Showing papers in "Quarterly Journal of Finance in 2011"
TL;DR: In this paper, the authors proposed a market-wide risk management system that would deal with computer-generated chaos in real time, and their regulators should address this."Make or take" pricing, the charging of access fees to market orders that take" liquidity and paying rebates to limit orders that make" liquidity, causes distortions that should be corrected.
Abstract: The US equity market has changed dramatically in recent years. Increasing automation and the entry of new trading platforms have resulted in intense competition among trading platforms.Despite these changes, traders still face the same challenges as before. They seek to minimize the total cost of trading, including commissions, bid/ask spreads, and market impact. New technologies allow traders to implement traditional strategies more effectively. For example, dark pools and indications of interest are just an updated form of tactics that NYSE (New York Stock Exchange) floor traders used to search for counterparties while minimizing the exposure of their clients' trading interest to prevent front running.Virtually every measurable dimension of US equity market quality has improved. Execution speeds and retail commissions have fallen. Bid-ask spreads have fallen and remain low, although they spiked upward along with volatility during the recent financial crisis. Market depth has increased. Studies of institutional transactions costs find US costs among the lowest in the world. Unlike during the Crash of 1987, the US equity market mechanism handled the increase in trading volume and volatility without disruption. However, our markets lack a market-wide risk management system that would deal with computer-generated chaos in real time, and our regulators should address this."Make or take" pricing, the charging of access fees to market orders that "take" liquidity and paying rebates to limit orders that "make" liquidity, causes distortions that should be corrected. Such charges are not reflected in the quotations used for the measurement of best execution. Direct access by nonbrokers to trading platforms requires appropriate risk management. Front running orders in correlated securities should be banned.
167 citations
TL;DR: This paper showed that the stylized fact of average mutual fund underperformance documented in the literature stems from expansion periods when funds have statistically significant negative risk-adjusted performance and not recession periods when risk adjusted fund performance is positive.
Abstract: This paper shows that the stylized fact of average mutual fund underperformance documented in the literature stems from expansion periods when funds have statistically significant negative risk-adjusted performance and not recession periods when risk-adjusted fund performance is positive. These results imply that traditional unconditional performance measures understate the value added by active mutual fund managers in recessions, when investors' marginal utility of wealth is high. The risk-adjusted performance (or alpha) difference between recession and expansion periods is statistically and economically significant at 3% to 5% per year. Our findings are based on a novel multi-variate conditional regime-switching performance methodology used to carry out one of the most comprehensive examinations of the performance of US domestic equity mutual funds in recessions and expansions from 1962 to 2005. The findings are robust to the choice of the factor model (including bond and liquidity factor extensions), the use of NBER business cycle dates, fund load, turnover, expenses and percentage of equity holdings.
140 citations
TL;DR: In this paper, the connections between stock market volatility and returns are studied within the context of a general equilibrium framework, which rules out a priori any purely statistical relationship between volatility and return by imposing uncorrelated innovations.
Abstract: The connections between stock market volatility and returns are studied within the context of a general equilibrium framework. The framework rules out a priori any purely statistical relationship between volatility and returns by imposing uncorrelated innovations. The main model generates a two-factor structure for stock market volatility along with time-varying risk premiums on consumption and volatility risk. It also generates endogenously a dynamic leverage eect (volatility asymmetry), the sign of which depends upon the magnitudes of the risk aversion and the intertemporal elasticity of substitution parameters.
90 citations
TL;DR: In this paper, the authors examined board structures and the use of corporate charter provisions in a sample of more than 2,300 firms over a four-year period, and found that firms cluster in their use of governance mechanisms.
