint options/returns data and present estimates of risk premiums for jump and volatility risks. The paper finds that while complex jump specifications add little explanatory power in fitting options data, these models fare better in fitting options and returns data simultaneously. THE STATISTICAL PROPERTIES of stock returns have long been of interest to finan

Social Interaction and Stock-Market Participation

Abstract: We propose that stock-market participation is influenced by social interaction. In our model, any given “social” investor finds the market more attractive when more of his peers participate. We test this theory using data from the Health and Retirement Study, and find that social households—those who interact with their neighbors, or attend church—are substantially more likely to invest in the market than non-social households, controlling for wealth, race, education, and risk tolerance. Moreover, consistent with a peer-effects story, the impact of sociability is stronger in states where stock-market participation rates are higher.

A Catering Theory of Dividends

Abstract: We propose that the decision to pay dividends is driven by prevailing investor demand for dividend payers. Managers cater to investors by paying dividends when investors put a stock price premium on payers, and by not paying when investors prefer nonpayers. To test this prediction, we construct four stock price-based measures of investor demand for dividend payers. By each measure, nonpayers tend to initiate dividends when demand is high. By some measures, payers tend to omit dividends when demand is low. Further analysis confirms that these results are better explained by catering than other theories of dividends. MILLER AND MODIGILIANI (1961) prove that dividend policy is irrelevant to share value in perfect and efficient capital markets. In that setup, no rational investor has a preference between dividends and capital gains. Arbitrage ensures that dividend policy is irrelevant. Forty-plus years later, the only assumption in this proof that has not been thoroughly scrutinized is market efficiency. 1 In this paper, we argue for a view of dividends that relaxes this assumption. It has three basic ingredients. First, for either psychological or institutional reasons, some investors have an uninformed and perhaps time-varying demand for dividend-paying stocks. Second, arbitrage fails to prevent this demand from driving apart the prices of payers and nonpayers. Third, managers rationally cater to investor demand—they pay dividends when investors put higher prices on payers, and they do not pay when investors prefer nonpayers. We formalize this catering view of dividends in a simple model. The prediction of the model that we focus on in our empirical work is that the propensity to pay dividends depends on a dividend premium (or sometimes

What Do Entrepreneurs Pay for Venture Capital Affiliation

Abstract: This study empirically evaluates the certification and value-added roles of reputable venture capitalists (VCs). Using a novel sample of entrepreneurial start-ups with multiple financing offers, I analyze financing offers made by competing VCs at the first professional round of start-up funding, holding characteristics of the start-up fixed. Offers made by VCs with a high reputation are three times more likely to be accepted, and high-reputation VCs acquire start-up equity at a 10‐14% discount. The evidence suggests that VCs’ “extra-financial” value may be more distinctive than their functionally equivalent financial capital. These extra-financial services can have financial consequences. A CENTRAL ISSUE for early-stage high-tech entrepreneurs is obtaining external resources when the assets of their start-up are intangible and knowledge-based. Particularly for entrepreneurs without an established reputation, convincing external resource providers such as venture capitalists (VCs) to provide financial capital may be challenging. The literature contains two main lines of research for overcoming this problem. One research stream has concentrated on designing institutional structures to permit financing early-stage ventures. This contractual- and monitoring-based approach is aimed at solving potential agency problems between investors and entrepreneurs (e.g., Admati and Pfleiderer (1994), Lerner (1995), Hellmann (1998), and Kaplan and Str¨ omberg (2001, 2002, 2003)). A second research stream has suggested that when the quality of a start-up cannot be directly observed, external actors rely on the quality of the start-up’s affiliates as a signal of the start-up’s own quality

Market Valuation and Merger Waves

Abstract: Does valuation affect mergers? Data suggest that periods of stock merger activity are correlated with high market valuations. The naive explanation that overvalued bidders wish to use stock is incomplete because targets should not be eager to accept stock. However, we show that potential market value deviations from fundamental values on both sides of the transaction can rationally lead to a correlation between stock merger activity and market valuation. Merger waves and waves of cash and stock purchases can be rationally driven by periods of over- and undervaluation of the stock market. Thus, valuation fundamentally impacts mergers.

