Showing papers in "Journal of Finance in 2007"

Giving Content to Investor Sentiment: The Role of Media in the Stock Market

Abstract: I quantitatively measure the interactions between the media and the stock market using daily content from a popular Wall Street Journal column. I find that high media pessimism predicts downward pressure on market prices followed by a reversion to fundamentals, and unusually high or low pessimism predicts high market trading volume. These and similar results are consistent with theoretical models of noise and liquidity traders, and are inconsistent with theories of media content as a proxy for new information about fundamental asset values, as a proxy for market volatility, or as a sideshow with no relationship to asset markets.

A Theory of Friendly Boards

Abstract: We analyze the consequences of the board's dual role as advisor as well as monitor of management. Given this dual role, the CEO faces a trade-off in disclosing information to the board: If he reveals his information, he receives better advice; however, an informed board will also monitor him more intensively. Since an independent board is a tougher monitor, the CEO may be reluctant to share information with it. Thus, management-friendly boards can be optimal. Using the insights from the model, we analyze the differences between sole and dual board systems. We highlight several policy implications of our analysis.

Information Asymmetry and Financing Arrangements: Evidence from Syndicated Loans

Abstract: I empirically explore the syndicated loan market, with an emphasis on how information asymmetry between lenders and borrowers influences syndicate structure and on which lenders become syndicate members. Consistent with moral hazard in monitoring, the lead bank retains a larger share of the loan and forms a more concentrated syndicate when the borrower requires more intense monitoring and due diligence. When information asymmetry between the borrower and lenders is potentially severe, participant lenders are closer to the borrower, both geographically and in terms of previous lending relationships. Lead bank and borrower reputation mitigates, but does not eliminate information asymmetry problems. SYNDICATED LOANS ARE A LARGE and increasingly important source of corporate finance. Nonfinancial U.S. businesses obtain almost $1 trillion in new syndicated loans each year, which represents approximately 15% of their aggregate debt outstanding, and of the largest 500 nonfinancial firms in the Compustat universe in 2002, almost 90% obtained a syndicated loan between 1994 and 2002. Indeed, according to the American Banker, syndicated lending represents 51% of U.S. corporate finance originated, and generates more underwriting revenue for the financial sector than both equity and debt underwriting (Weidner (2000)). The market for syndicated loans has also experienced strong growth, going from $137 million in 1987 to over $1 trillion today. However, despite the importance of syndicated loans, research on their role in U.S. corporate finance is limited. A syndicated loan is a loan whereby at least two lenders jointly offer funds to a borrowing firm. The “lead arranger” establishes a relationship with the firm, negotiates terms of the contract, and guarantees an amount for a price range.

Whom You Know Matters: Venture Capital Networks and Investment Performance

Abstract: Many financial markets are characterized by strong relationships and networks, rather than arm’s-length, spot market transactions. We examine the performance consequences of this organizational structure in the context of relationships established when VCs syndicate portfolio company investments. We find that better-networked VC firms experience significantly better fund performance, as measured by the proportion of investments that are successfully exited through an IPO or a sale to another company. Similarly, the portfolio companies of better-networked VCs are significantly more likely to survive to subsequent financing and eventual exit. We also provide initial evidence on the evolution of VC networks. NETWORKS ARE WIDESPREAD IN MANY FINANCIAL MARKETS. Bulge-bracket investment banks, for instance, make use of strong relationships with institutional investors when pricing and distributing corporate securities (Cornelli and Goldreich (2001)). In the corporate loan market, banks often prefer syndicating loans with other banks over being the sole lender. Similarly, in the primary equity and bond markets, banks tend to co-underwrite securities offerings with banks with which they have longstanding relationships (Ljungqvist, Marston, and Wilhelm (2005)). Networks also feature prominently in the venture capital (VC) industry. VCs tend to syndicate their investments with other VCs, rather than investing alone (Lerner (1994a)). They are thus bound by their current and past investments into webs of relationships with other VCs. Once they have invested in a company, VCs draw on their networks of service providers—head hunters, patent lawyers, investment bankers, etc.—to help the company succeed (Gorman and Sahlman (1989), and Sahlman (1990)). Indeed, one prominent VC goes as far

