Showing papers in "Review of Financial Studies in 1999"

Modeling Term Structures of Defaultable Bonds

Abstract: This article presents convenient reduced-form models of the valuation of contingent claims subject to default risk, focusing on applications to the term structure of interest rates for corporate or sovereign bonds. Examples include the valuation of a credit-spread option. This article presents a new approach to modeling term structures of bonds and other contingent claims that are subject to default risk. As in previous “reduced-form” models, we treat default as an unpredictable event governed by a hazard-rate process. 1 Our approach is distinguished by the parameterization of losses at default in terms of the fractional reduction in market value that occurs at default. Specifically, we fix some contingent claim that, in the event of no default, pays X at time T . We take as given an arbitrage-free setting in which all securities are priced in terms of some short-rate process r and equivalent martingale measure Q [see Harrison and Kreps (1979) and Harrison and Pliska (1981)]. Under this “risk-neutral” probability measure, we letht denote the hazard rate for default at time t and let Lt denote the expected fractional loss in market value if default were to occur at time t , conditional

Conflict of Interest and the Credibility of Underwriter Analyst Recommendations

Abstract: Brokerage analysts frequently comment on and sometimes recommend companies that their firms have recently taken public. We show that stocks that underwriter analysts recommend perform more poorly than “buy” recommendations by unaffiliated brokers prior to, at the time of, and subsequent to the recommendation date. We conclude that the recommendations by underwriter analysts show significant evidence of bias. We show also that the market does not recognize the full extent of this bias. The results suggest a potential conflict of interest inherent in the different functions that investment bankers perform.

A New Estimate of Transaction Costs

Abstract: Transaction costs are important for a host of empirical analyses from market efficiency to international market research. But transaction costs estimates are not always available, or where available, are cumbersome to use and expensive to purchase. We present a model that requires only the time series of daily security returns to endogenously estimate the effective transaction costs for any firm, exchange, or time period. The feature of the data that allows for the estimation of transaction costs is the incidence of zero returns. Incorporating zero returns in the return-generating process, the model provides continuous estimates of average round-trip transaction costs from 1963 to 1990 that are 1.2% and 10.3% for large and small decile firms, respectively. These estimates are highly correlated (85%), with the most commonly used transaction cost estimators. How much does it cost to trade common stock? The Plexus Group (1996) estimated that trading costs are at least 1.0-2.0% of market value for institutions trading the largest NYSE/AMEX firms. Such trades account for more than 20% of reported trading volume. Stoll and Whaley (1983) reported quoted spread and commission costs of 2.0% for the largest NYSE size decile to 9.0% for the small decile. Bwardwaj and Brooks (1992) reported median quoted spread and commission costs between 2.0% for NYSE securities with prices greater than $20.00 and 12.5% for securities priced less than $5.00. These costs are important in determining investment performance and "can substantially reduce or possibly outweigh the expected value created by an investment strategy" [Keim and Madhavan (1995)]. This article is based on a portion of the first chapter of David A. Lesmond's dissertation entitled: "Trans

Stock Market Overreactions to Bad News in Good Times: A Rational Expectations Equilibrium Model

Abstract: This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors’ willingness to hedge against changes in their own “uncertainty” on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, “leverage effects,” excess volatility, and time-varying expected returns.

A Theory of the Going-Public Decision

Abstract: We address the question: At what stage in its life should a firm go public rather than undertake its projects using private equity financing? In our model a firm may raise external financing either by placing shares privately with a risk-averse venture capitalist or by selling shares in an IPO to numerous small investors. The entrepreneur has private information about his firm’s value, but outsiders can reduce this informational disadvantage by evaluating the firm at a cost. The equilibrium timing of the going-public decision is determined by the firm’s tradeoff between minimizing the duplication in information production by outsiders (unavoidable in the IPO market, but mitigated by a publicly observable share price) and avoiding the risk-premium demanded by venture capitalists. Testable implications are developed for the cross-sectional variations in the age of goingpublic across industries and countries. This article develops a model of the going-public decision of a firm and addresses the question, At what stage in its life should a firm go public rather than financing its projects through a private placement of equity (e.g., with a venture capitalist)? Beyond the fact that most firms start out as small private companies and at some point in their growth go public, we know relatively little about the trade-offs underlying a firm’s choice between remaining private or going public. Indeed, beyond a general idea that going public allows the firm’s shares to become more liquid, discussions of the goingpublic decision usually do not include a precise notion of the economic advantages or disadvantages of financing a firm’s projects by going public

Implementing Statistical Criteria to Select Return Forecasting Models: What Do We Learn?

