Showing papers in "Review of Financial Studies in 2008"

A Comprehensive Look at the Empirical Performance of Equity Premium Prediction

Abstract: Our article comprehensively reexamines the performance of variables that have been suggested by the academic literature to be good predictors of the equity premium. We find that by and large, these models have predicted poorly both in-sample (IS) and out-of-sample (OOS) for 30 years now; these models seem unstable, as diagnosed by their out-of-sample predictions and other statistics; and these models would not have helped an investor with access only to available information to profitably time the market.

All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors

Abstract: We test and confirm the hypothesis that individual investors are net buyers of attention-grabbing stocks, e.g., stocks in the news, stocks experiencing high abnormal trading volume, and stocks with extreme one-day returns. Attention-driven buying results from the difficulty that investors have searching the thousands of stocks they can potentially buy. Individual investors do not face the same search problem when selling because they tend to sell only stocks they already own. We hypothesize that many investors consider purchasing only stocks that have first caught their attention. Thus, preferences determine choices after attention has determined the choice set.

Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average?

Abstract: Goyal and Welch (2007) argue that the historical average excess stock return forecasts future excess stock returns better than regressions of excess returns on predictor variables. In this article, we show that many predictive regressions beat the historical average return, once weak restrictions are imposed on the signs of coefficients and return forecasts. The out-of-sample explanatory power is small, but nonetheless is economically meaningful for mean-variance investors. Even better results can be obtained by imposing the restrictions of steady-state valuation models, thereby removing the need to estimate the average from a short sample of volatile stock returns. (JEL G10, G11) Towards the end of the last century, academic finance economists came to take seriously the view that aggregate stock returns are predictable. During the 1980s, a number of papers studied valuation ratios, such as the dividend-price ratio, earnings-price ratio, or smoothed earnings-price ratio. Value-oriented investors in the tradition of Graham and Dodd (1934) had always asserted that high valuation ratios are an indication of an undervalued stock market and should predict high subsequent returns, but these ideas did not carry much weight in the academic literature until authors such as Rozeff (1984), Fama and French (1988), and Campbell and Shiller (1988a, 1988b) found that valuation ratios are positively correlated with subsequent returns and that the implied predictability of returns is substantial at longer horizons. Around the same time, several papers pointed out that yields on short- and long-term treasury and corporate bonds are correlated with subsequent stock returns (Fama and Schwert,1977;KeimandStambaugh,1986;Campbell,1987;FamaandFrench, 1989).

Forecasting Default with the Merton Distance to Default Model

Abstract: We examine the accuracy and contribution of the Merton distance to default (DD) model, which is based on Merton's (1974) bond pricing model. We compare the model to a “naive” alternative, which uses the functional form suggested by the Merton model but does not solve the model for an implied probability of default. We find that the naive predictor performs slightly better in hazard models and in out-of-sample forecasts than both the Merton DD model and a reduced-form model that uses the same inputs. Several other forecasting variables are also important predictors, and fitted values from an expanded hazard model outperform Merton DD default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with Merton DD probabilities after adjusting for agency ratings and bond characteristics. We conclude that while the Merton DD model does not produce a sufficient statistic for the probability of default, its functional form is useful for forecasting defaults.

A Theory of Board Control and Size

Abstract: We extend the traditional view of corporate boards as monitors to include a role for outside board members as suppliers of expertise or information. Indeed, both outsiders and insiders may have private information relevant to the decision. Because of the agency problem between managers and owners (who are assumed to be represented by the outside directors), neither party will communicate his or her information fully to the other. Outsiders in our model control agency problems by making some decisions themselves. When they do, the refusal of insiders to communicate their information fully becomes costly. Therefore, shareholders can sometimes be better off by having boards controlled by insiders. We characterize whether the board is optimally controlled by insiders or outsiders, the optimal number of outsiders, and resulting profits as functions of the importance of insiders’ and outsiders’ information, the extent of agency problems, and some other factors. This leads to an endogenous relationship between profits and the number of outside directors that furthers our understanding of some documented empirical regularities.