Abstract: We provide arguments and present evidence that corporate governance structures are composed of interrelated mechanisms, which are in turn endogenous responses to the costs and benefits firms face when they choose those mechanisms. Examining board structures and the use of corporate charter provisions in a sample of more than 2,300 firms over a four-year period, we find that firms cluster in their use of governance mechanisms. In particular, the set of charter provisions that firms use, as measured by the Gompers et al. (2003) G Index, is associated with board structure, with the laws of the state in which the firm is incorporated, and with firm and industry characteristics. We also find that some governance structures appear to serve as substitutes. Specifically, firms that have powerful boards (as measured by board independence) also have the greatest number of charter provisions, suggesting that the market for corporate control is less effective as a monitoring mechanism for these firms. In contrast, firms that have less powerful boards tend to have few charter provisions, suggesting that the market for corporate control plays a greater monitoring role at such firms. To address potential endogeneity issues, we employ three-stage least squares analysis to estimate these relationships within a system of equations. Our results from this analysis are consistent with the hypothesis that powerful boards serve as a substitute for the market for corporate control. Finally, our findings suggest that causality runs from the board to the choice of charter provisions, but not vice versa.
53 citations
TL;DR: In this article, the authors propose a single evolutionary explanation for the origin of several behaviors observed in organisms ranging from ants to human subjects, including risk sensitive foraging, risk aversion, loss aversion, probability matching, randomization, and diversification.
Abstract: We propose a single evolutionary explanation for the origin of several behaviors that have been observed in organisms ranging from ants to human subjects, including risk-sensitive foraging, risk aversion, loss aversion, probability matching, randomization, and diversification. Given an initial population of individuals, each assigned a purely arbitrary behavior with respect to a binary choice problem, and assuming that offspring behave identically to their parents, only those behaviors linked to reproductive success will survive, and less reproductively successful behaviors will disappear at exponential rates. When the uncertainty in reproductive success is systematic, natural selection yields behaviors that may be individually sub-optimal but are optimal from the population perspective; when reproductive uncertainty is idiosyncratic, the individual and population perspectives coincide. This framework generates a surprisingly rich set of behaviors, and the simplicity and generality of our model suggest that these derived behaviors are primitive and nearly universal within and across species.
53 citations
TL;DR: In this article, the authors investigate the effect of fund managers' performance evaluation on their asset allocation decisions and derive optimal contracts for delegated portfolio management and show that they always contain relative performance elements, which biases fund managers to deviate from return-maximizing portfolio allocations and follow those of their benchmark.
Abstract: This paper investigates the effect of fund managers' performance evaluation on their asset allocation decisions. We derive optimal contracts for delegated portfolio management and show that they always contain relative performance elements. We then show that this biases fund managers to deviate from return-maximizing portfolio allocations and follow those of their benchmark (herding). In many cases, the trustees of the fund who employ the fund manager prefer such a policy. We also show that fund managers in some situations ignore their own superior information and "go with the flow" in order to reduce deviations from their benchmark. We conclude that incentive provisions for portfolio managers are an important factor in their asset allocation decisions.
52 citations
TL;DR: In this article, the adverse selection cost of debt has been examined in a large unbalanced panel of publicly traded US firms from 1971 to 2001 and it was shown that firms avoid issuing debt when the outside market is likely to know little about their risk.
Abstract: This paper argues that firms may not issue debt in order to avoid the adverse selection cost of debt. Theory suggests that since debt is a concave claim, it may be mispriced when outside investors are uninformed about firms' risk. The empirical literature has however paid little attention to the caveat that the "lemons" problem of external financing first identified by Myers (1984) only leads to debt issuance, i.e., a pecking order, if debt is risk free or, if it is risky, that it is not mispriced. This paper examines whether and for what firms the adverse selection cost of debt is more than a theoretical possibility and how this cost relates to other costs of debt such as bankruptcy. In the absence of any direct measure of something that is unknown to investors and thus cannot be in the econometrician's information set, we present extensive strong and robust evidence in a large unbalanced panel of publicly traded US firms from 1971 to 2001 that firms avoid issuing debt when the outside market is likely to know little about their risk.
50 citations
TL;DR: In this paper, the authors established a link between illiquidity and positive autocorrelation in asset returns among a sample of hedge funds, mutual funds, and various equity portfolios.
