Showing papers in "Journal of Finance in 2011"

When Is a Liability Not a Liability? Textual Analysis, Dictionaries, and 10‐Ks

Abstract: Previous research uses negative word counts to measure the tone of a text. We show that word lists developed for other disciplines misclassify common words in financial text. In a large sample of 10-Ks during 1994 to 2008, almost three-fourths of the words identified as negative by the widely used Harvard Dictionary are words typically not considered negative in financial contexts. We develop an alternative negative word list, along with five other word lists, that better reflect tone in financial text. We link the word lists to 10-K filing returns, trading volume, return volatility, fraud, material weakness, and unexpected earnings.

In Search of Attention

Abstract: We propose a new and direct measure of investor attention using search frequency in Google (Search Volume Index (SVI)). In a sample of Russell 3000 stocks from 2004 to 2008, we find that SVI (1) is correlated with but different from existing proxies of investor attention; (2) captures investor attention in a more timely fashion and (3) likely measures the attention of retail investors. An increase in SVI predicts higher stock prices in the next 2 weeks and an eventual price reversal within the year. It also contributes to the large first-day return and long-run underperformance of IPO stocks.

Presidential Address: Discount Rates

Abstract: Discount-rate variation is the central organizing question of current asset-pricing research. I survey facts, theories, and applications. Previously, we thought returns were unpredictable, with variation in price-dividend ratios due to variation in expected cashflows. Now it seems all price-dividend variation corresponds to discount-rate variation. We also thought that the cross-section of expected returns came from the CAPM. Now we have a zoo of new factors. I categorize discount-rate theories based on central ingredients and data sources. Incorporating discount-rate variation affects finance applications, including portfolio theory, accounting, cost of capital, capital structure, compensation, and macroeconomics.

Does Algorithmic Trading Improve Liquidity

Abstract: Algorithmic trading (AT) has increased sharply over the past decade. Does it improve market quality, and should it be encouraged? We provide the first analysis of this question. The New York Stock Exchange automated quote dissemination in 2003, and we use this change in market structure that increases AT as an exogenous instrument to measure the causal effect of AT on liquidity. For large stocks in particular, AT narrows spreads, reduces adverse selection, and reduces trade-related price discovery. The findings indicate that AT improves liquidity and enhances the informativeness of quotes. TECHNOLOGICAL CHANGE HAS REVOLUTIONIZED the way financial assets are traded. Every step of the trading process, from order entry to trading venue to back office, is now highly automated, dramatically reducing the costs incurred by intermediaries. By reducing the frictions and costs of trading, technology has the potential to enable more efficient risk sharing, facilitate hedging, improve liquidity, and make prices more efficient. This could ultimately reduce firms’ cost of capital. Algorithmic trading (AT) is a dramatic example of this far-reaching technological change. Many market participants now employ AT, commonly defined as the use of computer algorithms to automatically make certain trading decisions, submit orders, and manage those orders after submission. From a starting point near zero in the mid-1990s, AT is thought to be responsible for

Overconfidence and Early-life Experiences: The Impact of Managerial Traits on Corporate Financial Policies

Abstract: We show that measurable managerial characteristics have significant explanatory power for corporate financing decisions. First, managers who believe that their firm is undervalued view external financing as overpriced, especially equity financing. Such overconfident managers use less external finance and, conditional on accessing external capital, issue less equity than their peers. Second, CEOs who grew up during the Great Depression are averse to debt and lean excessively on internal finance. Third, CEOs with military experience pursue more aggressive policies, including heightened leverage. Complementary measures of CEO traits based on press portrayals confirm the results.

The Illiquidity of Corporate Bonds

Abstract: This paper examines the illiquidity of corporate bonds and its asset-pricing implications. Using transactions data from 2003 to 2009, we show that the illiquidity in corporate bonds is substantial, significantly greater than what can be explained by bid–ask spreads. We establish a strong link between bond illiquidity and bond prices. In aggregate, changes in market-level illiquidity explain a substantial part of the time variation in yield spreads of high-rated (AAA through A) bonds, overshadowing the credit risk component. In the cross-section, the bond-level illiquidity measure explains individual bond yield spreads with large economic significance.