Abstract: Statistical model selection criteria provide an informed choice of the model with best external (i.e., out-of-sample) validity. Therefore they guard against overfitting ('data snooping'). We implement several model selection criteria in order to verify recent evidence of predictability in excess stock returns and to determine which variables are valuable predictors. We confirm the presence of in-sample predictability in an international stock market dataset, but discover that even the best prediction models have no out-of-sample forecasting power. The failure to detect out-of-sample predictability is not due to lack of power.

On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model

Abstract: We evaluate the performance of models for the covariance structure of stock returns, focusing on their use for optimal portfolio selection. We compare the models’ forecasts of future covariances and the optimized portfolios’ out-of-sample performance. A few factors capture the general covariance structure. Portfolio optimization helps for risk control, and a three-factor model is adequate for selecting the minimum-variance portfolio. Under a tracking error volatility criterion, which is widely used in practice, larger differences emerge across the models. In general more factors are necessary when the objective is to minimize tracking error volatility.

Market Transparency: Who Wins and Who Loses?

Abstract: This study uses laboratory experiments to determine the effects of trade and quote disclosure on market efficiency, bid-ask spreads, and trader welfare. We show that trade disclosure increases the informational efficiency of transaction prices, but also increases opening bid-ask spreads, apparently by reducing market-makers' incentives to compete for order flow. As a result, trade disclosure benefits market makers at the expense of liquidity traders and informed traders. We find that quote disclosure has no discernible effects on market performance. Overall our results demonstrate that the degree of market transparency has important effects of market equilibria and on trader and market-maker welfare. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Volatility Timing in Mutual Funds: Evidence from Daily Returns

Abstract: I use daily mutual fund returns to shed new light on the question of whether or not mutual fund managers are successful market timers. Previous studies find that funds are unable to time the market return. I study the funds' ability to time market volatility. I show that volatility timing is an important factor in the returns of mutual funds and has led to higher risk-adjusted returns. The returns of surviving funds are especially sensitive to market volatility; those of nonsurvivors are not. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

A Parametric Nonlinear Model of Term Structure Dynamics

Abstract: Recent nonparametric estimation studies pioneered by Ait-Sahalia document that the diffusion of the short rate is similar to the parametric function, r[superscript 1.5], estimated by Chan et al., whereas the drift is substantially nonlinear in the short rate. These empirical properties call into question the efficacy of the existing affine term structure models and beg for alternative models which admit the observed behavior. This article presents such a model. Our model delivers closed-form solutions for bond prices and a concave relationship between the interest rate and the yields. We show that in empirical analyses, our model outperforms the one-factor affine models in both time-series as well as cross-sectional tests. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Causes and Effects of Corporate Refocusing Programs

Abstract: We study the precursors and outcomes of refocusing episodes by 107 diversified firms that were not taken over between 1984 and 1993. These firms had more value-reducing diversification policies than diversified firms that did not refocus. However, major disciplinary or incentive-altering events (including management turnover, outside shareholder pressure, changes in management compensation, and financial distress) usually occurred before refocusing took place. The cumulative abnormal returns over a firm's refocusing-related announcements averaged 7.3% and were significantly related to the amount of value reduction associated with the refocuser's diversification policy.

Filter Rules Based on Price and Volume in Individual Security Overreaction

Abstract: I present evidence of predictability in a sample constructed to minimize concerns about time-varying risk premia and market-microstructure effects. I use filter rules on lagged return and lagged volume information to uncover weekly over-reaction profits on large-capitalization NYSE and AMEX securities. I find that decreasing-volume stocks experience greater reversals. Increasing-volume stocks exhibit weaker reversals and positive autocorrelation. A real-time simulation of the filter strategies suggests that an investor who pursues the filter strategy with relatively low transaction costs will strongly outperform an investor who follows a buy-and-hold strategy. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Dynamics of Default and Debt Reorganization

Abstract: This article documents the fact that when debtors decide to default on their obligations too early, it is in the creditors’ collective interest, as residual claimants, to make concessions prior to forcing a costly liquidation. Symmetrically, when debtors prefer to default at an inefficiently late stage, it is in the creditors’ interest to propose a departure from the absolute priority rule. This article develops a continuous time pricing model of dynamic debt restructuring that reflects the crucial influence of the two counterparties’ relative bargaining power. Simple and intuitive path-dependent pricing formulae are derived for equity and debt. The debt capacity as well as the evolution of the firm’s capital structure throughout its existence is provided.