Value-Enhancing Capital Budgeting and Firm-specific Stock Return Variation

Abstract: We document a robust cross-sectional positive association across industries between a measure of the economic efficiency of corporate investment and the magnitude of firmspecific variation in stock returns This finding is interesting for two reasons, neither of which is a priori obvious First, it adds further support to the view that firm-specific return variation gauges the extent to which information about the firm is quickly and accurately reflected in share prices Second, it can be interpreted as evidence that more informative stock prices facilitate more efficient corporate investment CORPORATE CAPITAL INVESTMENT should be more efficient where stock prices are more informative Informed stock prices convey meaningful signals to management about the quality of their decisions They also convey meaningful signals to the financial markets about the need to intervene when management decisions are poor Corporate governance mechanisms, such as shareholder lawsuits, executive options, institutional investor pressure, and the market for corporate control, depend on stock prices Where stock prices are more informative, these mechanisms induce better corporate governance—which includes more efficient capital investment decisions Our objective in this paper is to examine empirically whether capital investment decisions are indeed more efficient where stock prices are more informative To do this, we require a measure of the efficiency of investment and a measure of the informativeness of stock prices

Diversification Discount or Premium? New Evidence from the Business Information Tracking Series

Abstract: I use the Business Information Tracking Series (BITS), a new census database that covers the whole U.S. economy at the establishment level, to examine whether the finding of a diversification discount is an artifact of segment data. BITS data allow me to construct business units that are more consistently and objectively defined than segments, and thus more comparable across firms. Using these data on a sample that yields a discount according to segment data, I find a diversification premium. The premium is robust to variations in the sample, business unit definition, and measures of excess value and diversification.

Characteristics, Contracts, and Actions: Evidence from Venture Capitalist Analyses

Abstract: We study the investment analyses of 67 portfolio investments by 11 venture capital (VC) firms. VCs consider the attractiveness and risks of the business, management, and deal terms as well as expected post-investment monitoring. We then consider the relation of the analyses to the contractual terms. Greater internal and external risks are associated with more VC cash flow rights, VC control rights; greater internal risk, also with more contingencies for the entrepreneur; and greater complexity, with less contingent compensation. Finally, expected VC monitoring and support are related to the contracts. We interpret these results in relation to financial contracting theories.

Hedge funds and the technology bubble

Abstract: This paper documents that hedge funds did not exert a correcting force on stock prices during the technology bubble. Instead, they were heavily invested in technology stocks. This does not seem to be the result of unawareness of the bubble: Hedge funds captured the upturn, but, by reducing their positions in stocks that were about to decline, avoided much of the downturn. Our findings question the efficient markets notion that rational speculators always stabilize prices. They are consistent with models in which rational investors may prefer to ride bubbles because of predictable investor sentiment and limits to arbitrage. TECHNOLOGY STOCKS ON NASDAQ ROSE to unprecedented levels during the 2 years leading up to March 2000. Ofek and Richardson (2002) estimate that at the peak, the entire internet sector, comprising several hundred stocks, was priced as if the average future earnings growth rate across all these firms would exceed the growth rates experienced by some of the fastest growing individual firms in the past, and, at the same time, the required rate of return would be 0% for the next few decades. By almost any standard, these valuation levels are so extreme that this period appears to be another episode in the history of asset price bubbles. Shiller (2000) argues that the stock price increase was driven by irrational euphoria among individual investors, fed by an emphatic media, which maximized TV ratings and catered to investor demand for pseudonews. Of course, only few economists doubt that there are both rational and irrational market participants. However, there are two opposing views about whether rational traders correct the price impact of behavioral traders. Proponents of the

Analyzing the Analysts: When Do Recommendations Add Value?

Abstract: We show that analysts from sell-side firms generally recommend “glamour” (i.e., positive momentum, high growth, high volume, and relatively expensive) stocks. Naive adherence to these recommendations can be costly, because the level of the consensus recommendation adds value only among stocks with favorable quantitative characteristics (i.e., value stocks and positive momentum stocks). In fact, among stocks with unfavorable quantitative characteristics, higher consensus recommendations are associated with worse subsequent returns. In contrast, we find that the quarterly change in consensus recommendations is a robust return predictor that appears to contain information orthogonal to a large range of other predictive variables.

