Showing papers in "Journal of Financial and Quantitative Analysis in 2008"
TL;DR: This paper examined the penalties imposed on the 585 firms targeted by SEC enforcement actions for financial misrepresentation from 1978-2002, which they track through November 15, 2005, and found that reputation losses impose substantial penalties for cooking the books.
Abstract: We examine the penalties imposed on the 585 firms targeted by SEC enforcement actions for financial misrepresentation from 1978–2002, which we track through November 15, 2005. The penalties imposed on firms through the legal system average only $3.83. In the cross section, the reputation loss is positively related to measures of the firm's reliance on implicit contracts. This evidence belies a widespread belief that financial misrepresentation is disciplined lightly. To the contrary, reputation losses impose substantial penalties for cooking the books.
785 citations
TL;DR: In this paper, the authors investigated how firms operating in capital market-oriented economies (the U.K. and the U.S.) and bank oriented economies (France, Germany, and Japan) determine their capital structure and found that the leverage ratio is positively affected by the tangibility of assets and the size of the firm.
Abstract: The paper investigates how firms operating in capital market-oriented economies (the U.K. and the U.S.) and bank-oriented economies (France, Germany, and Japan) determine their capital structure. Using panel data and a two-step system-GMM procedure, the paper finds that the leverage ratio is positively affected by the tangibility of assets and the size of the firm, but declines with an increase in firm profitability, growth opportunities, and share price performance in both types of economies. The leverage ratio is also affected by the market conditions in which the firm operates. The degree and effectiveness of these determinants are dependent on the country's legal and financial traditions. The results also confirm that firms have target leverage ratios with French firms being the fastest in adjusting their capital structure toward their target level and Japanese firms the slowest. Overall, the capital structure of a firm is heavily influenced by the economic environment and its institutions, corporate governance practices, tax systems, the borrower-lender relation, exposure to capital markets, and the level of investor protection in the country in which the firm operates.
562 citations
TL;DR: In this paper, the authors examined the cross-sectional relation between idiosyncratic volatility and expected stock returns and concluded that no robustly significant relation exists between the idiosyncratic risk and expected returns.
Abstract: This paper examines the cross-sectional relation between idiosyncratic volatility and expected stock returns. The results indicate that i) the data frequency used to estimate idiosyncratic volatility, ii) the weighting scheme used to compute average portfolio returns, iii) the breakpoints utilized to sort stocks into quintile portfolios, and iv) using a screen for size, price, and liquidity play critical roles in determining the existence and significance of a relation between idiosyncratic risk and the cross section of expected returns. Portfoliolevel analyses based on two different measures of idiosyncratic volatility (estimated using daily and monthly data), three weighting schemes (value-weighted, equal-weighted, inverse volatility-weighted), three breakpoints (CRSP, NYSE, equal market share), and two different samples (NYSE/AMEX/NASDAQ and NYSE) indicate that no robustly significant relation exists between idiosyncratic volatility and expected returns.
421 citations
TL;DR: In this article, the authors incorporate well-documented managerial traits into a tradeoff model of capital structure to study their impact on corporate financial policy and firm value, finding that managers' investment decisions can increase firm value by reducing this bondholder-shareholder conflict.
Abstract: This article incorporates well-documented managerial traits into a tradeoff model of capital structure to study their impact on corporate financial policy and firm value. Optimistic and/or overconfident managers choose higher debt levels and issue new debt more often but need not follow a pecking order. The model also surprisingly uncovers that these managerial traits can play a positive role. Biased managers' higher debt levels restrain them from diverting funds, which increases firm value by reducing this manager-shareholder conflict. Although higher debt levels delay investment, mildly biased managers' investment decisions can increase firm value by reducing this bondholder-shareholder conflict.
348 citations
TL;DR: Using stock transactions data along with detailed stockholdings for a comprehensive sample of US actively managed equity mutual funds from 1993 to 2002, the authors empirically examined the effect of liquidity and investment style on the relation between fund size and fund performance.