Quote Disclosure and Price Discovery in Multiple-Dealer Financial Markets

Abstract: We examine the effects of price disclosure on market performance in a continuous experimental multiple-dealer market in which seven professional market makers trade a single security. The dealers trade with one another and with computerized informed and liquidity traders. Our key comparison is between fully public price queues (pretrade transparent market) and bilateral quoting (pretrade opaque). We find that opening spreads are wider and trading volume is lower in the opaque markets due to higher search costs there. More importantly, however, higher search costs also induce more aggressive pricing strategies, so that price discovery is much faster in the opaque markets. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

On the Heterogeneity of Leveraged Going Private Transactions

Abstract: In contrast to previous literature, we argue that are two types of poorly performing firms going private through a leveraged buyout (LBO). One group consists of firms in which managers own an insignificant fraction of their firm's stock and are vulnerable to a hostile takeover. The other group consists of firms in which managers own a significant fraction of their firm's stock and so face little risk of hostile takeover. Our evidence indicates that there are two such groups of LBOs and that their motivations and posttransaction actions are different. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Information Revelation Through Option Exercise

Abstract: In many real-world situations, agents must formulate option exercise strategies with imperfect information In such a setting, agents may infer the private signals of other agents through their observed exercise strategies The building of an office building, the drilling of an exploratory oil well, and the commitment of a pharmaceutical company toward the research of a new drug all convey private information to other market participants This article develops an equilibrium framework for option exercise games with asymmetric private information Many interesting aspects of the patterns of equilibrium exercise are analyzed In particular, informational cascades, where agents ignore their private information and jump on the exercise bandwagon, may arise endogenously Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies

Stock Returns and Inflation with Supply and Demand Disturbances

Abstract: We account for the relation between stock returns and inflation with two independent disturbances: supply shocks and demand shocks. Supply shocks reflect real output shocks and cause a negative relation between stock returns and inflation, while demand shocks are mainly due to monetary shocks and generate a positive relation between stock returns and inflation. We show, both theoretically and empirically, that the stock return-inflation relation varies over time and across countries, depending on the relative importance of the two types of shocks. Our empirical evidence is based on pre- and postwar periods in the United States, as well as the postwar period in the United Kingdom, Japan, Germany. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Effect of Derivative Assets on Information Acquisition and Price Behavior in a Rational Expectations Equilibrium

Abstract: This article shows that introducing derivative assets increases incentives to collect information about asset payoffs. The increase in information collection makes the price of the underlying asset more informative and causes the expected price to increase. Extending the model to a dynamic setting with multiple risky assets, we find the introducing derivative assets for one asset increases the expected prices of positively correlated assets and reduces price reaction to future earnings announcements. These findings are consistent with the bulk of the empirical evidence on the relationship between the introduction of derivative assets and the behavior of asset prices. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Determinants of Mutual Fund Starts

Abstract: For a sample of 1163 mutual funds started over the period 1979‐1992, we find that fund initiations are positively related to the level of assets invested in and the capital gains embedded in other funds with the same objective, the fund family’s prior performance, the fraction of funds in the family in the low range of fees, and the decision by large families to open similar funds in the prior year. In addition, consistent with the presence of scale and scope economies in fund openings, we find that large families and families that have more experience in opening funds in the past are more likely to open new funds. The dramatic growth in mutual funds in recent years has been one of the most significant developments in the financial services industry. Mutual fund organizations wield significant market power in today’s financial markets both in terms of their ability to control large equity stakes in publicly traded corporations and their ability to affect market prices. 1 Despite rapid industry growth both in terms of the total assets under management and the number of fund offerings available to investors, little attention has been devoted to the decision-making process within funds and fund families. In particular, the factors that fund families consider in their decision to open a new fund have not been closely examined. Understanding the new fund opening decision assumes added importance in light of the fact that new funds in existence for less than 1 year (2 years) controlled as much as 6% (25%) of all fund assets in any given year during the 1980s and early 1990s. In this article, we investigate the rationale behind the emergence of new funds, both by new families as well as by existing families of funds. Understanding why new funds get started is useful for all the constituents: (i) academics would be interested since it highlights the industrial organization