The Dog That Did Not Bark: A Defense of Return Predictability

Abstract: If returns are not predictable, dividend growth must be predictable, to generate the observed variation in divided yields. I find that the absence of dividend growth predictability gives stronger evidence than does the presence of return predictability. Long-horizon return forecasts give the same strong evidence. These tests exploit the negative correlation of return forecasts with dividend-yield autocorrelation across samples, together with sensible upper bounds on dividend-yield autocorrelation, to deliver more powerful statistics. I reconcile my findings with the literature that finds poor power in long-horizon return forecasts, and with the literature that notes the poor out-of-sample R 2 of return-forecasting regressions. (JEL G12, G14, C22) Are stock returns predictable? Table 1 presents regressions of the real and excess value-weighted stock return on its dividend-price ratio, in annual data. In contrast to the simple random walk view, stock returns do seem predictable. Similar or stronger forecasts result from many variations of the variables and data sets.

Jumps in Financial Markets: A New Nonparametric Test and Jump Dynamics

Abstract: This paper introduces a new nonparametric test to detect jump arrival times and realized jump sizes in asset prices up to the intra-day level. We demonstrate that the likelihood of misclassiflcation of jumps becomes negligible when we use high-frequency returns. Using our test, we examine jump dynamics and their distributions in the U.S. equity markets. The results show that individual stock jumps are associated with prescheduled earnings announcements and other company-speciflc news events. Additionally, S&P 500 Index jumps are associated with general market news announcements. This suggests difierent pricing models for individual equity options versus index op

The Spline-GARCH Model for Low Frequency Volatility and its Global Macroeconomic Causes

Abstract: Twenty-five years of volatility research has left the macroeconomic environment playing a minor role. This paper proposes modeling equity volatilities as a combination of macro- economic effects and time series dynamics. High-frequency return volatility is specified to be the product of a slow-moving component, represented by an exponential spline, and a unit GARCH. This slow-moving component is the low-frequency volatility, which in this model coincides with the unconditional volatility. This component is estimated for nearly 50 countries over various sample periods of daily data. Low-frequency volatility is then modeled as a function of macroeconomic and financial variables in an unbalanced panel with a variety of dependence structures. It is found to vary over time and across countries. The low-frequency component of volatility is greater when the macroeconomic factors of GDP, inflation, and short-term interest rates are more volatile or when inflation is high and output growth is low. Volatility is higher not only for emerging markets and markets with small numbers of listed companies and market capitalization relative to GDP, but also for large economies. The model allows long horizon forecasts of volatility to depend on macroeconomic developments, and delivers estimates of the volatility to be anticipated in a newly opened market.

Formal Versus Informal Finance : Evidence from China

Abstract: China is often mentioned as a counterexample to the findings in the finance and growth literature since, despite the weaknesses in its banking system, it is one of the fastest growing economies in the world. The fast growth of Chinese private sector firms is taken as evidence that it is alternative financing and governance mechanisms that support China's growth. This paper takes a closer look at firm financing patterns and growth using a database of 2,400 Chinese firms. The authors find that a relatively small percentage of firms in the sample utilize formal bank finance with a much greater reliance on informal sources. However, the results suggest that despite its weaknesses, financing from the formal financial system is associated with faster firm growth, whereas fund raising from alternative channels is not. Using a selection model, the authors find no evidence that these results arise because of the selection of firms that have access to the formal financial system. Although firms report bank corruption, there is no evidence that it significantly affects the allocation of credit or the performance of firms that receive the credit. The findings suggest that the role of reputation and relationship based financing and governance mechanisms in financing the fastest growing firms in China is likely to be overestimated.

Reconciling the Return Predictability Evidence

Abstract: Evidence of stock-return predictability by financial ratios is still controversial, as docu- mented by inconsistent results for in-sample and out-of-sample regressions and by substan- tial parameter instability. This article shows that these seemingly incompatible results can be reconciled if the assumption of a fixed steady state mean of the economy is relaxed. We find strong empirical evidence in support of shifts in the steady state and propose simple methods to adjust financial ratios for such shifts. The in-sample forecasting relationship of adjusted price ratios and future returns is statistically significant and stable over time. In real time, however, changes in the steady state make the in-sample return forecastability hard to exploit out-of-sample. The uncertainty of estimating the size of steady-state shifts rather than the estimation of their dates is responsible for the difficulty of forecasting stock returns in real time. Our conclusions hold for a variety of financial ratios and are robust to changes in the econometric technique used to estimate shifts in the steady state. (JEL 12, 14)