Corporate Governance, Product Market Competition, and Equity Prices

Abstract: This paper examines whether firms in noncompetitive industries benefit more from good governance than do firms in competitive industries. We find that weak governance firms have lower equity returns, worse operating performance, and lower firm value, but only in noncompetitive industries. When exploring the causes of the inefficiency, we find that weak governance firms have lower labor productivity and higher input costs, and make more value-destroying acquisitions, but, again, only in noncompetitive industries. We also find that weak governance firms in noncompetitive industries are more likely to be targeted by activist hedge funds, suggesting that investors take actions to mitigate the inefficiency. ECONOMISTS OFTEN ARGUE THATmanagersoffirmsincompetitiveindustrieshave strong incentives to reduce slack and maximize profits, or else the firm will go out of business. 1 Accordingly, the need to provide managers with incentives throughgoodgovernance—and thusthebenefitsofgoodgovernance—should be smaller for firms in competitive industries. In contrast, firms in noncompetitive industries, where lack of competitive pressure fails to enforce discipline on managers, should benefit relatively more from good governance. That firms with good governance have better performance on average is well established. In a seminal article, Gompers, Ishii, and Metrick (2003, GIM) find that a hedge portfolio that is long in good governance firms (“Democracy firms”) and short in weak governance firms (“Dictatorship firms”) earns a monthly alpha of 0.71%. Governance is measured using the G-index, which consists of 24 antitakeover and shareholder rights provisions. In addition to showing that good governance is associated with higher equity returns, GIM also show that it is associated with both higher firm value and better operating performance. 2 ∗ Giroud is at the NYU Stern School of Business. Mueller is at the NYU Stern School of Business, NBER, CEPR, and ECGI. We thank Cam Harvey (the Editor), an associate editor, two anonymous referees, and seminar participants at NYU, Yale, Michigan, Illinois, the WFA Meetings in San Diego (2009), and the Harvard Law School/Sloan Foundation Corporate Governance Research Conference (2009) for helpful comments. We are especially grateful to Wei Jiang and Martijn Cremers for providing us with data.

The Causal Impact of Media in Financial Markets

Abstract: Disentangling the causal impact of media reporting from the impact of the events being reported is challenging. We solve this problem by comparing the behaviors of investors with access to different media coverage of the same information event. We use zip codes to identify 19 mutually exclusive trading regions corresponding with large U.S. cities. For all earnings announcements of S&P 500 Index firms, we find that local media coverage strongly predicts local trading, after controlling for earnings, investor, and newspaper characteristics. Moreover, local trading is strongly related to the timing of local reporting, a particular challenge to nonmedia explanations.

Prices or knowledge? What drives demand for financial services in emerging markets?

Abstract: This brief summarizes the results of a gender impact evaluation study, entitled Prices or knowledge? What drives demand for financial services in emerging markets? Conducted in 2008 in Indonesia. The study observed that financial development is critical for growth, but its micro determinants are not well understood. Financial literacy training has no impact on the probability of opening a bank account, although it does have an impact among those with low levels of education and financial literacy. A change from $3 to $14 led to a 7.6 percent increase in the probability of owning a bank account. The results hold two years after a study. Funding for the study derived from World Bank, HBS Division of Research and Faculty Development.

Tails, Fears, and Risk Premia

Abstract: We show that the compensation for rare events accounts for a large fraction of the average equity and variance risk premia. Exploiting the special structure of the jump tails and the pricing thereof, we identify and estimate a new Investor Fears index. The index reveals large time-varying compensation for fears of disasters. Our empirical investigations involve new extreme value theory approximations and high-frequency intraday data for estimating the expected jump tails under the statistical probability measure, and short maturity out-of-the-money options and new model-free implied variation measures for estimating the corresponding risk-neutral expectations.