Nontraded Asset Valuation with Portfolio Constraints: A Binomial Approach

Abstract: We provide a simple binomial framework to value American-style derivatives subject to trading restrictions. The optimal investment of liquid wealth is solved simultaneously with the early exercise decision of the nontraded derivative. Noshort-sales constraints on the underlying asset manifest themselves in the form of an implicit dividend yield in the risk-neutralized process for the underlying asset. One consequence is that American call options may be optimally exercised prior to maturity even when the underlying asset pays no dividends. Applications to executive stock options (ESO) are presented: it is shown that the value of an ESO could be substantially lower than that computed using the Black‐Scholes model. We also analyze nontraded payoffs based on a price that is imperfectly correlated with the price of a traded asset. The economics of asset pricing when one or more of the assets in the opportunity set are either subject to trading restrictions or entirely nontraded is a matter of great interest. Viewed from a practical perspective, we have several important examples of such assets that are subject to trading restrictions. Pensions, which represent perhaps the most significant of assets held by individual households, are subject to trading restrictions. It is typically the case that assets in pensions are not available for immediate consumption. Borrowing against pension assets is subject to significant direct and indirect costs by way of taxes and early withdrawal penalties. Human capital is another example. Housing investment is also illiquid and subject to significant transaction costs. Together, pensions, human capital, and housing constitute a substantial part of a typical household’s assets. The significance of such nontraded assets for risk premia has already been noted by Bewley (1982). There are other circumstances where lack of unrestricted trading plays an important role. Executive compensation plans usually take the This article was presented at Boston University. We would like to thank the editor, Bernard Dumas, and two anonymous referees for very helpful comments. We also thank Nalin Kulatilaka and seminar participants for useful suggestions. Ganlin Chang, Fei Guan, and Carlton Osakwe provided valuable research assistance. J. Detemple acknowledges support from the Social Sciences and Humanities Research ‐

FX Spreads and Dealer Competition Across the 24-Hour Trading Day

Abstract: This study examines the impact of competition on bid-ask spreads in the spot foreign exchange market. We measure competition primarily by the number of dealers active in the market and find that bid-ask spreads decrease with an increase in competition, even after controlling for the effects of volatility. The expected level of competition is time varying, highly predictable, and displays a strong seasonal component that in part is induced by geographic concentration of business activity over the 24-hour trading day. Our estimates show that the expected addition of one more competing dealer lowers the average quoted spread by 1.7%. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Quantitative Asset Pricing Implications of Endogenous Solvency Constraints

Abstract: We study the asset pricing implications of an economy where solvency constraints are endogenously determined to deter agents from defaulting while allowing as much risk sharing as possible. We solve analytically for efficient allocations and for the corresponding asset prices, portfolio holdings, and solvency constraints for a simple example. Then we calibrate a more general model to U.S. aggregate as well as idiosyncratic income processes. We find equity premia, risk premia for long-term bonds, and Sharpe ratios of magnitudes similar to the U.S. data for low risk aversion and a low time-discount factor. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Demand for Stocks: An Analysis of IPO Auctions

Abstract: We analyze a unique dataset that includes the full demand schedules of 27 Israeli IPOs that were conducted as nondiscriminatory (uniform price) auctions. To the best of our knowledge, this is the first time the whole demand schedule for any asset is described. The demand schedules are relatively flat around the auction clearing price: The average elasticity is 27. The elasticity is low when the return distribution contains a large unique component. We also find a significant average abnormal return of 4.5% on the first trading day and a positive correlation between the abnormal return and the elasticity of demand. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Optimal Bankruptcy Laws Across Different Economic Systems

Abstract: We model fundamental differences across economic systems and propose optimal bankruptcy laws. We show that creditor-debtor relationships in a given economy are affected by the ability of creditors to obtain information about fundamentals and the managers' ability to strategically use their private information. An optimal bankruptcy law utilizes creditors' information while minimizing managers' use of strategic information. Our proposed laws for a developed bank-based system like Germany include a creditor chapter only, for a developed market-based system like the United States include both a creditor chapter and a debtor chapter, and for an underdeveloped system include both a creditor chapter and a debtor chapter that gives the manager more protection than in a market-based system. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Underreaction Hypothesis and the New Issue Puzzle: Evidence from Japan

Abstract: This article investigates the long-term equity performance of Japanese firms issuing convertible debt and equity. We find that issuing firms perform poorly (except for equity rights issues) compared to nonissuing firms even though the stockprice reaction to convertible debt and equity issues is not negative for Japanese firms. This underperformance is strongest for firms issuing public convertible debt. In contrast to the United States, poor performance is not concentrated in smaller firms and in firms with a high market-to-book ratio. Simple behavioral explanations advanced for the new issue puzzle in the United States do not seem consistent with the Japanese experience.