Informed Trading in Stock and Option Markets

Abstract: We investigate the contribution of option markets to price discovery, using a modification of Hasbrouck’s (1995) “information share” approach. Based on five years of stock and options data for 60 firms, we estimate the option market’s contribution to price discovery to be about 17% on average. Option market price discovery is related to trading volume and spreads in both markets, and stock volatility. Price discovery across option strike prices is related to leverage, trading volume, and spreads. Our results are consistent with theoretical arguments that informed investors trade in both stock and option markets, suggesting an important informational role for options. INVESTORS WHO HAVE ACCESS to private information can choose to trade in the stock market or in the options market. Given the high leverage achievable with options and the built-in downside protection, one might think the options market would be an ideal venue for informed trading. If informed traders do trade in the options market, we would expect to see price discovery in the options market. That is, we would expect at least some new information about the stock price to be reflected in option prices first. Establishing that price discovery straddles both the stock and options markets is important for several reasons. In a frictionless, dynamically complete market, options would be redundant securities. This paper contributes to the understanding of why options are relevant in actual markets, by providing the first unambiguous evidence that stock option trading contributes to price discovery in the underlying stock market. Further, we document that the level

An Examination of Long-Term Abnormal Stock Returns and Operating Performance Following R&D Increases

Abstract: We examine a sample of 8,313 cases, between 1951 and 2001, where firms unexpectedly increase their research and development (R&D) expenditures by a significant amount. We find consistent evidence of a misreaction, as manifested in the significantly positive abnormal stock returns that our sample firms' shareholders experience following these increases. We also find consistent evidence that our sample firms experience significantly positive long-term abnormal operating performance following their R&D increases. Our findings suggest that R&D increases are beneficial investments, and that the market is slow to recognize the extent of this benefit (consistent with investor underreaction).

Market States and Momentum

Abstract: We test overreaction theories of short-run momentum and long-run reversal in the cross section of stock returns. Momentum profits depend on the state of the market, as predicted. From 1929 to 1995, the mean monthly momentum profit following positive market returns is 0.93%, whereas the mean profit following negative market returns is −0.37%. The up-market momentum reverses in the long-run. Our results are robust to the conditioning information in macroeconomic factors. Moreover, we find that macroeconomic factors are unable to explain momentum profits after simple methodological adjustments to take account of microstructure concerns. SEVERAL BEHAVIORAL THEORIES have been developed to jointly explain the shortrun cross-sectional momentum in stock returns documented by Jegadeesh and Titman (1993) and the long-run cross-sectional reversal in stock returns documented by DeBondt and Thaler (1985). 1 Daniel, Hirshleifer, and Subrahmanyam (1998; hereafter DHS) and Hong and Stein (1999; hereafter HS) each employ different behavioral or cognitive biases to explain these anomalies. 2, 3

The 52-Week High and Momentum Investing

Abstract: When coupled with a stock’s current price, a readily available piece of information—the 52-week high price‐explains a large portion of the profits from momentum investing. Nearness to the 52-week high dominates and improves upon the forecasting power of past returns (both individual and industry returns) for future returns. Future returns forecast using the 52-week high do not reverse in the long run. These results indicate that short-term momentum and long-term reversals are largely separate phenomena, which presents a challenge to current theory that models these aspects of security returns as integrated components of the market’s response to news. THERE IS SUBSTANTIAL EVIDENCE that stock prices do not follow random walks and that returns are predictable. Jegadeesh and Titman (1993) show that stock returns exhibit momentum behavior at intermediate horizons. A self-financing strategy that buys the top 10% and sells the bottom 10% of stocks ranked by returns during the past 6 months, and holds the positions for 6 months, produces profits of 1% per month. Moskowitz and Grinblatt (1999) argue that momentum in individual stock returns is driven by momentum in industry returns. DeBondt and Thaler (1985), Lee and Swaminathan (2000), and Jegadeesh and Titman (2001) document long-term reversals in stock returns. Stocks that perform poorly in the past perform better over the next 3 to 5 years than stocks that perform well in the past. Barberis, Shleifer, and Vishny (1998), Daniel, Hirshleifer, and Subrahmanyam (1998), and Hong and Stein (1999) present theoretical models that attempt to explain the coexistence of intermediate horizon momentum and long horizon reversals in individual stock returns as the result of systematic violations of rational behavior by traders. In Barberis, Shleifer, and Vishny and in Hong and Stein, momentum occurs because traders are slow to revise their priors when new information arrives. Long-term reversals occur because when traders finally do adjust, they overreact. In Daniel, Hirshleifer, and Subrahmanyam, momentum occurs because traders overreact to prior information when new information confirms it. Long-term reversals occur as the overreaction is corrected in the long run. In all three models, short-term