Corporate Governance and Acquirer Returns

Abstract: We examine whether corporate governance mechanisms, especially the market for corporate control, affect the profitability of firm acquisitions. We find that acquirers with more antitakeover provisions experience significantly lower announcementperiod abnormal stock returns. This supports the hypothesis that managers at firms protected by more antitakeover provisions are less subject to the disciplinary power of the market for corporate control and thus are more likely to indulge in empire-building acquisitions that destroy shareholder value. We also find that acquirers operating in more competitive industries or separating the positions of CEO and chairman of the board experience higher abnormal announcement returns. FOLLOWING A STRING OF CORPORATE SCANDALS in the United States, legislators and regulators rushed to enact corporate governance reforms, which resulted in the passage of the Sarbanes-Oxley Act of 2002. Yet, these reforms were instituted with little scientific evidence to support their purported benefits. As the impact of these reforms continues to be strongly felt, with further reforms likely in the future, it is of great economic import to understand how major corporate governance mechanisms affect shareholder wealth. A series of recent studies by Gompers, Ishii, and Metrick (GIM, 2003), Bebchuk, Cohen, and Ferrell (BCF, 2004), Bebchuk and Cohen (2005), and Cremers and Nair (2005) examine one important dimension of corporate governance, namely, the market for corporate control. They document negative relations between various indices of antitakeover provisions (ATPs) and both firm value and

How Costly Is External Financing? Evidence from a Structural Estimation

Abstract: We apply simulated method of moments to a dynamic model to infer the magnitude of financing costs. The model features endogenous investment, distributions, leverage, and default. The corporation faces taxation, costly bankruptcy, and linear-quadratic equity flotation costs. For large (small) firms, estimated marginal equity flotation costs start at 5.0% (10.7%) and bankruptcy costs equal to 8.4% (15.1%) of capital. Estimated financing frictions are higher for low-dividend firms and those identified as constrained by the Cleary and Whited-Wu indexes. In simulated data, many common proxies for financing constraints actually decrease when we increase financing cost parameters. CORPORATE FINANCE IS PRIMARILY THE STUDY OF FINANCING FRICTIONS. After all,

Sports Sentiment and Stock Returns

Abstract: This paper investigates the stock market reaction to sudden changes in investor mood. Motivated by psychological evidence of a strong link between soccer outcomes and mood, we use international soccer results as our primary mood variable. We find a significant market decline after soccer losses. For example, a loss in the World Cup elimination stage leads to a next-day abnormal stock return of −49 basis points. This loss effect is stronger in small stocks and in more important games, and is robust to methodological changes. We also document a loss effect after international cricket, rugby, and basketball games. THIS PAPER EMPLOYS A NOVEL MOOD VARIABLE, international soccer results, to investigate the effect of investor sentiment on asset prices. Using a cross-section of 39 countries, we find that losses in soccer matches have an economically and statistically significant negative effect on the losing country’s stock market. For example, elimination from a major international soccer tournament is associated with a next-day return on the national stock market index that is 38 basis points lower than average. We also document a loss effect after international cricket, rugby, and basketball games. On average, the effect is smaller in magnitude for these other sports than for soccer, but is still economically and statistically significant. We find no evidence of a corresponding effect after wins for any of the sports that we study. Controlling for the pre-game expected outcome, we are able to reject the hypothesis that the loss effect after soccer games is driven by economic factors such as reduced productivity or lost revenues. We

Corporate Bond Market Transaction Costs and Transparency

Abstract: Using a complete record of U.S. over-the-counter (OTC) secondary trades in corporate bonds, we estimate average transaction costs as a function of trade size for each bond that traded more than nine times between January 2003 and January 2005. We find that transaction costs decrease significantly with trade size. Highly rated bonds, recently issued bonds, and bonds close to maturity have lower transaction costs than do other bonds. Costs are lower for bonds with transparent trade prices, and they drop when the TRACE system starts to publicly disseminate their prices. The results suggest that public traders benefit significantly from price transparency.

Corporate Yield Spreads and Bond Liquidity

Abstract: We find that liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4,000 corporate bonds and spanning both investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads, and an improvement in liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond-specific, firm-specific, and macroeconomic variables, and are robust to issuers' fixed effect and potential endogeneity bias. Our findings justify the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants.