Abstract: Using stock transactions data along with detailed stockholdings for a comprehensive sample of US actively managed equity mutual funds from 1993 to 2002, this paper empirically examines the effect of liquidity and investment style on the relation between fund size and fund performance Consistent with Chen, Hong, Huang, and Kubik (2004), I find a significant inverse relation between fund size and fund performance Further, this inverse relation is stronger among funds that hold less liquid portfolios The inverse relation between fund size and fund performance is also more pronounced among growth and high turnover funds that tend to have high demands for immediacy Overall, this paper's findings suggest that liquidity is an important reason why fund size erodes performance
268 citations
TL;DR: In this article, a further investigation of asymmetric dependence structures in international equity markets is performed by using the Markov switching model and copula theory combining these two theories enables me to model dependence structures with sufficient flexibility using this flexible framework, I indeed find that there are two distinct regimes in the U S-U K market.
Abstract: A number of recent studies finds two asymmetries in dependence structures in international equity markets; specifically, dependence tends to be high in both highly volatile markets and in bear markets In this paper, a further investigation of asymmetric dependence structures in international equity markets is performed by using the Markov switching model and copula theory Combining these two theories enables me to model dependence structures with sufficient flexibility Using this flexible framework, I indeed find that there are two distinct regimes in the U S-U K market I also show that for the U S-U K market the bear regime is better described by an asymmetric copula with lower tail dependence with clear rejection of the Markov switching multivariate normal model In addition, I show that ignorance of this further asymmetry in bear markets is very costly for risk management Lastly, I conduct a similar analysis for other G7 countries, where I find other cases in which the use of a Markov switching multivariate normal model would be inappropriate
249 citations
TL;DR: This article found that households that choose to concentrate their brokerage accounts in a few stocks outperform those made by households with more diversified accounts (especially among those with large portfolios) and that the excess returns of concentrated relative to diversified portfolios are stronger for stocks not included in the S&P 500 index.
Abstract: This paper tests whether information advantages help explain why some individual investors concentrate their stock portfolios in a few stocks. Stock investments made by households that choose to concentrate their brokerage accounts in a few stocks outperform those made by households with more diversified accounts (especially among those with large portfolios). Excess returns of concentrated relative to diversified portfolios are stronger for stocks not included in the S&P 500 index and local stocks, potentially reflecting concentrated investors’ successful exploitation of information asymmetries. Controlling for households’ average investment abilities, their trades and holdings perform better when their portfolios include fewer stocks.
234 citations
TL;DR: In this article, the authors apply an event-study methodology on over 10,000 Morningstar star rating changes and find that Morningstar has subsantial independent influence on the investment allocation decisions of retail mutual fund investors.
Abstract: We apply an event-study methodology on over 10,000 Morningstar star rating changes and find that Morningstar has subsantial independent influence on the investment allocation decisions of retail mutual fund investors. It is the discrete change in the star rating itself and not the change in the underlying performance measures that drives frow. We document econnomically and statistically significant positive abnormal flow following rating upgrades, and negative abnormal flow following rating downgrades. In contrast to the cross-sectional flow performance literature, we find evidence of investor punishment of performance declines, some of which is evident immediately in the month of the rating change.
209 citations
TL;DR: Li et al. as discussed by the authors investigated performance effects for China's listed firms when there is a change in the controlling shareholder and found positive performance effects when control is passed to a private entity.
Abstract: We investigate performance effects for China's listed firms when there is a change in the controlling shareholder. These changes include ownership transfers from one state entity to another state entity and from a state entity to a private entity. We find positive performance effects when control is passed to a private entity. In contrast, when the transfer is made to another branch of the state, there is little change in performance. The stock market responds positively to a change in control, with the largest effect observed for private transfers. Our results suggest the Chinese government should continue to sell down its share ownership in listed firms as the transfer of control to private owners enhances corporate profitability and efficiency. Moreover, to help ownership reform, China should encourage an active market for corporate control.
209 citations
TL;DR: This article showed that even information that is publicly and simultaneously released to all market participants is largely impounded into prices via the key micro-level price determinant, order flow, and found that between a half and two thirds of price relevant information is incorporated into prices through the trading process.