The New Issues Puzzle: Testing the Investment-Based Explanation

Abstract: An investment factor, long in low-investment stocks and short in high-investment stocks, helps explain the new issues puzzle. Adding the investment factor into standard factor regressions reduces the SEO underperformance by about 75%, the IPO underperformance by 80%, the underperformance following convertible debt offerings by 50%, and Daniel and Titman’s (2006) composite issuance effect by 40%. The reason is that issuers invest more than nonissuers, and the investment factor earns a significantly positive average return of 0.57% per month. Equity and debt issuers underperform matching nonissuers with similar characteristics in the post-issue years (e.g., Ritter, 1991; Loughran and Ritter, 1995; and Spiess and Affleck-Graves, 1995, 1999). We explore empirically the investment-based hypothesis of this underperformance. The q-theory of investment and the real options theory imply a negative relation between real investment and expected returns. If the proceeds from equity and debt issues are used to finance investment, then issuers should invest more and earn lower average returns than matching nonissuers.

Unobserved Actions of Mutual Funds

Abstract: Despite extensive disclosure requirements, mutual fund investors do not observe all actions of fund managers. We estimate the impact of unobserved actions on fund returns using the return gap—the difference between the reported fund return and the return on a portfolio that invests in the previously disclosed fund holdings. We document that unobserved actions of some funds persistently create value, while such actions of other funds destroy value. Our main result shows that the return gap predicts fund performance.

Does Capital Account Liberalization Lead to Growth

Abstract: We test whether capital account liberalization led to higher economic growth using de jure measures of capital account and financial current account openness for 94 nations, from 1950 (or independence) onward. We argue that measurement error, differing time periods used, and collinearity among independent variables account for conflicting results in prior scholarship. We use pooled time-series, cross-sectional OLS and system GMM estimators toexamineeconomicgrowthrates,1955‐2004.Capitalaccountliberalizationhadapositive association with growth in both developed and emerging market nations. We confirm that equity market liberalization has an independent effect on economic growth. (JEL F02, F43, P16) In this paper, we reexamine the effects of capital account liberalization on economic growth in the context of addressing the inconsistent and widely diverging results that have been reported in the scholarly literature over the last decade. (See the comprehensive review essays on the topic by Eichengreen, 2001 and Kose et al., 2006; henceforth KPRW.) We strive to untangle the reasons behind this inconsistency, and to situate our results in the broader literature on finance and growth. • We propose that conflicting prior results are associated in part with measurement error in capital account variables. We offer a new dataset that contains more precise de jure measures of capital account regulation for a wide sample of countries (94) for up to 50 years (1950 to 1999). The

Complex ownership structures and corporate valuations

Abstract: The bulk of corporate governance theory examines the agency problems that arise from two extreme ownership structures: 100% small shareholders or one large, controlling owner combined with small shareholders. In this paper, we question the empirical validity of this dichotomy. In fact, one-third of publicly listed firms in Europe have multiple large owners, and the market value of firms with multiple blockholders differs from firms with a single large owner and from widely held firms. Moreover, the relationship between corporate valuations and the distribution of cash-flow rights across multiple large owners is consistent with the predictions of recent theoretical models.

Interpreting the Value Effect Through the Q-Theory: An Empirical Investigation

Abstract: This article interprets the well-known value effect through the implications of standard Q-theory. An investment growth factor, defined as the difference in returns between low-investment stocks and high-investment stocks, contains information similar to the Fama and French (1993) value factor (HML), and can explain the value effect about as well as HML. In the cross-section, portfolios of firms with low investment growth rates (IGRs) or low investment-to-capital ratios have significantly higher average returns than those with high IGRs or high investment-to-capital ratios. The value effect largely disappears after controlling for investment, and the investment effect is robust against controls for the marginal product of capital. These results are consistent with the predictions of a standard Q-theory model with a stochastic discount factor.

Contracts and Exits in Venture Capital Finance

Abstract: Using a sample of European venture capital (VC) investments, I study the relation between VC contracts and exits. The data indicate that ex ante, stronger VC control rights increase the likelihood that an entrepreneurial firm will exit by an acquisition, rather than through a write-off or an IPO. My findings are robust to controls for a variety of factors, including endogeneity and cases in which the VC preplans the exit at the time of contract choice. My findings are consistent with control-based theories of financial contracting, such as Aghion and Bolton (1992).

Small Trades and the Cross-Section of Stock Returns

Abstract: This paper uses volume arising from small trades to analyze the relationship between retail investor trading behavior and the cross-section of future stock returns. The central finding is that stocks with intense sell-initiated small-trade volume, measured over the past several months, outperform stocks with intense buy-initiated small-trade volume. This return difference accrues from the first month after the portfolio formation up to two years later. Among small- and medium-sized firms, the return difference continues in the third year. The results suggest that stocks favored by retail investors subsequently experience prolonged underperformance relative to stocks out of favor with retail investors.