How Laws and Institutions Shape Financial Contracts: The Case of Bank Loans

Abstract: Legal and institutional differences shape the ownership and terms of bank loans across the world. We show that under strong creditor protection, loans have more concentrated ownership, longer maturities, and lower interest rates. Moreover, the impact of creditor rights on loans depends on borrower characteristics such as the size and tangibility of assets. Foreign banks appear especially sensitive to the legal and institutional environment, with their ownership declining relative to domestic banks as creditor protection falls. Our multidimensional empirical model paints a more complete picture of how financial contracts respond to the legal and institutional environment than existing studies.

Growth Opportunities and the Choice of Leverage, Debt Maturity, and Covenants

Abstract: We investigate the effect of growth opportunities in a firm's investment opportunity set on its joint choice of leverage, debt maturity, and covenants. Using a database that contains detailed debt covenant information, we provide large-sample evidence of the incidence of covenants in public debt and construct firm-level indices of bondholder covenant protection. We find that covenant protection is increasing in growth opportunities, debt maturity, and leverage. We also document that the negative relation between leverage and growth opportunities is significantly attenuated by covenant protection, suggesting that covenants can mitigate the agency costs of debt for high growth firms.

How Smart Is Smart Money? A Two‐Sided Matching Model of Venture Capital

Abstract: I find that companies funded by more experienced VCs are more likely to go public. This follows both from the direct influence of more experienced VCs and from sorting in the market, which leads experienced VCs to invest in better companies. Sorting creates an endogeneity problem, but a structural model based on a two-sided matching model is able to exploit the characteristics of the other agents in the market to separately identify and estimate influence and sorting. Both effects are found to be significant, with sorting almost twice as important as influence for the difference in IPO rates.

Model specification and risk premia: evidence from futures options

Abstract: This paper examines model specification issues and estimates diffusive and jump risk premia using S&P futures option prices from 1987 to 2003. We first develop a time series test to detect the presence of jumps in volatility, and find strong evidence in support of their presence. Next, using the cross section of option prices, we find strong evidence for jumps in prices and modest evidence for jumps in volatility based on model fit. The evidence points toward economically and statistically significant jump risk premia, which are important for understanding option returns.

Do Tests of Capital Structure Theory Mean What They Say

Abstract: In the presence of frictions, firms adjust their capital structure infrequently. As a consequence, in a dynamic economy the leverage of most firms is likely to differ from the “optimum” leverage at the time of readjustment. This paper explores the empirical implications of this observation. I use a calibrated dynamic trade-off model to simulate firms' capital structure paths. The results of standard cross-sectional tests on these data are consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results leads to the rejection of the underlying model. Taken together, the results suggest a rethinking of the way capital structure tests are conducted.

Decoupling CEO Wealth and Firm Performance: The Case of Acquiring CEOs

Abstract: We explore how compensation policies following mergers affect a CEO's incentives to pursue a merger. We find that even in mergers where bidding shareholders are worse off, bidding CEOs are better off three quarters of the time. Following a merger, a CEO's pay and overall wealth become insensitive to negative stock performance, but a CEO's wealth rises in step with positive stock performance. Corporate governance matters; bidding firms with stronger boards retain the sensitivity of their CEOs' compensation to poor performance following the merger. In comparison, we find that CEOs are not rewarded for undertaking major capital expenditures.

Efficiency and the Bear: Short Sales and Markets Around the World

Abstract: We analyze cross-sectional and time-series information from 46 equity markets around the world to consider whether short sales restrictions affect the efficiency of the market and the distributional characteristics of returns to individual stocks and market indices. We find some evidence that prices incorporate negative information faster in countries where short sales are allowed and practiced. A common conjecture by regulators is that short sales restrictions can reduce the relative severity of a market panic. We find strong evidence that in markets where short selling is either prohibited or not practiced, market returns display significantly less negative skewness.