Abstract: We establish a link between illiquidity and positive autocorrelation in asset returns among a sample of hedge funds, mutual funds, and various equity portfolios. For hedge funds, this link can be confirmed by comparing the return autocorrelations of funds with shorter vs. longer redemption-notice periods. We also document significant positive return-autocorrelation in portfolios of securities that are generally considered less liquid, e.g., small-cap stocks, corporate bonds, mortgage-backed securities, and emerging-market investments. Using a sample of 2,927 hedge funds, 15,654 mutual funds, and 100 size- and book-to-market-sorted portfolios of US common stocks, we construct autocorrelation-sorted long/short portfolios and conclude that illiquidity premia are generally positive and significant, ranging from 2.74% to 9.91% per year among the various hedge funds and fixed-income mutual funds. We do not find evidence for this premium among equity and asset-allocation mutual funds, or among the 100 US equity portfolios. The time variation in our aggregated illiquidity premium shows that while 1998 was a difficult year for most funds with large illiquidity exposure, the following four years yielded significantly higher illiquidity premia that led to greater competition in credit markets, contributing to much lower illiquidity premia in the years leading up to the Financial Crisis of 2007–2008.
37 citations
TL;DR: The authors generalize Pratt's risk premium to uncertainty premium based on Klibanoff et al.'s (2005) smooth model of ambiguity, and show that the uncertainty premium can decrease with an increase in decision maker's risk aversion.
Abstract: The uncertainty premium is the premium that is derived from not knowing the sure outcome (risk premium) and from not knowing the precise odds of outcomes (ambiguity premium). We generalize Pratt's risk premium to uncertainty premium based on Klibanoff et al.'s (2005) smooth model of ambiguity. We show that the uncertainty premium can decrease with an increase in decision maker's risk aversion. This happens because increasing risk aversion always results in a lower ambiguity premium. The positive ambiguity premium may provide an additional explanation to the equity premium puzzle.
26 citations
TL;DR: In this article, the conditional mean and volatility of the stock market Sharpe ratio are used to estimate the mean and the volatility of stock market returns, and these moments are combined to estimate either the conditional Sharpe ratios directly as a linear function of these same variables.
Abstract: This paper documents predictable time-variation in stock market Sharpe ratios. Predetermined financial variables are used to estimate both the conditional mean and volatility of equity returns, and these moments are combined to estimate the conditional Sharpe ratio, or the Sharpe ratio is estimated directly as a linear function of these same variables. In sample, estimated conditional Sharpe ratios show substantial time-variation that coincides with the phases of the business cycle. Generally, Sharpe ratios are low at the peak of the cycle and high at the trough. In an out-of-sample analysis, using 10-year rolling regressions, relatively naive market-timing strategies that exploit this predictability can identify periods with Sharpe ratios more than 45% larger than the full sample value. In spite of the well-known predictability of volatility and the more controversial forecastability of returns, it is the latter factor that accounts primarily for both the in-sample and out-of-sample results.
22 citations
TL;DR: In this article, the authors explore inference about assets that have survived by avoiding poor performance and find that the greater the commonality across assets in prior uncertainty about parameters, the more an asset's inferred expected return should depend on its having survived.
Abstract: This study explores inference about assets that have survived by avoiding poor performance. The greater is the commonality across assets in prior uncertainty about parameters, the more an asset's inferred expected return should depend on its having survived. If there is no commonality, then a surviving asset's average return can possess substantial sampling bias while nevertheless equaling the appropriate conditional expected return. Survival bias as typically computed generally makes too severe an adjustment to survivors, unless one assumes that expected returns on all assets, dead or alive, are equal to one common value that is completely unknown before observing returns data.
TL;DR: In this paper, the authors examined the impact of status-seeking considerations on investors' portfolio choices and asset prices in a general equilibrium setting and found that asset returns obey a novel two-factor model in which one factor is the traditional market factor and the other is a particular high volatility factor.
Abstract: This paper examines the impact of status-seeking considerations on investors' portfolio choices and asset prices in a general equilibrium setting. The economy studied in this paper consists of traditional ("Markowitz") investors as well as status-seekers who are concerned about relative wealth. The model highlights the strategic and interdependent nature of portfolio selection in such a setting: Low-status investors look for portfolio choices that maximize their chances of moving up the ladder while high-status investors look to maintain the status quo and hedge against these choices of the low-status investors. In equilibrium, asset returns obey a novel two-factor model in which one factor is the traditional market factor and the other is a particular "high volatility factor" that does not appear to have been identified so far in the theoretical or empirical literature. This two-factor model found significant support when tested with stock market data. Of particular interest is that the model and the empirical results attribute the low returns on idiosyncratic volatility stocks to their covariance with the portfolio of highly volatile stocks held by investors with relatively low status.