Investment, Idiosyncratic Risk, and Ownership

Abstract: We find a significant negative effect of idiosyncratic stock-return volatility on investment. We address the endogeneity problem of stock return volatility by instrumenting for volatility with a measure of a firm's customer base concentration. We propose that the negative effect of idiosyncratic risk on investment is partly due to managerial risk aversion, and find that the negative relationship between idiosyncratic uncertainty and investment is stronger for firms with high levels of insider ownership. Several mecha nisms can mitigate this effect namely the use of option-based compensation and shareholder monitoring. We find that the investment-idiosyncratic relationship is weaker for firms that make use of option-based compensation, and insider ownership does not matter for firms primarily held by institutional investors.

Stock Market Liquidity and the Business Cycle

Abstract: In the recent financial crisis we saw liquidity in the stock market drying up as a precursor to the crisis in the real economy. We show that such effects are not new; in fact, we find a strong relation between stock market liquidity and the business cycle. We also show that investors' portfolio compositions change with the business cycle and that investor participation is related to market liquidity This suggests that systematic liquidity variation is related to a "flight to quality" during economic down? turns. Overall, our results provide a new explanation for the observed commonality in liquidity. In discussions of the current financial crisis, much is made of the apparent causality between a decline in the liquidity of financial assets and the economic crisis. In this paper we show that such effects are not new; changes in the liquidity of the U.S. stock market have been coinciding with changes in the real economy at least since the Second World War. In fact, stock market liquidity is a very good "leading indicator" of the real economy. Using data for the United States over the period 1947 to 2008, we document that measures of stock market liquidity contain leading information about the real economy, even after controlling for other asset price predictors. Figure 1 provides a time-series plot of one measure of market liquidity, the Amihud (2002) measure, together with the National Bureau of Economic Research (NBER) recession periods (gray bars). This figure illustrates the re? lationship found between stock market liquidity and the business cycle. As can be seen from the figure, liquidity clearly worsens (illiquidity increases) well ahead of the onset of the NBER recessions. Our results are relevant for several strands of the literature. One impor? tant strand is the literature on forecasting economic growth using different asset prices, including interest rates, term spreads, stock returns, and ex? change rates. The forward-looking nature of asset markets makes the use *Randi Naes is at the Norwegian Ministry of Trade and Industry Johannes A. Skjeltorp is at Norges Bank (the Central Bank of Norway). Bernt Arne 0degaard is at the University of Stavanger, Norges Bank, and Norwegian School of Management. We are grateful for comments from an anonymous referee, an associate editor, and our Editor (Campbell Harvey). We also thank Kristian Miltersen, Luis Viceira, and seminar participants at the fourth Annual Central Bank

A Unified Theory of Tobin's q, Corporate Investment, Financing, and Risk Management

Abstract: We propose a model of dynamic investment, financing, and risk management for financially constrained firms. The model highlights the central importance of the endogenous marginal value of liquidity (cash and credit line) for corporate decisions. Our three main results are: (1) investment depends on the ratio of marginal q to the marginal value of liquidity, and the relation between investment and marginal q changes with the marginal source of funding; (2) optimal external financing and payout are characterized by an endogenous double-barrier policy for the firm's cash-capital ratio; and (3) liquidity management and derivatives hedging are complementary risk management tools.

Are Incentive Contracts Rigged by Powerful CEOs

Abstract: We argue that some powerful CEOs induce boards to shift the weight on performance measures toward the better performing measures, thereby rigging incentive pay. A simple model formalizes this intuition and gives an explicit structural form on the rigged incentive portion of CEO wage function. Using U.S. data, we find support for the model's predictions: rigging accounts for at least 10% of the compensation to performance sensitivity and it increases with CEO human capital and firm volatility. Moreover, a firm with rigged incentive pay that is one standard deviation above the mean faces a subsequent decrease of 4.8% in firm value and 7.5% in operating return on assets.

IQ and stock market participation

Abstract: Stock market participation is monotonically related to IQ, controlling for wealth, income, age, and other demographic and occupational information. The high correlation between IQ and participation exists even among the affluent. Supplemental data from siblings, studied with an instrumental variables approach and regressions that control for family effects, demonstrate that IQ’s influence on participation extends to females and does not arise from omitted familial and nonfamilial variables. High-IQ investors are more likely to hold mutual funds and larger numbers of stocks, experience lower risk, and earn higher Sharpe ratios. We discuss implications for policy and finance research.