Corporate Governance and Firm Value: The Impact of the 2002 Governance Rules

Abstract: The 2001 to 2002 corporate scandals led to the Sarbanes‐Oxley Act and to various amendments to the U.S. stock exchanges’ regulations. We find that the announcement of these rules has a significant effect on firm value. Firms that are less compliant with the provisions of the rules earn positive abnormal returns compared to firms that are more compliant. We also find variation in the response across firm size. Large firms that are less compliant earn positive abnormal returns but small firms that are less compliant earn negative abnormal returns, suggesting that some provisions are detrimental to small firms. THE HIGH-PROFILE CORPORATE FAILURES IN THE UNITED STATES over the 2001‐2002 period have led to the Sarbanes‐Oxley Act of 2002 (SOX) and to various amendments to the stock exchanges’ regulations. These rules include different provisions whose purpose is to ensure alignment of incentives of corporate insiders with those of investors, and to reduce the likelihood of corporate misconduct and fraud. For example, SOX imposes higher penalties on officers who are charged with forging documents and requires more timely disclosure of equity transactions by corporate insiders. It also requires independence of audit committees, certification of financial statements by the chief executive officer and the chief financial officer, procedures to evaluate the effectiveness of the firms’ internal controls and increased oversight over audit firms. The exchange regulations require a majority of independent directors on corporate boards and independence of the board committees that choose new directors and compensate managers. Proponents of the rules argue that such rules are necessary because the corporate scandals indicate that existing monitoring mechanisms in U.S. public corporations should be improved. Yet, it is not clear whether the provisions of the rules indeed lead to more effective monitoring and to higher corporate value. To the extent that these provisions are only cosmetic in nature, they might not have any material effect on firm value. But even if the provisions have an effect, it is not clear whether all firms should benefit from them. Optimal governance structure depends both on a firm’s monitoring needs and the costs and benefits of different monitoring mechanisms. To the extent that these costs and benefits vary across firms and

Banking Deregulation and Industry Structure: Evidence from the French Banking Reforms of 1985

Abstract: We investigate how the deregulation of the French banking industry in the 1980s affected the real behavior of firms and the structure and dynamics of product markets. Following deregulation, banks are less willing to bail out poorly performing firms and firms in the more bank-dependent sectors are more likely to undertake restructuring activities. At the industry level, we observe an increase in asset and job reallocation, an improvement in allocative efficiency across firms, and a decline in concentration. Overall, these findings support the view that a more efficient banking sector helps foster a Schumpeterian process of “creative destruction.” MANY ECONOMIES AROUND THE WORLD are characterized by heavily regulated bank

Short-Sales Constraints and Price Discovery: Evidence from the Hong Kong Market

Abstract: Short-sales practices in the Hong Kong stock market are unique in that only stocks on a list of designated securities can be sold short. By analyzing the price effects following the addition of individual stocks to the list, we find that short-sales constraints tend to cause stock overvaluation and that the overvaluation effect is more dramatic for individual stocks for which wider dispersion of investor opinions exists. These findings are consistent with Miller's (1977) intuition and other optimism models. We also document higher volatility and less positive skewness of individual stock returns when short sales are allowed. THE QUESTION OF HOW SHORT SALES IMPACT capital markets is highly controversial, with short-sale regulations varying widely across countries and capital markets.1 Although short selling has been carried out for years in major financial markets around the world, its effects on market efficiency, especially on pricing efficiency, remain of interest to financial researchers. Miller (1977) theorizes that in the presence of short-sales constraints, security prices tend to reflect a more optimistic valuation than the average opinion of potential investors and thus tend to be upward biased. This overvaluation argument is based on two conditions: (1) A security's short sales are either prohibited or costly, and (2) investors have heterogeneous beliefs or information about the security's value. The underlying intuition is quite straightforward. Pessimistic investors are forced to sit out of the market when short sales are not available, and thus some negative information is not reflected in prices, enabling enthusiastic buyers to bid prices above the level that average investors perceive as fair. This argument has significant implications for market efficiency theories, since one of the major functions of capital markets is price discovery. Indeed, an efficient market should be "a market in which prices always