Can Growth Options Explain the Trend in Idiosyncratic Risk

Abstract: While recent studies document increasing idiosyncratic volatility over the past four decades, an explanation for this trend remains elusive. We establish a theoretical link between growth options available to managers and the idiosyncratic risk of equity. Empirically both the level and variance of corporate growth options are significantly related to idiosyncratic volatility. Accounting for growth options eliminates or reverses the trend in aggregate firm-specific risk. These results are robust for different measures of idiosyncratic volatility, different growth option proxies, across exchanges, and through time. Finally, our results suggest that growth options explain the trend in idiosyncratic volatility beyond alternative explanations.

Money Illusion and Housing Frenzies

Abstract: A reduction in in‡ation can fuel run-ups in housing prices if people suer from money illusion For example, investors who decide whether to rent or buy a house simply comparing monthly rent and mortgage payments do not take into account that in‡ation lowers future real mortgage costs We decompose the price-rent ratio in a rational component -meant to capture proxy eect and risk premia -and an implied mispricing We …nd that in‡ation and nominal interest rates explain a large share of the time-series variation of the mispricing, and that the tilt eect is unlikely to rationalize this …nding

The Value of Investor Protection: Firm Evidence from Cross-Border Mergers

Abstract: International law prescribes that in a cross-border acquisition of 100% of the target shares, the target firm becomes a national of the country of the acquiror, and consequently subject to its corporate governance system. Therefore, cross-border mergers provide a natural experiment to analyze the effects of changes in corporate governance on firm value. We construct measures of the change in investor protection in a sample of 506 acquisitions from 39 countries. We find that the better the shareholder protection and accounting standards in the acquiror's country, the higher the merger premium in cross-border mergers relative to matching domestic acquisitions.

The myth of long-horizon predictability

Abstract: The prevailing view in finance is that the evidence for long-horizon stock return predictability is significantly stronger than that for short horizons. We show that for persistent regressors, a characteristic of most of the predictive variables used in the literature, the estimators are almost perfectly correlated across horizons under the null hypothesis of no predictability. For the persistence levels of dividend yields, the analytical correlation is 99% between the 1- and 2-year horizon estimators and 94% between the 1- and 5-year horizons. Common sampling error across equations leads to ordinary least squares coefficient estimates and R 2 s that are roughly proportional to the horizon under the null hypothesis. This is the precise pattern found in the data. We perform joint tests across horizons for a variety of explanatory variables and provide an alternative view of the existing evidence. (JEL G12, G14, C12) Over the last two decades, the finance literature has produced growing evidence of stock return predictability, though not without substantial debate. The strongest evidence cited so far comes from long-horizon stock returns regressed on variables such as dividend yields, term structure slopes, and credit spreads, among others. A typical view is expressed in Campbell, Lo, and MacKinlay’s (1997, p.268) standard textbook for empirical financial economics, The Econometrics of Financial Markets: At a horizon of 1-month, the regression results are rather unimpressive: The R 2 statistics never exceed 2%, and the t-statistics exceed 2 only in the post-World War II subsample. The striking fact about the table is how much stronger the results become when one increases the horizon. At a 2-year horizon the R 2 statistic is 14% for the full sample ... at a 4-year horizon the R 2 statistic is 26% for the full sample.

Building Relationships Early: Banks in Venture Capital

Abstract: This paper examines bank behavior in venture capital. It considers the relation between a bank's venture capital investments and its subsequent lending, which can be thought of as intertemporal cross-selling. Theory suggests that unlike independent venture capital firms, banks may be strategic investors who seek complementarities between venture capital and lending activities. We find evidence that banks use venture capital investments to build lending relationships. Having a prior relationship with a company in the venture capital market increases a bank's chance of subsequently granting a loan to that company. Companies can benefit from these relationships through more favorable loan pricing.

The Declining Equity Premium: What Role Does Macroeconomic Risk Play?