Private Equity and Long‐Run Investment: The Case of Innovation

Abstract: a long-standing controversy is whether leveraged buyouts (LBOs) relieve managers from short-term pressures from public shareholders, or whether LBO funds them? selves sacrifice long-term growth to boost short-term performance. We examine one form of long-run activity, namely, investments in innovation as measured by patent? ing activity. Based on 472 LBO transactions, we find no evidence that LBOs sacrifice long-term investments. LBO firm patents are more cited (a proxy for economic impor? tance), show no shifts in the fundamental nature of the research, and become more concentrated in important areas of companies' innovative portfolios. In his influential 1989 paper, "The Eclipse of the Public Corporation," Michael Jensen predicted that the leveraged buyout (LBO) would emerge as the dom? inant corporate organizational form. With its emphasis on corporate gover? nance, concentrated ownership, monitoring by active owners, strong manage? rial incentives, and efficient capital structure, he argued that the buyout is superior to the public corporation with its dispersed shareholders and weak governance. These features enable LBO managers to add value more effec? tively and make long-run investments without catering to the public market's demands for steadily growing quarterly profits, which Stein (1988) and others argue can lead firms to myopically sacrifice such expenditures.1 In this case, it

Disasters Implied by Equity Index Options

Abstract: We use equity index options to quantify the distribution of consumption growth disasters. The challenge lies in connecting the risk-neutral distribution of equity returns implied by options to the true distribution of consumption growth estimated from macroeconomic data. We attack the problem from three perspectives. First, we compare pricing kernels constructed from macro-finance and option-pricing models. Second, we compare option prices derived from a macro-finance model to those we observe. Third, we compare the distribution of consumption growth derived from option prices using a macro-finance model to estimates based on macroeconomic data. All three perspectives suggest that options imply smaller probabilities of extreme outcomes than have been estimated from international macroeconomic data. The third comparison yields a viable alternative calibration of the distribution of consumption growth that matches the equity premium, option prices, and the sample moments of US consumption growth.

Do Buyouts (Still) Create Value

Abstract: We examine how leveraged buyouts from the most recent wave of public to private transactions created value. Buyouts completed between 1990 and 2006 are more con? servatively priced and less levered than their predecessors from the 1980s. For deals with post-buyout data available, median market- and risk-adjusted returns to pre (post-) buyout capital invested are 72.5% (40.9%). In contrast, gains in operating per? formance are either comparable to or slightly exceed those observed for benchmark firms. Increases in industry valuation multiples and realized tax benefits from in? creasing leverage, while private, are each economically as important as operating gains in explaining realized returns. The leveraged buyout (LBO) wave of the 1980s was an important phenomenon well studied by academics and practitioners. The recession of the early 1990s, however, brought most of that activity to an end, as many of the deals from later in that period defaulted. Nearly 15 years later, however, the pace of LBO activity reached new record levels, renewing questions about whether and how these deals create value.1 A substantial body of empirical work based on leveraged buyout transac? tions from the 1980s supports the notion that leveraged transactions create value. Several studies show large gains in operating performance following the buyout; theories attribute these gains to reduced agency costs through the dis? ciplining effects of leverage and better governance (monitoring by the financial

Overconfidence, Compensation Contracts, and Capital Budgeting

Abstract: A risk-averse manager's overconfidence makes him less conservative. As a result, it is cheaper for firms to motivate him to pursue valuable risky projects. When compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that make him better off. Overconfident managers are also more attractive to firms than their rational counterparts because overconfidence commits them to exert effort to learn about projects. Still, too much overconfidence is detrimental to the manager since it leads him to accept highly convex compensation contracts that expose him to excessive risk.

Leverage, Moral Hazard, and Liquidity

Abstract: Financial firms raise short-term debt to finance asset purchases; this induces risk shifting when economic conditions worsen and limits their ability to roll over debt. Constrained firms de-lever by selling assets to lower-leverage firms. In turn, asset-market liquidity depends on the system-wide distribution of leverage, which is itself endogenous to future economic prospects. Good economic prospects yield cheaper short-term debt, inducing entry of higher-leverage firms. Consequently, adverse asset shocks in good times lead to greater de-leveraging and sudden drying up of market and funding liquidity.

