Showing papers in "Review of Financial Studies in 2014"
TL;DR: In this paper, the role of high-frequency traders (HFTs) in price discovery and price efficiency is examined, and it is shown that HFTs facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors.
Abstract: We examine the role of high-frequency traders (HFTs) in price discovery and price efficiency. Overall HFTs facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors, both on average and on the highest volatility days. This is done through their liquidity demanding orders. In contrast, HFTs' liquidity supplying orders are adversely selected. The direction of HFTs' trading predicts price changes over short horizons measured in seconds. The direction of HFTs' trading is correlated with public information, such as macro news announcements, market-wide price movements, and limit order book imbalances.
1,025 citations
TL;DR: This paper analyzed time-series of investor expectations of future stock market returns from six data sources between 1963 and 2011 and found that investor expectations are strongly negatively correlated with model-based expected returns.
Abstract: We analyze time-series of investor expectations of future stock market returns from six data sources between 1963 and 2011. The six measures of expectations are highly positively correlated with each other, as well as with past stock returns and with the level of the stock market. However, investor expectations are strongly negatively correlated with model-based expected returns. We reconcile the evidence by calibrating a simple behavioral model, in which fundamental traders require a premium to accommodate expectations shocks from extrapolative traders, but markets are not efficient.
847 citations
TL;DR: In this article, the extent to which investor opinions transmitted through social media predict future stock returns and earnings surprises was investigated, and it was shown that the views expressed in both articles and commentaries predict the future stock return and earnings.
Abstract: Social media has become a popular venue for individuals to share the results of their own analysis on financial securities. This paper investigates the extent to which investor opinions transmitted through social media predict future stock returns and earnings surprises. We conduct textual analysis of articles published on one of the most popular social media platforms for investors in the United States. We also consider the readers' perspective as inferred via commentaries written in response to these articles. We find that the views expressed in both articles and commentaries predict future stock returns and earnings surprises.
565 citations
TL;DR: The authors discusses limitations of two approaches commonly used to control for unobserved group-level heterogeneity in finance research, i.e., demeaning the dependent variable with respect to the group and adding the mean of the group's dependent variable as a control.
Abstract: Controlling for unobserved heterogeneity (or “common errors”), such as industry-specific shocks, is a fundamental challenge in empirical research, as failing to do so can introduce omitted variables biases and preclude causal inference. This paper discusses limitations of two approaches commonly used to control for unobserved group-level heterogeneity in finance research—demeaning the dependent variable with respect to the group (e.g., “industry-adjusting”) and adding the mean of the group’s dependent variable as a control. We show that these techniques, which are used widely in both asset pricing and corporate finance research, typically provide inconsistent coefficients and can lead researchers to incorrect inferences. In contrast, the fixed effects estimator is consistent and should be used instead. We also explain how to estimate the fixed effects model when traditional methods are computationally infeasible. (JEL G12, G2, G3, C01, C13)
563 citations
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TL;DR: In this paper, the authors developed two measures of board composition to investigate whether directors appointed by the CEO have allegiance to the CEO and decrease their monitoring, i.e., turnover-performance sensitivity diminishes, pay increases (without commensurate increase in payperformance sensitivity), and investment increases.
Abstract: We develop two measures of board composition to investigate whether directors appointed by the CEO have allegiance to the CEO and decrease their monitoring. Co-option is the fraction of the board comprised of directors appointed after the CEO assumed office. As Co-option increases, board monitoring decreases: turnover-performance sensitivity diminishes, pay increases (without commensurate increase in pay-performance sensitivity), and investment increases. Non-Co-opted Independence�the fraction of directors who are independent and were appointed before the CEO�has more explanatory power for monitoring effectiveness than the conventional measure of board independence. Our results suggest that not all independent directors are effective monitors.
472 citations
TL;DR: In this paper, a measure of VC investors' failure tolerance by examining their willingness to continue investing in underperforming ventures was developed, and the authors found that VC firms backed by more failure-tolerant VC investors are significantly more innovative.
Abstract: Based on a sample of venture capital (VC)-backed IPO firms, we examine whether tolerance for failure spurs corporate innovation. We develop a novel measure of VC investors' failure tolerance by examining their willingness to continue investing in underperforming ventures. We find that IPO firms backed by more failure-tolerant VC investors are significantly more innovative and VC failure tolerance is particularly important for ventures that are subject to high failure risk. We show that these results are not driven by endogenous matching between failure-tolerant VC firms and start-ups with high ex ante innovative potential. We also examine the determinants of the cross-sectional heterogeneity in a VC firm's failure tolerance. We find that both capital constraints and career concerns can negatively distort a VC firm's failure tolerance. Less experienced VC firms are more exposed to these distortions, making them less failure tolerant than are more established VC firms.