Compensation, Incentives, and the Duality of Risk Aversion and Riskiness

Abstract: The common folklore that giving options to agents will make them more willing to take risks is false. In fact, no incentive schedule will make all expected utility maximizers more or less risk averse. This paper finds simple, intuitive, necessary and sufficient conditions under which incentive schedules make agents more or less risk averse. The paper uses these to examine the incentive effects of some common structures such as puts and calls, and it briefly explores the duality between a fee schedule that makes an agent more or less risk averse, and gambles that increase or decrease risk. WITH THE GROWING INTEREST in executive compensation and agency problems,

A Multinational Perspective on Capital Structure Choice and Internal Capital Markets

Abstract: This paper analyzes the capital structures of foreign affiliates and internal capital markets of multinational corporations. Ten percent higher local tax rates are associated with 2.8% higher debt/asset ratios, with internal borrowing being particularly sensitive to taxes. Multinational affiliates are financed with less external debt in countries with underdeveloped capital markets or weak creditor rights, reflecting significantly higher local borrowing costs. Instrumental variable analysis indicates that greater borrowing from parent companies substitutes for three-quarters of reduced external borrowing induced by capital market conditions. Multinational firms appear to employ internal capital markets opportunistically to overcome imperfections in external capital markets.

Does Net Buying Pressure Affect the Shape of Implied Volatility Functions

Abstract: This paper examines the relation between net buying pressure and the shape of the implied volatility function (IVF) for index and individual stock options. We find that changes in implied volatility are directly related to net buying pressure from public order flow. We also find that changes in implied volatility of S&P 500 options are most strongly affected by buying pressure for index puts, while changes in implied volatility of stock options are dominated by call option demand. Simulated delta-neutral option-writing trading strategies generate abnormal returns that match the deviations of the IVFs above realized historical return volatilities.

Option‐Implied Risk Aversion Estimates

Abstract: Using a utility function to adjust the risk-neutral PDF embedded in cross sections of options, we obtain measures of the risk aversion implied in option prices. Using FTSE 100 and S&P 500 options, and both power and exponential-utility functions, we estimate the representative agent's relative risk aversion (RRA) at different horizons. The estimated coefficients of RRA are all reasonable. The RRA estimates are remarkably consistent across utility functions and across markets for given horizons. The degree of RRA declines broadly with the forecast horizon and is lower during periods of high market volatility.

Why Do Firms Use Incentives That Have No Incentive Effects

Abstract: This paper illustrates why firms might choose to implement stock option plans or other pay instruments that reward “luck.” I consider a model where adjusting compensation contracts is costly and where employees’ outside opportunities are correlated with their firms’ performance. The model may help to explain the use and recent rise of broad-based stock option plans, as well as other financial instruments, even when these pay plans have no effect on employees’ on-the-job behavior. The model suggests that agency theory’s often-overlooked participation constraint may be an important determinant of some common compensation schemes, particularly for employees below the highest executive ranks. MANY COMPENSATION PLANS REWARD or punish employees for factors they cannot control. An often-discussed example of this phenomenon is executive compensation (where stock options are not generally indexed to the overall market). However, many firms also offer firm-wide stock options and profit sharing plans that provide even weaker incentives than executive plans—after all, most workers can expect to reap trivial personal gain from their contribution to firm value or profits. I consider an explanation for this phenomenon in which firms contract with employees as a means of indexing wages to market rates rather than to provide incentives. While much of the agency literature has concentrated on inducing optimal effort, I consider the importance of the generally overlooked participation constraint. I study a model in which employees’ outside opportunities are correlated with firm profits or stock price, and in which both turnover and adjusting the pay scheme parameters are costly. Given these assumptions, the firm may find it most profitable to pay the employee in a way that is correlated with the outside options presented by the outside labor market (despite the requisite risk premium) rather than pay a fixed wage that insures participation in all states. The model derived below starts from the assumption that wage adjustments are costly, but that workers are willing to make part of their pay contingent