Abstract: Under rational expectations and efficient markets, the news contained in public information announcements is directly impounded into prices with there being no role for trades in this process of information assimilation. This paper directly tests this assertion using transaction level exchange rate data and a sample of scheduled macroeconomic announcements. The main result of the paper is that even information that is publicly and simultaneously released to all market participants is largely impounded into prices via the key micro-level price determinant — order flow. We quantify the role that order flow plays and find that between a half and two thirds of price relevant information is incorporated into prices via the trading process.
206 citations
TL;DR: This article examined the hypothesis that there has been a fundamental change in participation and links this change to the reduction of these frictions by the advent of the Internet and found that computer/Internet using households raised participation substantially more than non-computer using households.
Abstract: Theory indicates that frictions (e. g., information and transaction costs) could account for the lower than expected stock market participation rates. This paper examines the hypothesis that there has been a fundamental change in participation and links this change to the reduction of these frictions by the advent of the Internet. Using panel data on household participation rates over the past decade, the results show computer/Internet using households raised participation substantially more than non-computer using households. The increased probability of participation was equivalent to having over $27,000 in additional household income or over two more mean years of education.
TL;DR: In this paper, the importance and price implications of style investing by institutional investors in the stock market were explored, and it was found that institutional investors reallocate across style groupings more intensively than across random stock groupings.
Abstract: This paper explores the importance and price implications of style investing by institutional investors in the stock market. To analyze styles, we assign stocks to deciles or segments across three style dimensions: size, value/growth, and sector. We find strong evidence that institutional investors reallocate across style groupings more intensively than across random stock groupings. In addition, we show that own segment style inflows and returns positively forecast future stock returns, while distant segment style inflows and returns forecast negatively. We argue that behavioral theories play a role in explaining these results.
TL;DR: In this paper, the authors assess the potential of small-cap stocks as a vehicle for international portfolio diversification during the period 1980-1999 and show that the extra gains from the augmented diversification with smallcap funds are statistically significant for both in-sample and out-of-sample periods.
Abstract: To the extent that investors diversify internationally, large-cap stocks receive the dominant share of fund allocation. Increasingly, however, returns to large-cap stocks or stock market indices tend to comove, mitigating the benefits from international diversification. In contrast, stocks of locally oriented, small companies do not exhibit the same tendency. In this paper, we assess the potential of small-cap stocks as a vehicle for international portfolio diversification during the period 1980–1999. We show that the extra gains from the augmented diversification with small-cap funds are statistically significant for both in-sample and out-of-sample periods and remain robust to the consideration of market frictions.
TL;DR: This article found evidence that conflicts of interest arising from mergers and acquisitions relations influence analysts' recommendations, corroborating regulators' and practitioners' suspicions in a setting, i.e., M&A relations, not previously examined in research on analyst conflicts.
Abstract: We find evidence that conflicts of interest arising from mergers and acquisitions (M&A) relations influence analysts' recommendations, corroborating regulators' and practitioners' suspicions in a setting, i.e., M&A relations, not previously examined in research on analyst conflicts. In addition, the M&A context allows us to disentangle the conflict of interest effect from selection bias. We find that analysts affiliated with acquirer advisors upgrade acquirer stocks around M&A deals, even around all-cash deals, in which selection bias is unlikely. Also consistent with conflict of interest but not selection bias, target-affiliated analysts publish optimistic reports about acquirers after, but not before, the exchange ratio of an all-stock deal is set.
TL;DR: The authors showed that if true returns are independently distributed and a manager fully reports gains but delays reporting losses, then reported returns will feature conditional serial correlation, which is a measure of conditional return smoothing.
Abstract: We show that if true returns are independently distributed and a manager fully reports gains but delays reporting losses, then reported returns will feature conditional serial correlation. We use conditional serial correlation as a measure of conditional return smoothing. We estimate conditional serial correlation in a large sample of hedge funds. We find that the probability of observing conditional serial correlation is related to the volatility and mag nitude of investor cash flows, consistent with conditional return smoothing in response to the risk of capital flight. We also present evidence that conditional serial correlation is a leading indicator of fraud.
TL;DR: Li et al. as discussed by the authors investigated the simultaneous linkages between debt capacity, cost of debt, and corporate property insurance in Chinese publicly listed companies and concluded that debt capacity and corporate insurance appear to be simultaneously related.