458 citations
TL;DR: In this article, the authors study the capital structure choices that entrepreneurs make in their firms' initial year of operation, using restricted-access data from the Kauffman Firm Survey, and find that firms in their data rely heavily on external debt sources, such as bank financing, and less extensively on friends-and-family-based funding sources.
Abstract: We study capital structure choices that entrepreneurs make in their firms' initial year of operation, using restricted-access data from the Kauffman Firm Survey. Firms in our data rely heavily on external debt sources, such as bank financing, and less extensively on friends-and-family-based funding sources. Many startups receive debt financed through the personal balance sheets of the entrepreneur, effectively resulting in the entrepreneur holding levered equity claims in their startups. This fact is robust to numerous controls, including credit quality. The reliance on external debt underscores the importance of credit markets for the success of nascent business activity.
418 citations
TL;DR: This article proposed a new measure of time-varying tail risk that is directly estimable from the cross-section of returns to identify common fluctuations in tail risk among individual stocks.
Abstract: We propose a new measure of time-varying tail risk that is directly estimable from the cross-section of returns. We exploit firm-level price crashes every month to identify common fluctuations in tail risk among individual stocks. Our tail measure is significantly correlated with tail risk measures extracted from S&P 500 index options and negatively predicts real economic activity. We show that tail risk has strong predictive power for aggregate market returns. Cross-sectionally, stocks with high loadings on past tail risk earn an annual three-factor alpha 5.4% higher than stocks with low tail risk loadings. We explore potential mechanisms giving rise to these asset pricing facts.
410 citations
TL;DR: In this paper, the authors use strong discontinuities in angel-funding behavior over small changes in their collective interest levels to implement a regression discontinuity approach, and confirm the positive effects for venture operations, with qualitative support for a higher likelihood of successful exits.
Abstract: This article documents the fact that ventures funded by two successful angel groups experience superior outcomes to rejected ventures: They have improved survival, exits, employment, patenting, Web traffic, and financing. We use strong discontinuities in angel- funding behavior over small changes in their collective interest levels to implement a regression discontinuity approach. We confirm the positive effects for venture operations, with qualitative support for a higher likelihood of successful exits. On the other hand, there is no difference in access to additional financing around the discontinuity. This might suggest that financing is not a central input of angel groups.
384 citations
TL;DR: The authors analyzed how corporate venture capital differs from independent venture capital in nurturing innovation in entrepreneurial firms and found that CVC-backed firms are more innovative, as measured by their patenting outcome, although they are younger, riskier, and less profitable than IVC-based firms.
Abstract: We analyze how corporate venture capital (CVC) differs from independent venture capital (IVC) in nurturing innovation in entrepreneurial firms. We find that CVC-backed firms are more innovative, as measured by their patenting outcome, although they are younger, riskier, and less profitable than IVC-backed firms. Our baseline results continue to hold in a propensity score matching analysis of IPO firms and a difference-in-differences analysis of the universe of VC-backed entrepreneurial firms. We present evidence consistent with two possible underlying mechanisms: CVC's greater industry knowledge due to the technological fit between their parent firms and entrepreneurial firms and CVC's greater tolerance for failure.
356 citations
TL;DR: In this paper, the authors provide empirical evidence that managers adjust advertising expenditures to inuence investor behavior and short-term stock prices, and show that increased advertising expenditures increase investor behavior.
Abstract: This paper provides empirical evidence that managers adjust rm advertising expenditures to inuence investor behavior and short-term stock prices. First, this paper shows that increased
TL;DR: In this paper, the authors show that wrongful discharge laws, particularly those that prohibit employers from acting in bad faith ex post, limit employers' ability to hold up innovating employees after the innovation is successful.
Abstract: We show that wrongful discharge laws - laws that protect employees against unjust dismissal - spur innovation and new firm creation. Wrongful discharge laws, particularly those that prohibit employers from acting in bad faith ex post, limit employers' ability to hold up innovating employees after the innovation is successful. By reducing the possibility of holdup, these laws enhance employees'innovative efforts and encourage firms to invest in risky but potentially mould-breaking projects. We develop a model and provide supporting empirical evidence of this effect using the staggered adoption of wrongful discharge laws across U.S. states.
TL;DR: In this article, the authors explore a contracting model that captures the observed features and find that intermediary leverage is negatively aligned with the banks' value-at-risk (VaR).