Stressed, not Frozen: The Federal Funds Market in the Financial Crisis

Abstract: We examine the importance of liquidity hoarding and counterparty risk in the U.S. overnight interbank market during the financial crisis of 2008. Our findings suggest that counterparty risk plays a larger role than does liquidity hoarding: the day after Lehman Brothers' bankruptcy, loan terms become more sensitive to borrower characteristics. In particular, poorly performing large banks see an increase in spreads of 25 basis points, but are borrowing 1% less, on average. Worse performing banks do not hoard liquidity. While the interbank market does not freeze entirely, it does not seem to expand to meet latent demand.

Rollover Risk and Market Freezes

Abstract: The debt capacity of an asset is the maximum amount that can be borrowed using the asset as collateral. We model a sudden collapse in the debt capacity of good collateral. We assume short-term debt that must be frequently rolled over, a small transaction cost of selling collateral in the event of default, and a small probability of meeting a buy-to-hold investor. We then show that a small change in the asset's fundamental value can be associated with a catastrophic drop in the debt capacity, the kind of market freeze observed during the crisis of 2007 to 2008. One of the many striking features of the crisis of 2007 to 2008 was the sudden freeze in the market for the rollover of short-term debt. From an in? stitutional perspective, the inability to borrow overnight against high quality but long-term assets was a market failure that effectively led to the demise of a substantial part of investment banking in the United States. More broadly, it led to the collapse, in the United States, the United Kingdom, and other countries, of banks and other financial institutions that had relied on signifi? cant maturity mismatch between assets and liabilities, and, in particular, on the rollover of short-term wholesale debt in the asset-backed commercial paper (ABCP) and overnight sale and repurchase (repo) markets. In this paper, we are interested in developing a model of a sudden collapse in the ability to borrow short-term against long-lived assets in the absence of obvious problems of asymmetric information or fears about the value of col? lateral. We refer to this phenomenon as a "market freeze." More precisely, a market freeze occurs when the debt capacity, the maximum amount of collat eralized borrowing that can be supported by an asset, is a small fraction of the fundamental value, the economic value measured by the net present value (NPV) of the stream of future returns. An extreme form of a market freeze occurs when the fundamental value is close to the maximum possible value of the asset whereas the debt capacity is close to the minimum possible value of the asset.

Information Disclosure, Cognitive Biases and Payday Borrowing

Abstract: If people face cognitive limitations or biases that lead to financial mistakes, what are possible ways lawmakers can help? One approach is to remove the option of the bad decision; another approach is to increase financial education such that individuals can reason through choices when they arise. A third, less discussed, approach is to mandate disclosure of information in a form that enables people to overcome limitations or biases at the point of the decision. This third approach is the topic of this paper. We study whether and what information can be disclosed to payday loan borrowers to lower their use of high-cost debt via a field experiment at a national chain of payday lenders. We find that information that helps people think less narrowly (over time) about the cost of payday borrowing, and in particular information that reinforces the adding-up effect over pay cycles of the dollar fees incurred on a payday loan, reduces the take-up of payday loans by about 10 percent in a 4 month-window following exposure to the new information. Overall, our results suggest that consumer information regulations based on a deeper understanding of cognitive biases might be an effective policy tool when it comes to regulating payday borrowing, and possibly other financial and non-financial products.