On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing

Abstract: We investigate the empirical implications of using various measures of payout yield rather than dividend yield for asset pricing models. We find statistically and economically significant predictability in the time series when payout (dividends plus repurchases) and net payout (dividends plus repurchases minus issuances) yields are used instead of the dividend yield. Similarly, we find that payout (net payout) yields contains information about the cross section of expected stock returns exceeding that of dividend yields, and that the high minus low payout yield portfolio is a priced factor. WHILE THE IRRELEVANCE THEOREM of Miller and Modigliani (1961) implies that there is no reason to suspect that dividends play a role in determining equity price levels or equity returns, the theorem is silent on the usefulness of dividends in explaining these variables. It is then, perhaps, not surprising that there is a considerable literature exploiting the properties of dividends and dividend yields to better understand the fundamentals of asset pricing both in the time series and in the cross section. Motivation for the former comes from variations of the Gordon growth model in which dividend yields can be written as the return minus the dividend’s growth rate (see, e.g., Fama and French (1988)), from consumption-based asset pricing models in which the firm’s dividends covary with aggregate consumption (e.g., Lucas (1978) and Shiller (1981)), and so forth. Additional motivation comes from cross-sectional heterogeneity in tax, agency, and asymmetric information considerations (e.g., Litzenberger and Ramaswamy (1979), Jensen (1986), John and Williams (1985), Allen, Bernardo, and Welch (2000), and Grullon, Michaely, and Swaminathan (2002)). We propose that this underlying motivation really refers to distributed cash flow going to equity holders, be it in the form of dividends or anything that

Common Failings: How Corporate Defaults are Correlated

Abstract: We test the doubly stochastic assumption under which firms’ default times are correlated only as implied by the correlation of factors determining their default intensities. Using data on U.S. corporations from 1979 to 2004, this assumption is violated in the presence of contagion or “frailty” (unobservable explanatory variables that are correlated across firms). Our tests do not depend on the time-series properties of default intensities. The data do not support the joint hypothesis of well-specified default intensities and the doubly stochastic assumption. We find some evidence of default clustering exceeding that implied by the doubly stochastic model with the given intensities. WHY DO CORPORATE DEFAULTS CLUSTER IN TIME? Several explanations have been explored. First, firms may be exposed to common or correlated risk factors whose co-movements cause correlated changes in conditional default probabilities. Second, the event of default by one firm may be “contagious,” in that one such event may directly induce other corporate failures, as with the collapse of Penn Central Railway in 1970. Third, learning from default may generate default correlation. For example, to the extent that the defaults of Enron and WorldCom revealed accounting irregularities that could be present in other firms, they may have had a direct impact on the conditional default probabilities of other firms. Our primary objective is to examine whether cross-firm default correlation that is associated with observable factors determining conditional default probabilities (the first channel on its own) is sufficient to account for the degree of time clustering in defaults that we find in the data.

Corporate Governance, Idiosyncratic Risk, and Information Flow

Abstract: We study the relationship of corporate governance policy and idiosyncratic risk. Firms with fewer antitakeover provisions display higher levels of idiosyncratic risk, trading activity, private information flow, and information about future earnings in stock prices. Trading interest by institutions, especially those active in merger arbitrage, strengthens the relationship of governance to idiosyncratic risk. Our results indicate that openness to the market for corporate control leads to more informative stock prices by encouraging collection of and trading on private information. Consistent with an information-flow interpretation, the component of volatility unrelated to governance is associated with the efficiency of corporate investment. THE EFFECT OF CORPORATE GOVERNANCE on equity prices and the distribution of returns is an important issue in corporate finance. Gompers, Ishii, and Metrick (2003) and Cremers and Nair (2005) find that governance can directly influence equity prices. These and other authors generally posit that management constraints and incentives are the mechanisms through which governance influences prices. Any systematic effect on returns, however, also requires a link between governance provisions and investors’ expectations or information. For instance, Gompers et al. (2003) argue that in the early 1990s, investors might not have fully appreciated the agency costs engendered by weak governance. This paper extends the current understanding by showing how governance provisions and informed trading interact to influence the incorporation of information into stock prices. We test a trading link hypothesis, showing how specific aspects of governance that influence takeover vulnerability impact stock price informativeness. In particular, we focus on the specific path through the trading volume of arbitrage-oriented institutional investors. We reason that the absence of antitakeover provisions creates incentives to collect private information, which is a central determinant of idiosyncratic volatility. When trading activity is generated, it contributes to this idiosyncratic volatility and to other indications of

Portfolio Choice over the Life-Cycle when the Stock and Labor Markets are Cointegrated

Abstract: We study portfolio choice when labor income and dividends are cointegrated. Economically plausible calibrations suggest young investors should take substantial short positions in the stock market. Because of cointegration the young agent’s human capital efiectively becomes \stock-like." However, for older agents with shorter times-to-retirement, cointegration does not have su‐cient time to act, and thus their human capital becomes more \bond-like." Together, these efiects create hump-shaped life-cycle portfolio holdings, consistent with empirical observation. These results hold even when asset return predictability is accounted for.