Abstract: The availability of credit varies over the business cycle through shifts in the leverage of financial intermediaries. Empirically, we find that intermediary leverage is negatively aligned with the banks’ value-at-risk (VaR). Motivated by the evidence, we explore a contracting model that captures the observed features. Under general conditions on the outcome distribution given by Extreme Value Theory (EVT), intermediaries maintain a constant probability of default to shifts in the outcome distribution, implying substantial deleveraging during downturns. For some parameter values, we can solve the model explicitly, thereby endogenizing the VaR threshold probability from the contracting problem.
TL;DR: In this article, the credit supply effects of the unexpected freeze of the European interbank market, using exhaustive Portuguese loan-level data, were studied and it was shown that banks that rely more on interbank borrowing before the crisis decrease their credit supply more during the crisis.
Abstract: We study the credit supply effects of the unexpected freeze of the European interbank market, using exhaustive Portuguese loan-level data. We find that banks that rely more on interbank borrowing before the crisis decrease their credit supply more during the crisis. The credit supply reduction is stronger for firms that are smaller, with weaker banking relationships. Small firms cannot compensate the credit crunch with other sources of debt. Furthermore, the impact of illiquidity on the credit crunch is stronger for less solvent banks. Finally, we find no overall positive effects of central bank liquidity but instead higher hoarding of liquidity.
TL;DR: In this paper, the authors model the impact of public and private ownership structures on firms' incentives to invest in innovative projects and show that it is optimal to go public when exploiting existing ideas and optimal when exploring new ideas.
Abstract: We model the impact of public and private ownership structures on firms' incentives to invest in innovative projects. We show that it is optimal to go public when exploiting existing ideas and optimal to go private when exploring new ideas. This result derives from the fact that private firms are less transparent to outside investors than are public firms. In private firms, insiders can time the market by choosing an early exit strategy if they receive bad news. This option makes insiders more tolerant of failures and thus more inclined to invest in innovative projects. In contrast, the prices of publicly traded securities react quickly to good news, providing insiders with incentives to choose conventional projects and cash in early.
TL;DR: In this article, the authors examine empirically how the supply and maturity structure of government debt affect bond yields and expected returns, and find that the maturity-weighted-debt-to-GDP ratio is positively related to bond yields.
Abstract: We examine empirically how the supply and maturity structure of government debt affect bond yields and expected returns. We organize our investigation around a term-structure model in which risk-averse arbitrageurs absorb shocks to the demand and supply for bonds of different maturities. These shocks affect the term structure because they alter the price of duration risk. Consistent with the model, we find that the maturity-weighted-debt-to-GDP ratio is positively related to bond yields and future returns, controlling for the short rate. Moreover, these effects are stronger for longer-maturity bonds and following periods when arbitrageurs have lost money.
TL;DR: This article showed that education increases financial market participation, measured by investment income and equities ownership, while dramatically reducing the probability that an individual declares bankruptcy, experiences a foreclosure, or is delinquent on a loan.
Abstract: Household financial decisions are important for household welfare, economic growth, and financial stability. Yet our understanding of the determinants of financial decision making is limited. Exploiting exogenous variation in state compulsory schooling laws in both standard and two-sample instrumental variable strategies, we show that education increases financial market participation, measured by investment income and equities ownership, while dramatically reducing the probability that an individual declares bankruptcy, experiences a foreclosure, or is delinquent on a loan. Further results and a simple calibration suggest that the result is driven by changes in savings or investment behavior, rather than simply increased labor earnings.
TL;DR: In this paper, the role of directors from related industries on a firm's board is analyzed and the evidence suggests that firms choose DRIs when the adverse effects due to conflicts of interest are dominated by the benefits due to DRIs' information and expertise.
Abstract: We analyze the role of �directors from related industries� (DRIs) on a firm's board. DRIs are officers and/or directors of companies in the upstream/downstream industries of the firm. DRIs are more likely when the information gap vis-a-vis related industries is more severe or the firm has greater market power. DRIs have a significant impact on firm value/performance, especially when information problems are worse. Furthermore, DRIs help firms handle industry shocks and shorten their cash conversion cycles. Overall, our evidence suggests that firms choose DRIs when the adverse effects due to conflicts of interest are dominated by the benefits due to DRIs' information and expertise.
TL;DR: In this article, the authors test a frog-in-the-pan (FIP) hypothesis that predicts investors are inattentive to information arriving continuously in small amounts.