Abstract: Using a unique insurance dataset for a sample of Chinese publicly listed companies for the period 1997 through 2003, this study tests the simultaneous linkages between debt capacity, cost of debt, and corporate property insurance. Our results suggest that, on the one hand, a higher cost of debt appears to motivate the use of more property insurance, but high leverage alone does not lead to the purchase of more property insurance. The latter finding might reflect the unique institutional setting of China, for example, where there is a low chanceof legally enforced company liquidation. Also, there is evidence that leverage can interact with tangible assets intensity and exert a positive conjoint effect on the corporate purchase ofproperty insurance. On the other hand, we find evidence that supports that property insurance helps expand insuring firms' debt capacity and helps lower their borrowing costs. However, themoderate evidence on the cost reduction effect suggests that lowering the borrowing cost is likely to be a concern secondary to facilitating corporate borrowing and thereby expanding debt capacity in corporate property insurance decisions in China. Overall, we conclude that debt capacity, cost of debt, and corporate insurance appear to be simultaneously related.
TL;DR: In this paper, the authors examined time-series forecast errors of expected returns from conditional and unconditional asset pricing models for portfolio and individual firm equity returns, and found that the conditional versions of the models generally produce higher mean squared errors than unconditional versions for step ahead prediction.
Abstract: This paper examines time-series forecast errors of expected returns from conditional and unconditional asset pricing models for portfolio and individual firm equity returns. A new result that increases predictive precision concerning model specification and forecasting is introduced. Conditional versions of the models generally produce higher mean squared errors than unconditional versions for step ahead prediction. This holds for individual firm data when the instruments are firm specific. Mean square forecast error decompositions indicate that the asset pricing models produce relatively unbiased predictions, but the vari ance is severe enough to ruin the step ahead predictive ability beyond that of a constant benchmark.
TL;DR: In this article, the authors examine how industry structure affects corporate investment patterns and find that firms in monopolistic industries exhibit lower investment-q; sensitivity and are slower to invest than firms in competitive industries.
Abstract: This paper examines how industry structure affects corporate investment patterns. Real options theory shows that deferring irreversible investment in the face of uncertainty is valuable. Theory also shows that the value of waiting to invest falls if investment opportunities are contestable. Consistent with these theories, we find that firms in monopolistic industries exhibit lower investment-q; sensitivity and are slower to invest than firms in competitive industries. However, we find that investment-q; sensitivity and investment speed are highest in oligopolistic industries, suggesting that the value of investing strategically can outweigh the value of waiting. Indeed, oligopolistic industries experience less entry and more exit than other industries.
TL;DR: In this paper, the authors provide an explicit solution to the valuation of a credit default swap when the interest rate and the hazard rate are correlated by using the change of measure approach and solving a bivariate Riccati equation.
Abstract: With the recent significant growth in the single-name credit default swap (CDS) market has come the need for accurate and computationally efficient models to value these instruments. While the model developed by Duffie, Pan, and Singleton (2000) can be used, the solution is numerical (solving a series of ordinary differential equations) rather than explicit. In this paper, we provide an explicit solution to the valuation of a credit default swap when the interest rate and the hazard rate are correlated by using the “change of measure” approach and solving a bivariate Riccati equation. CDS transaction data for the period 2/15/2000 through 4/8/2003 for 60 firms are used to test both the goodness of fit of the model and provide estimates of the influence of economic variables in the market for credit-risky bonds.
TL;DR: In this paper, the authors compare the informational advantages of intermediaries with those of other investors in the market and find that intermediaries account for greater price discovery than other institutional and individual investors.
Abstract: A significant but unresolved question in the current debate about the role of intermediaries in financial markets is whether intermediaries behave as passive traders or whether they actively seek and trade on information. We address this issue by explicitly comparing the informational advantages of intermediaries with those of other investors in the market. We find that intermediaries account for greater price discovery than other institutional and individual investors in spite of initiating fewer trades and volume. Furthermore, intermediary information does not arise from inappropriate handling of customer orders by intermediaries. We propose that our findings are consistent with noisy rational expectations models, where agents extract valuable information from past prices. Intermediaries bear little or no opportunity cost of monitoring market conditions, which gives them an advantage in making profitable price-contingent trades. Lower trading costs may also enable intermediaries to trade more effectively and frequently on their information.