The Interim Trading Skills of Institutional Investors

Abstract: Using a large proprietary database of institutional trades, this paper examines the interim (intraquarter) trading skills of institutional investors. We find strong evidence that institutional investors earn significant abnormal returns on their trades within the trading quarter and that interim trading performance is persistent. After transactions costs, our estimates suggest that interim trading skills contribute between 20 and 26 basis points per year to the average fund’s abnormal performance. Our findings also indicate that any trading skills documented by previous studies that use quarterly data are biased downwards because of their inability to account for interim trades. FINANCIAL ECONOMISTS OFTEN refer to institutional investors as “informed” traders, and individuals attempting to trade in the same markets as institutions are likened to “tourists playing poker with professionals in the smoky backroom of a Las Vegas casino.” 1 In spite of this conventional wisdom, empirical evidence on institutional investors’ ability to generate positive abnormal returns is mixed. On the one hand, Jensen (1968), Gruber (1996), Carhart (1997), Wermers (2000), and Fama and French (2010) find that actively managed mutual funds underperform passive benchmarks after fees. On the other hand, a number of studies provide evidence that a subset of mutual funds seems to possess superior skill. 2 Furthermore, while the presence of skilled institutions suggests that past winners should continue to outperform, the literature is ambiguous about whether superior performance persists over adjacent periods. 3

Public Pension Promises: How Big Are They and What Are They Worth?

Abstract: We calculate the present value of state employee pension liabilities using discount rates that reflect the risk of the payments from a taxpayer perspective. If benefits have the same default and recovery characteristics as state general obligation debt, the national total of promised liabilities based on current salary and service is $3.20 trillion. If pensions have higher priority than state debt, the value of liabilities is much larger. Using zero-coupon Treasury yields, which are default-free but contain other priced risks, promised liabilities are $4.43 trillion. Liabilities are even larger under broader concepts that account for salary growth and future service.

Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market

Abstract: We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short-selling due to hedging of nontraded risk. We show that illiquid assets can have lower expected returns if the short-sellers have more wealth, lower risk aversion, or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive-net-supply assets, and depends on investors' net nontraded risk exposure. We estimate this model for the credit default swap market. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.

Are All Inside Directors the Same? Evidence from the External Directorship Market

Abstract: Agency theory and optimal contracting theory posit opposing roles and shareholder wealth effects for corporate inside directors. We evaluate these theories using the market for outside directorships to differentiate among inside directors. Firms with inside directors holding outside directorships have better operating performance and market-to-book ratios, especially when monitoring is more difficult. These firms make better acquisition decisions, have greater cash holdings, and overstate earnings less often. Announcements of outside board appointments improve shareholder wealth, while departure announcements reduce it, consistent with these inside directors improving board performance and outside directorships being an important source of inside director incentives.

The Joy of Giving or Assisted Living? Using Strategic Surveys to Separate Public Care Aversion from Bequest Motives

Abstract: The “annuity puzzle,” conveying the apparently low interest of retirees in longevity insurance, is central to household finance. Two possible explanations are “public care aversion” (PCA), retiree aversion to simultaneously running out of wealth and being in need of long-term care, and an intentional bequest motive. To disentangle the relative importance of PCA and bequest motive, we estimate a structural model of the retirement phase using a novel survey instrument that includes hypothetical questions. We identify PCA as very significant and find bequest motives that spread deep into the middle class. Our results highlight potential interest in annuities that make allowance for long-term care expenses.

Financial Distress and the Cross Section of Equity Returns

Abstract: We explicitly consider financial leverage in a simple equity valuation model and study the cross-sectional implications of potential shareholder recovery upon resolution of financial distress. Our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book-to-market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump-shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions. FINANCIAL DISTRESS IS FREQUENTLY INVOKED to justify the existence of “anoma

The Real and Financial Implications of Corporate Hedging

Abstract: We study the implications of hedging for corporate financing and investment. We do so using an extensive, hand-collected data set on corporate hedging activities. Hedging can lower the odds of negative realizations, thereby reducing the expected costs of financial distress. In theory, this should ease a firm's access to credit. Using a tax-based instrumental variable approach, we show that hedgers pay lower interest spreads and are less likely to have capital expenditure restrictions in their loan agreements. These favorable financing terms, in turn, allow hedgers to invest more. Our tests characterize two exact channels—cost of borrowing and investment restrictions—through which hedging affects corporate outcomes. The analysis shows that hedging has a first-order effect on firm financing and investment, and provides new insights into how hedging affects corporate value. More broadly, our study contributes novel evidence on the real consequences of financial contracting.