Remuneration, Retention, and Reputation Incentives for Outside Directors

Abstract: I study incentives received by outside directors in Fortune 500 firms from compensation, replacement, and the opportunity to obtain other directorships. Previous research has only shown these relations to apply under limited circumstances such as financial distress. Together these incentive mechanisms provide directors with wealth increases of approximately 11 cents per $1,000 rise in firm value. Although smaller than the performance sensitivities of CEOs, outside directors' incentives imply a change in wealth of about $285,000 for a 1 standard deviation (SD) change in typical firm performance. Cross-sectional patterns of director equity awards conform to agency and financial theories. WHAT CAUSES OUTSIDE DIRECTORS to monitor managers, rather than collude with them? Fama and Jensen (1983) posit the existence of a market for outside directors' services, conjecturing that "Our hypothesis is that outside directors have incentives to develop reputations as experts in decision control... They use their directorships to signal to internal and external markets for decision agents that they are experts... The signals are credible when the direct payments to outside directors are small, but there is substantial devaluation of human capital when internal decision control breaks down..." (p. 315). To date, most studies of the market for outside directors have focused on directors' accumulation of seats on additional boards, finding some evidence that fewer offers for new directorships are made to board members of firms that perform poorly. However, little research into outside directors has examined the most direct incentives-compensation and replacement-that form the backbone of rewards for company executives. Exceptions such as Gilson (1990) and Harford (2003) tend to focus on extreme circumstances, such as financial distress or hostile takeovers. For the vast majority of firms that do not face these crises, we have little evidence that outside directors face significant performance incentives. This paper investigates the range of incentives received by outside directors, studying a panel of 734 directors elected to the boards of Fortune 500 firms

Short‐Selling Prior to Earnings Announcements

Abstract: This paper examines short-sales transactions in the five days prior to earnings announcements of 913 Nasdaq-listed firms. The tests provide evidence of informed trading in pre-announcement short-selling because they reveal that abnormal short-selling is significantly linked to post-announcement stock returns. Also, the tests indicate that short-sellers typically are more active in stocks with low book-to-market valuations or low SUEs. The levels of pre-announcement short-selling, however, mostly appear to reflect firm-specific information rather than these fundamental financial characteristics. We believe that these results should encourage financial market regulators to consider providing more extensive and timely disclosures of short-selling to investors.

Forecast Dispersion and the Cross Section of Expected Returns

Abstract: Recent work by Diether, Malloy, and Scherbina (2002) has established a negative relationship between stock returns and the dispersion of analysts’ earnings forecasts. I offer a simple explanation for this phenomenon based on the interpretation of dispersion as a proxy for unpriced information risk arising when asset values are unobservable. The relationship then follows from a general options-pricing result: For a levered firm, expected returns should always decrease with the level of idiosyncratic asset risk. This story is formalized with a straightforward model. Reasonable parameter values produce large effects, and the theory’s main empirical prediction is supported in cross-sectional tests. IN AN INTRIGUING RECENT ARTICLE, Diether, Malloy, and Scherbina (2002) (hereafter DMS) document a new anomaly in the cross section of returns: Firms with more uncertain earnings (as measured by the dispersion of analysts’ forecasts) do worse. The finding is important in that it directly links asset returns with a quantitative measure of an economic primitive—information about fundamentals—but the sign of the relationship is apparently wrong. Rather than discounting uncertainty, investors appear to be paying a premium for it. This would seem to pose a formidable challenge to usual notions of efficiently functioning markets. This article argues that the challenge can be met. In fact, a simple, standard asset pricing model implies the DMS effect even when there is no cross-sectional relationship between dispersion of beliefs and fundamental risk. The logic relies on two elements. First, when fundamentals are unobservable, dispersion may proxy for idiosyncratic parameter risk. Second, for a levered firm, expected equity returns will in general decrease with the level of idiosyncratic asset risk due to convexity. I formalize this in a straightforward way. The story has some direct and distinguishing testable implications, which I take to the data. The empirical evidence is remarkably supportive. The theory offered here contrasts sharply with the explanation suggested by DMS. They view the negative relationship between forecast dispersion and subsequent returns as supportive of a story in which costly arbitrage leads

Corporate Investment and Asset Price Dynamics: Implications for the Cross-section of Returns

Abstract: We show that corporate investment decisions can explain the conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and the current product market demand. Book-to-market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data. CORPORATE INVESTMENT DECISIONS are often evaluated in a real options context, 1 and option exercise can change the riskiness of a firm in various ways. For example, if growth opportunities are finite, the decision to invest changes the ratio of growth options to assets in place. Additionally, the resulting increase in physical capital may generate operating leverage through long-term obligations, including the fixed operating costs of a larger plant, wage contracts, and commitments to suppliers. It is natural to conclude that expected returns might be related to current and historical investment decisions of the firm. The empirical literature has long recognized a need to account for the dynamic structure of risk when testing asset pricing models. 2 A small but