Abstract: Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. Empirically, we find a strong correlation between low-frequency movements in macroeconomic volatility and low-frequency movements in the stock market. To model this phenomenon, we estimate a two-state regime switching model for the volatilityandmeanofconsumptiongrowth,andfindevidenceofashifttosubstantially lower consumption volatility at the beginning of the 1990s. We then use these estimates from postwar data to calibrate a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth. Plausible parameterizations of the model are found to account for a significant portion of the run-up in asset valuation ratios observed in the late 1990s. (JEL G12) It is difficult to imagine a single issue capable of eliciting near unanimous agreement among the many opposing cadres of economic thought. Yet if those who study financial markets are in accord on any one point, it is this: the close of the 20th century marked the culmination of the greatest surge in equity values ever recorded in U.S. history. Aggregate stock prices, relative to virtually any indicator of fundamental value,

Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures

Abstract: As the number of bank failures increases, the set of assets available for acquisition by surviving banks enlarges but the total liquidity available with surviving banks falls. This results in “cash-in-the-market” pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity-endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show, however, that there exists a policy that involves granting liquidity to surviving banks in the purchase of failed banks, which is equivalent to the bailout policy from an ex-post standpoint. Crucially, this liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and thereby dominates the bailout policy from an ex-ante standpoint.

Investor Sentiment and Option Prices

Abstract: This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. The findings reveal that the index option volatility smile is steeper (flatter) and the risk-neutral skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more impediments to arbitrage in index options. They cannot be explained by rational perfect-market-based option pricing models. Changes in investor sentiment help explain time variation in the slope of index option smile and risk-neutral skewness beyond factors suggested by the current models.

Momentum Profits, Factor Pricing, and Macroeconomic Risk

Abstract: Recent winners have temporarily higher loadings than recent losers on the growth rate of industrial production. The loading spread derives mostly from the positive loadings of winners. The growth rate of industrial production is a priced risk factor in standard asset pricing tests. In many specifications, this macroeconomic risk factor explains more than half of momentum profits. We conclude that risk plays an important role in driving momentum profits.

Estimating the Dynamics of Mutual Fund Alphas and Betas

Abstract: This article develops a Kalman filter model to track dynamic mutual fund factor loadings. It then uses the estimates to analyze whether managers with market-timing ability can be identified ex ante. The primary findings are as follows: (i) Ordinary least squares (OLS) timing models produce false positives (nonzero alphas) at too high a rate with either daily or monthly data. In contrast, the Kalman filter model produces them at approximately the correct rate with monthly data; (ii) In monthly data, though the OLS models fail to detect any timing among fund managers, the Kalman filter does; (iii) The alpha and beta forecasts from the Kalman model are more accurate than those from the OLS timing models; (iv) The Kalman filter model tracks most fund alphas and betas better than OLS models that employ macroeconomic variables in addition to fund returns.

Institutional Portfolio Flows and International Investments

Abstract: Using a new technique, and weekly data for 25 countries from 1994 to 1998, we analyze the relationship between institutional cross-border portfolio flows, and domestic and foreign equity returns. In emerging markets, institutional flows forecast statistically indistinguishable movements in country closed-end fund NAV returns and price returns. In contrast, closed-end fund flows forecast price returns, but not NAV returns. Furthermore, institutional flows display trend-following (trend-reversing) behavior in response to symmetric (asymmetric) movements in NAV and price returns. The results suggest that institutional cross-border flows are linked to fundamentals, while closed-end fund flows are a source of price pressure in the short run.

Asset Pricing with Limited Risk Sharing and Heterogeneous Agents

Abstract: We develop a model with incomplete markets and heterogeneous agents that generates a large equity premium, while simultaneously matching stock market participation and individual asset holdings. The high risk-premium is driven by incomplete risk sharing among stockholders, which results from the combination of aggregate uncertainty, borrowing constraints, and a (realistically) calibrated life-cycle earnings profile subject to idiosyncratic shocks. We show that it is challenging to simultaneously match asset pricing moments and individual portfolio decisions, while limited participation has a negligible impact on the risk-premium, contrary to the results of models where it is imposed exogenously.

Financial Constraints and Growth: Multinational and Local Firm Responses to Currency Depreciations

Abstract: This article examines how financial constraints and product market exposures determine the response of multinational and local firms to sharp depreciations. U.S. multinational affiliates increase sales, assets, and investment significantly more than local firms during, and subsequent to, depreciations. Differing product market exposures do not explain these differences in performance. Instead, a differential ability to circumvent financial constraints is a significant determinant of the observed differences in investment responses. Multinational affiliates also access parent equity when local firms are most constrained. These results indicate another role for foreign direct investment in emerging markets—multinational affiliates expand economic activity during currency crises when local firms are most constrained. (JEL F23, F31, G15, G31, G32)