Pay Me Later: Inside Debt and Its Role in Managerial Compensation

Abstract: Though widely used in executive compensation, inside debt has been almost entirely overlooked by prior work. We initiate this research by studying CEO pension arrangements in 237 large capitalization firms. Among our findings are that CEO compensation exhibits a balance between debt and equity incentives; the balance shifts systematically away from equity and toward debt as CEOs grow older; annual increases in pension entitlements represent about 10% of overall CEO compensation, and about 13% for CEOs aged 61–65; CEOs with high debt incentives manage their firms conservatively; and pension compensation influences patterns of CEO turnover and cash compensation.

Why Is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium

Abstract: We propose a dynamic risk-based model that captures the value premium. Firms are modeled as long-lived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model implies that growth firms covary more with the discount rate than do value firms, which covary more with cash flows. When calibrated to explain aggregate stock market behavior, the model accounts for the observed value premium, the high Sharpe ratios on value firms, and the poor performance of the CAPM. THIS PAPER PROPOSES A DYNAMIC RISK-BASED MODEL that captures both the high expected returns on value stocks relative to growth stocks, and the failure of the capital asset pricing model to explain these expected returns. The value premium, first noted by Graham and Dodd (1934), is the finding that assets with a high ratio of price to fundamentals (growth stocks) have low expected returns relative to assets with a low ratio of price to fundamentals (value stocks). This finding by itself is not necessarily surprising, as it is possible that the premium on value stocks represents compensation for bearing systematic risk. However, Fama and French (1992) and others show that the capital asset pricing model (CAPM) of Sharpe (1964) and Lintner (1965) cannot account for the value premium: While the CAPM predicts that expected returns should rise with the beta on the market portfolio, value stocks have higher expected returns yet do not have higher betas than growth stocks. To model the difference between value and growth stocks, we introduce a cross-section of long-lived firms distinguished by the timing of their cash flows. Firms with cash flows weighted more to the future endogenously have high price ratios, while firms with cash flows weighted more to the present have low price ratios. Analogous to long-term bonds, growth firms are high-duration ∗ Lettau is at the Stern School of Business at New York University. Wachter is at the Wharton

How Are Firms Sold

Abstract: As measured by the number of bidders that publicly attempt to acquire a target, the takeover arena in the 1990s appears noncompetitive. However, we provide novel data on the pre-public, private takeover process that indicates that public takeover activity is only the tip of the iceberg of actual takeover competition during the 1990s. We show a highly competitive market where half of the targets are auctioned among multiple bidders, while the remainder negotiate with a single bidder. In event study analysis, we find that the wealth effects for target shareholders are comparable in auctions and negotiations. THE TRADITIONAL MEASURE OF COMPETITION in a corporate takeover is the number of bidders that publicly attempt to acquire the target. Using this measure, many notable researchers report that the takeover market during the 1990s was not very competitive. For instance, Andrade, Mitchell, and Stafford (2001) describe the prototypical takeover in the 1990s as a friendly transaction with only one bidding firm. Similarly, Schwert (2000) reports that the 1990s witnessed far fewer public takeover auctions than previous time periods, and argues that this was due to the growing use of poison pills and the imposition of state antitakeover laws. More recent research such as Hartzell, Ofek, and Yermack (2004), Moeller (2005), and Wulf (2004) suggests that target managers used their growing bargaining power in the 1990s to negotiate sweet deals for themselves at the expense of their shareholders. In this paper, we present a new measure of takeover competition that indicates that the takeover market during the 1990s was actually quite competitive. Using data from SEC merger documents, we provide a novel depiction of the method by which firms are sold and we demonstrate the existence of an active takeover market that takes place prior to the public announcement of takeover deals. For a sample of 400 takeovers from the 1990s representing over $1 trillion