Trade Disclosure Regulation in Markets with Negotiated Trades

Abstract: In dealership markets disclosure of size and price details of public trades is typically incomplete. We examine whether full and prompt disclosure of public-trade details improves the welfare of a risk-averse investor. We analyze a model of dealership market where a market maker first executes a public trade and then offsets her position by trading with other market makers. We distinguish between quantity risk and price revision risk. We show that if the market maker learns some information about the motive behind public trade, neither regime is unambiguously welfare superior. This is because greater transparency improves quantity risk sharing but worsens price revision risk sharing. It is widely believed that greater transparency in the trading process is desirable. In this view, increasing disclosure in trading is desirable because it reduces adverse selection, encourages uninformed investors to participate in the market, and facilitates risk sharing. The purpose of this article is to examine circumstances in dealership environments in which requiring full and prompt disclosure may reduce welfare. 1 We model the market with

The Specialist's Discretion: Stopped Orders and Price Improvement

Abstract: When a market order arrives, the NYSE specialist can offer a price one tick better than the limit orders on the book and trade for his own account. Alternatively, the specialist can "stop" the market order, which means he guarantees execution at the current quote but provides the possibility of price improvement. My model shows that specialists can use stops to sample the future order flow before making a commitment to trade. I present empirical evidence that both stops and immediate price improvement impose adverse selection costs on limit order traders. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Dynamics of the Management-Shareholder Conflict

Abstract: This article investigates the distribution of equity ownership between entrenched management and dispersed outsiders when management has the ability to manipulate the cash flows and when it is costly for equity holders to prove managerial wrongdoing in court. Management chooses the distribution of equity ownership so as to maximize private benefits against the risk of potential control challenges. When shareholders are long-term oriented, then outside shares trade at a premium over the value to management, and management is inclined to sell off its equity stake to dispersed outsiders. When shareholders are short-term oriented, then outside shares trade at a discount below their value to management, and disciplinary pressure can be substantially reduced via strategic share purchases. Changes in the cost of capital drive a wedge between entrenched management's and dispersed outsider's valuation of shares. Management exercises its option to buy (sell) shares when the option is in the money: when management values shares more (less) than outsiders do. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Changes of Numeraire for Pricing Futures, Forwards, and Options

Abstract: A change of numeraire argument is used to derive a general option parity, or equivalence, result relating American call and put prices, and to obtain new expressions for futures and forward prices. The general parity result unifies and extends a number of existing results. The new futures and forward pricing formulas are often simpler to compute in multifactor models than existing alternatives. We also extend previous work by deriving a general formula relating exchange options to ordinary call options. A number of applications to diffusion models, including stochastic volatility, stochastic interest rate, and stochastic dividend rate models, and jump-diffusion models are examined. A self-financing portfolio is called a numeraire if security prices, measured in units of this portfolio, admit an equivalent martingale measure. The most commonly used numeraire is the reinvested short-rate process; the corresponding equivalent martingale measure is the risk-neutral measure. Geman, El Karoui, and Rochet (1995) show that other numeraires can simplify many asset pricing problems. In this article, we build on their results and, using the reinvested asset price as the numeraire, unify and extend the literature on option parity, or equivalence, results relating American call and put prices for asset and futures options. The same numeraire change is used to obtain new pricing formulas for futures and forwards that are often simpler to compute in multifactor models. Finally, we use a numeraire change to simplify exchange option pricing, extending a similar result in Geman, El Karoui, and Rochet to dividend-paying assets. The change of numeraire method is most intuitive in the context of foreign currency derivative securities. As discussed by Grabbe (1983), an American call option to buy 1 DM, with dollar price process S, for K dollars is equivalent to an American put option to sell K dollars, with DM price process K=S, for a strike price of 1 DM. The dollar price of the call must therefore equal the product of the current exchange rate, S0, and the DM price of the put. The call price is computed using the dollar value of a U.S. I am grateful to Kerry Back (the editor) and Costis Skiadas for their many helpful suggestions. Thanks also to Peter DeMarzo, Matt Jackson, Naveen Khanna, David Marshall, Robert McDonald, Jim Moser, Phyllis Payette, and an anonymous referee for their comments. This article subsumes Schroder (1992).

A Transactions Data Analysis of Nonsynchronous Trading

Abstract: Weekly returns of stock portfolios exhibit substantial autocorrelation. Analytical studies suggest that nonsynchronous trading is capable of explaining from 5% to 65% of the autocorrelation. The varying importance of nonsynchronous trading in these studies arises primarily from differing assumptions regarding nontrading periods of stocks. We simulate the effects of nonsynchronous trading by sampling stock returns from a return generating process using transactions data to obtain the precise time of each stock's last trade. We find that simulated weekly portfolio returns exhibit autocorrelations that are roughly 25% that of their observed (CRSP) weekly returns. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.