TL;DR: In this article, the authors show that the consolidation of orders is important for producing efficient prices, especially during times of high liquidity demand, and that the NYSE's centralized opening call market performs better than Nasdaq's decentralized opening process on typical trading days.
Abstract: We show that the consolidation of orders is important for producing efficient prices, especially during times of high liquidity demand. The NYSE’s centralized opening call market performs better than Nasdaq’s decentralized opening process on typical trading days. The NYSE is much better than Nasdaq on witching days when index arbitrage activity subjects S&P 500 stocks to large, predictable, and mostly informationless order flow around quarterly futures contract expirations. Nasdaq opening price efficiency improves to NYSE levels once Nasdaq initiates a consolidated opening call in November 2004, but prices on the decentralized Nasdaq remain less efficient at other times of day.
TL;DR: This article found that local analyst recommendations are systematically more optimistic than for foreign analyst recommendations in emerging markets, and the effects of this novel "home bias" among local analysts overwhelm any information asymmetry between foreign and local analysts.
Abstract: We find that local analyst recommendations are systematically more optimistic than for eign analyst recommendations in emerging markets. The effects of this novel "home bias" among local analysts overwhelm any information asymmetry between foreign and local analysts. Consequently, local analyst upgrades underperform foreign analyst upgrades, while local analyst downgrades outperform foreign analyst downgrades. Neither foreign investors, local institutions, nor retail investors appear to be fully cognizant of this bias. Trade reactions suggest that foreign investors overestimate the bias in foreign analyst rec ommendations while local institutions underestimate the bias in local analyst recommen dations. These results are pervasive across countries, time periods, and stock groupings, and can be traced to investment banking pressure.
TL;DR: In this article, the joint effects of data snooping and spurious regression were studied for the estimation of asset pricing model regressions with conditional alphas and betas, focusing on the joint effect of the data snoops and spurious regressions.
Abstract: This paper studies the estimation of asset pricing model regressions with conditional alphas and betas, focusing on the joint effects of data snooping and spurious regression We find that the regressions are reasonably well specified for conditional betas, even in settings where simple predictive regressions are severely biased However, there are biases in estimates of the conditional alphas When time-varying alphas are suppressed and only time-varying betas are considered, the betas become biased Previous studies overstate the significance of time-varying alphas
TL;DR: In this article, the authors examined the effect of commercial bank entry on underwriting spreads for IPOs, SEOs, and debt issues using a long time series that spans 30 years, from 1975 to 2004.
Abstract: This paper examines the effect of commercial bank entry on underwriting spreads for IPOs, SEOs, and debt issues using a long time series that spans 30 years, from 1975 to 2004. We find that, on average, commercial banks charge lower spreads of approximately 72 basis points for IPOs, 43 basis points for SEOs, and 14 basis points for debt over the entire sample period. The economic impact of commercial banks on lowering underwriting spreads is most significant when commercial banks were allowed to enter via Section 20 subsidiaries but persists beyond. Commercial bank entry into underwriting appears to have a procompetitive effect that lasts many years after their initial entry.
TL;DR: In this paper, the predictability of stock returns using market-, industry-, and firm-level earnings was analyzed using market, industry, and firm level data, and it was shown that neither dividend payout ratio nor the level of aggregate earnings can forecast the excess market return.
Abstract: This paper provides an analysis of the predictability of stock returns using market-, industry-, and firm-level earnings. Contrary to Lamont (1998), we find that neither dividend payout ratio nor the level of aggregate earnings can forecast the excess market return. We show that these variables do not have robust predictive power across different stock portfolios and sample periods. In contrast to the aggregate-level findings, earnings yield has significant explanatory power for the time-series and cross-sectional variation in firmlevel stock returns and the 48 industry portfolio returns. The mean reversion of stock prices as well as the earnings' correlation with expected stock returns are responsible for the forecasting power of earnings yield. These results are robust after controlling for bookto-market, size, price momentum, and post-earnings announcement drift. At the aggregate level, the information content of firm-level earnings about future cash flows is diversified away and higher aggregate earnings do not forecast higher returns.