TL;DR: The authors provided a behavioral analysis of BP, whose capital budgeting decisions in the last decade have resulted in a series of high-profile accidents, including the worst environmental disaster in US history.
Abstract: This paper provides a behavioral analysis of BP, whose capital budgeting decisions in the last decade have resulted in a series of high-profile accidents, including the worst environmental disaster in US history. This analysis uses BP as a vehicle to discuss the application of business processes and psychological pitfalls to analyze corporate culture. The paper identifies weaknesses and vulnerabilities in BP's culture, makes comparisons with the corporate financial practices at other firms, and offers suggestions about how BP can engage in debiasing. Notably, the paper also suggests that insufficient knowledge of behavioral decision making resulted in analysts, investors, and regulators attaching insufficient emphasis to the risks in BP's operations. The paper calls for more attention to the psychological aspects of corporate behavior by analysts, regulators, corporate managers, and academics.
TL;DR: In this paper, the authors argue that the United States has a history of providing guarantees, either implicit or explicit, regardless of its professed position on the matter, and that it is in the best interest of the country to acknowledge the existence of such guarantees, and to price them appropriately before, rather than after, they become necessary.
Abstract: In 2007 and 2008, the mortgage market failed. It failed in a number of dimensions: Default rates rose to their highest levels since the great depression, and mortgage liquidity ground to a halt. This failure has produced recriminations: Blame has been laid at the feet of borrowers, brokers, lenders, investment banks, investors and government and quasi-government entities that guaranteed mortgages. These recent events have produced an important debate: Whether the U.S. mortgage market requires a federal guarantee in order to best serve consumers, investors and markets. My view is that such a guarantee is necessary. I will divide my argument into four areas: (1) I will argue that the United States has had a history of providing guarantees, either implicit or explicit, regardless of its professed position on the matter. This phenomenon goes back to the origins of the republic. It is in the best interest of the country to acknowledge the existence of such guarantees, and to price them appropriately before, rather than after, they become necessary. (2) I will argue that in times of economic stress, such as now, the absence of government guarantees would lead to an absence of mortgages. (3) I will argue that a purely "private" market would likely not provide a 30 year fixed rate pre-payable mortgage. I think that this is no longer a particularly controversial statement; what is more controversial is whether such a mortgage is necessary — I will argue that it is. (4) I will argue that in the absence of a federal guarantee, the price and quantity of mortgages will vary across geography. In particular, rural areas will have less access to mortgage credit that urban areas, central cities will have less access than suburbs. Condominiums already are treated less favorably than detached houses, and this difference is likely to get larger in the absence of a guarantee.
TL;DR: In this paper, the authors focus on the manager's risk-taking incentives and derive an optimal compensation contract by using the concept of a comparable benchmark and imposing a volatility constraint in a principal-agent framework.
Abstract: There is controversy about the relative merits of stock and options in executive compensation. Some observers contend that stock is a more efficient mechanism, while others reach the opposite conclusion. We focus on the manager's risk-taking incentives and derive an optimal compensation contract by using the concept of a comparable benchmark and imposing a volatility constraint in a principal-agent framework. We demonstrate a joint role for both stock and options in the optimal contract. We show that firms with higher volatility should use more options in compensating their executives and provide empirical evidence supporting this testable implication.
TL;DR: In this paper, the authors present a model that incorporates product market competition into the standard neoclassical framework to explain why value-maximizing firms conduct mergers that appear to lower shareholder value.
Abstract: This paper presents a model that incorporates product market competition into the standard neoclassical framework. The model explains why value-maximizing firms conduct mergers that appear to lower shareholder value. In a Cournot setting, the model demonstrates a prisoners’ dilemma for merging firms in a merger wave. Consistent with the model’s implications, the paper empirically documents that horizontal mergers are followed by substantially worse performance when they occur during waves. Moreover, further empirical tests show that the empirical relation between performance and merger waves is independent of the method of payment and increasing in the acquirer’s managerial ownership. These findings are difficult to reconcile with alternative interpretations from existing theories.