Participation Costs and the Sensitivity of Fund Flows to Past Performance

Abstract: We present a simple rational model to highlight the effect of investors’ participation costs on the response of mutual fund flows to past fund performance. By incorporating participation costs into a model in which investors learn about managers’ ability from past returns, we show that mutual funds with lower participation costs have a higher flow sensitivity to medium performance and a lower flow sensitivity to high performance than their higher-cost peers. Using various fund characteristics as proxies for the reduction in participation costs, we provide empirical evidence supporting the model’s implications for the asymmetric flow-performance relationship. MANY RESEARCHERS DOCUMENT AN asymmetric relationship between mutual fund flows and past performance: Funds with superior recent performance enjoy disproportionately large new money inflows, while funds with poor performance suffer smaller outflows. 1 Moreover, fund characteristics such as age, volatility of past performance, affiliation with a large or “star”-producing fund complex, and marketing expenditures affect both the level of fund flows and the sensitivity of flows to past performance. 2 In this paper, we develop a rational model to explain simultaneously the asymmetric response of fund flows to past performance and

Why Do Firms Issue Equity

Abstract: We develop and test a new theory of security issuance that is consistent with the puzzling stylized fact that firms issue equity when their stock prices are high. The theory also generates new predictions. Our theory predicts that managers use equity to finance projects when they believe that investors’ views about project payoffs are likely to be aligned with theirs, thus maximizing the likelihood of agreement with investors. Otherwise, they use debt. We find strong empirical support for our theory and document its incremental explanatory power over other security-issuance theories such as market timing and time-varying adverse selection. A CENTRAL QUESTION IN CORPORATE FINANCE IS: Why and when do firms issue equity? Recent empirical papers have exposed significant gaps between the stylized facts and theories of security issuance and capital structure, so we seem to lack a coherent answer to this question. Our purpose is to develop a new theory of security issuance that is consistent with these difficult-to-explain stylized facts. One empirical regularity is the genesis of the current debate: Firms issue equity when their stock prices are high. This fact is inconsistent with the two main theories of security issuance and capital structure: tradeoff and pecking order. The tradeoff theory asserts that a firm’s security issuance decisions move its capital structure toward an optimum that is determined by a tradeoff between the marginal costs (bankruptcy and agency costs) and benefits (debt tax shields and reduction of free cash flow problems) of debt. Thus, an increase in a firm’s stock price, which effectively lowers its leverage ratio, should lead to debt issuance. However, the evidence suggests the opposite is true. While CEOs do consider stock prices to be a key factor in security issuance decisions (Graham and Harvey (2001)), firms issue equity rather than debt when stock prices are high (e.g., Asquith and Mullins (1986), Baker and Wurgler (2002), Jung, Kim, and Stulz (1996), Marsh (1982), and Mikkelson and Partch (1986)). Moreover, Welch (2004) finds that firms let their leverage ratios drift with their stock

Analyst Disagreement, Mispricing, and Liquidity*

Abstract: Examining returns of stocks with high levels of analyst disagreement about future earnings reveals a close link between mispricing and liquidity. Previous research finds these stocks often to be overpriced, but prices to correct down within a fiscal year as uncertainty about earnings is resolved. We conjecture that one reason mispricing has persisted is that these stocks have higher trading costs than otherwise similar stocks, possibly because some investors are better informed than the market maker about how to aggregate analysts’ opinions. As analyst disagreement increases so does the informational disadvantage of the marker maker, and trading costs rise. In the cross-section, less liquid stocks are, on average, more severely mispriced. Moreover, increases in aggregate market liquidity accelerate convergence of prices to fundamentals. As a result, returns of initially overpriced stocks are negatively correlated with the time series of innovations in aggregate market liquidity.

Lower Salaries and No Options? On the Optimal Structure of Executive Pay

Abstract: We estimate a standard principal agent model with constant relative risk aversion and lognormal stock prices for a sample of 598 US CEOs. The model is widely used in the compensation literature, but it predicts that almost all of the CEOs in our sample should hold no stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies. For a typical value of relative risk aversion, almost half of the CEOs in our sample would be required to purchase additional stock in their companies from their private savings. The model predicts contracts that would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We investigate a number of extensions and modi.cations of the standard model, but .nd none of them to be satisfactory. We conclude that the standard principal agent model typically used in the literature cannot rationalize observed contracts. One reason may be that executive pay contracts are suboptimal.