TL;DR: For instance, this article found that start-ups tend to be based close to the origins of their founders and in regions with more investment management firms, banking establishments, and large institutional money managers.
Abstract: Fund managers' bias toward geographically proximate securities is a well-researched phenomenon, yet the origins of managers' location choices have received little empirical scrutiny. This paper traces the employment and geographic heritage of 358 entrepreneurial fund managers and analyzes the determinants of where they locate their firms and stock selections. The evidence suggests that start-ups tend to be based close to the origins of their founders and in regions with more investment management firms, banking establishments, and large institutional money managers. New money managers show a strong local bias in their equity holdings, three times the levels previously documented for mutual funds. The propensity to invest closer to home correlates strongly with the presence of sub-advisory opportunities from institutional investors in the vicinity. While home bias levels between managers who relocate with their start-ups and the rest of the entrepreneurs are similar, preferences for stocks that were formally local persist.
TL;DR: This paper presents a new method of approximating the risk neutral density (RND) from option prices based on the C-type Gram-Charlier series expansion (GCSE) of a probability density function, and presents simulation and empirical evidence.
Abstract: In this paper we present a new method of approximating the risk neutral density (RND) from option prices based on the C-type Gram-Charlier series expansion (GCSE) of a prob ability density function. The exponential form of this type of GCSE guarantees that it will always give positive values of the risk neutral probabilities, and it can allow for stronger deviations from normality, which are two drawbacks of the A-type GCSE used in practice. To evaluate the performance of the suggested expansion of the RND, the paper presents simulation and empirical evidence.
TL;DR: In this article, the authors use Italian household portfolio data and time series on financial assets and housing stock returns to assess whether actual portfolios are efficient and find that housing wealth plays a key role in determining whether portfolios chosen by homeowners are efficient.
Abstract: Standard tests of portfolio efficiency neglect the existence of illiquid wealth. The most important illiquid asset in household portfolios is housing: if housing stock adjustments are infrequent, optimal portfolios in periods of no adjustment are affected by housing price risk through a hedge term and tests for portfolio efficiency of financial assets must be run conditionally upon housing wealth. We use Italian household portfolio data and time series on financial assets and housing stock returns to assess whether actual portfolios are efficient. We find that housing wealth plays a key role in determining whether portfolios chosen by homeowners are efficient.
TL;DR: In contrast to the mean-variance model, reward-risk portfolio selection arises from an axiomatic definition of reward and risk measures based on a few basic principles, including consistency with secondorder stochastic dominance as discussed by the authors.
Abstract: Starting from the reward-risk model for portfolio selection introduced in De Giorgi (2005), we derive the reward-risk Capital Asset Pricing Model (CAPM) analogously to the classical mean-variance CAPM. In contrast to the mean-variance model, reward-risk portfolio selection arises from an axiomatic definition of reward and risk measures based on a few basic principles, including consistency with second-order stochastic dominance. With complete markets, we show that at any financial market equilibrium, reward-risk investors' optimal allocations are comonotonic and, therefore, our model reduces to a representative investor model. Moreover, the pricing kernel is an explicitly given, non-increasing function of the market portfolio return, reflecting the representative investor's risk attitude. Finally, an empirical application shows that the reward-risk CAPM captures the cross section of U.S. stock returns better than the mean-variance CAPM does.
TL;DR: This paper examined the effect of poison pill adoptions on firm value, controlling for the adopting firm's preexisting corporate governance structure and found that only companies with the most democratic governance structures experience significantly positive abnormal stock returns and significantly positive normalization in five-year earnings growth rate forecasts.
Abstract: We examine the effect of poison pill adoptions on firm value, controlling for the adopting firm's preexisting corporate governance structure. We find that only companies with the most democratic governance structures, defined as those with the fewest preexisting pro tective governance provisions, experience significantly positive abnormal stock returns and significantly positive abnormal revisions in five-year earnings growth rate forecasts. More over, regression results indicate that abnormal returns and forecast revisions are signifi cantly related to governance structure and not to board composition or subsequent merger activity.