TL;DR: Theories are metaphors, relative descriptions of the object of their attention that compare it to something similar already better understood via theories as discussed by the authors, and models are reductions in dimensionality that always simplify and sweep dirt under the rug.
Abstract: Theories deal with the world on its own terms, absolutely. Models are metaphors, relative descriptions of the object of their attention that compare it to something similar already better understood via theories. Models are reductions in dimensionality that always simplify and sweep dirt under the rug. Theories tell you what something is. Models tell you merely what something is partially like.
TL;DR: In this article, the authors show that even when initial convertible debt is designed to minimize the risk-shifting likelihood, the risk of asset substitution remains economically substantial, contrasting with the agency theoretic rationale for issuing convertible debt.
Abstract: Convertible debt eliminates asset substitution in a one-period setting (Green, 1984). But convertible debt terms are usually set before the asset substitution opportunity. This allows shareholders and convertible debtholders to play a strategic noncooperative game. Two risk-shifting Nash equilibria are attainable: pure asset substitution when, despite no conversion, shareholders benefit from shifting risk, and strategic conversion when, despite early conversion, convertible debtholders expropriate wealth from straight debtholders. Even when initial convertible debt is designed to minimize the risk-shifting likelihood, the risk of asset substitution remains economically substantial — contrasting with the agency theoretic rationale for issuing convertible debt.
TL;DR: In this article, the authors employ a new model where liquidity plays an important role in forecasting excess returns, and calculate the portfolio behavior and the utility benefits for three types of investors, the "sophisticated", the "average" and the "lazy" investor.
Abstract: This paper studies dynamic asset allocations across stocks, Treasury bonds, and corporate bond indices. We employ a new model where liquidity plays an important role in forecasting excess returns. We document the significant utility benefits an investor gains by optimally including corporate bond indices in his portfolio. The benefits are bigger for lower-grade bonds. We also find that investment-grade indices are different from high-yield indices in that different risks are priced in these two asset classes. One important difference is that there exist positive "flight-to-liquidity" premia in investment-grade bonds, but we find no such premia in high-yield bonds. We calculate the portfolio behavior and the utility benefits for three types of investors, the "sophisticated", the "average" and the "lazy" investor. We provide practical portfolio advice on investing throughout the business cycle and we study how the total allocations and hedging demands vary with the business conditions. In addition, utilizing our model, we evaluate the significance of the liquidity variable information for the investor. We find that the liquidity information greatly enhances the investor's portfolio performance. Finally, further support in the optimality of the strategies is provided by calculating their in- and out-of-sample realized returns for the last decade.
TL;DR: This article developed a model that measures the tradeoff between the compensation and incentive values of options and found that firms that use options more as a compensation device use fewer options and reduce other cash payments suggesting a resourceful and not abusive use of options.
Abstract: Because stock options have a dual role as both compensation and incentives, a portion of option value represents compensation and a portion represents incentives We develop a model that measures the tradeoff between the compensation and incentive values of options Empirical estimates over a 14-year period show that the median option contains $108 of incentives for every $100 of compensation and that option compensation is around 30% of total compensation We also find that firms that use options more as a compensation device use fewer options and reduce other cash payments suggesting a resourceful and not abusive use of options
TL;DR: In this article, the authors evaluate the major alternative proposals for reforming the U.S. home mortgage market assuming that the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mae, will be closed.
Abstract: This paper evaluates the major alternative proposals for reforming the U.S. home mortgage market assuming that the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mae, will be closed. The paper compares proposals that advocate primary reliance on private markets to take on the GSE functions with proposals that advocate government mortgage guarantees, including a discussion of how these plans differ in terms of duration, scope, and risk-sharing. The paper concludes with a discussion of current government attempts to expedite the modification or refinancing of existing mortgages, including a plan for the transition from the current situation to the long-term reforms.