Abstract: We test a frog-in-the-pan (FIP) hypothesis that predicts investors are inattentive to information arriving continuously in small amounts Intuitively, we hypothesize that a series of frequent gradual changes attracts less attention than infrequent dramatic changes Consistent with the FIP hypothesis, we find that continuous information induces strong persistent return continuation that does not reverse in the long run Momentum decreases monotonically from 594% for stocks with continuous information during their formation period to �207% for stocks with discrete information but similar cumulative formation-period returns Higher media coverage coincides with discrete information and mitigates the stronger momentum following continuous information
TL;DR: This paper used credit default swaps (CDS) trading data to demonstrate that the credit risk of reference firms, reflected in rating downgrades and bankruptcies, increases significantly upon the inception of CDS trading.
Abstract: We use credit default swaps (CDS) trading data to demonstrate that the credit risk of reference firms, reflected in rating downgrades and bankruptcies, increases significantly upon the inception of CDS trading, a finding that is robust after controlling for the endogeneity of CDS trading. Additionally, distressed firms are more likely to file for bankruptcy if they are linked to CDS trading. Furthermore, firms with more “no restructuring” contracts than other types of CDS contracts (i.e., contracts that include restructuring) are more adversely affected by CDS trading, and the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure in the resolution of financial distress.
TL;DR: In this paper, a dark pool alongside an exchange concentrates price-relevant information into the exchange and improves price discovery, which coincides with reduced exchange liquidity, making the exchanges more attractive to informed traders.
Abstract: Dark pools are equity trading systems that do not publicly display orders. Dark pools oer potential price improvements but do not guarantee execution. Informed traders tend to trade in the same direction, crowd on the heavy side of the market, and face a higher execution risk in the dark pool, relative to uninformed traders. Consequently, exchanges are more attractive to informed traders, and dark pools are more attractive to uninformed traders. Under certain conditions, adding a dark pool alongside an exchange concentrates price-relevant information into the exchange and improves price discovery. Improved price discovery coincides with reduced exchange liquidity.
TL;DR: In this article, the authors studied the relation between mutual fund trades and mass media coverage of stocks and found that funds exhibit persistent differences in their propensity to buy media-covered stocks and that this propensity is negatively related to their future performance.
Abstract: We study the relation between mutual fund trades and mass media coverage of stocks. We find that funds exhibit persistent differences in their propensity to buy media-covered stocks. Moreover, this propensity is negatively related to their future performance. Funds in the highest propensity decile underperform funds in the lowest propensity decile by 1.1% to 2.8% per year. These results do not extend to fund sells, likely because of funds' inability to sell short. Overall, the findings suggest that professional investors are subject to limited attention.
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TL;DR: In this paper, the authors identify flight-to-safety (FTS) days for twenty-three countries using only stock and bond returns and a model averaging approach and find that FTS days comprise less than 2% of the sample and are associated with a 2.7% average bond-equity return differential and significant flows out of equity funds and into government bond and money market funds.
Abstract: We identify flight-to-safety (FTS) days for twenty-three countries using only stock and bond returns and a model averaging approach. FTS days comprise less than 2% of the sample and are associated with a 2.7% average bond-equity return differential and significant flows out of equity funds and into government bond and money market funds. FTS represents flights to both quality and liquidity in international equity markets, but mainly a flight to quality in the U.S. corporate bond market. Emerging markets, endowment funds, and hedge funds perform poorly during FTS, whereas hedge funds appear to vary their systematic exposures prior to an FTS.
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TL;DR: This paper found that firms particularly covered by the media exhibit, ceteris paribus, significantly stronger momentum than stocks with high uncertainty, and are stronger in states with high investor individualism.
Abstract: Relying on 2.2 million articles from forty-five national and local U.S. newspapers between 1989 and 2010, we find that firms particularly covered by the media exhibit, ceteris paribus, significantly stronger momentum. The effect depends on article tone, reverses in the long run, is more pronounced for stocks with high uncertainty, and is stronger in states with high investor individualism. Our findings suggest that media coverage can exacerbate investor biases, leading return predictability to be strongest for firms in the spotlight of public attention. These results collectively lend credibility to an overreaction-based explanation for the momentum effect.
TL;DR: In this paper, the authors develop a methodology to infer the amount of capital allocated to quantitative equity arbitrage strategies, which exploits time-variation in the cross-section of short interest.
Abstract: We develop a novel methodology to infer the amount of capital allocated to quantitative equity arbitrage strategies. Using this methodology, which exploits time-variation in the cross-section of short interest, we document that the amount of capital devoted to value and momentum strategies has grown significantly since the late 1980s. We provide evidence that this increase in capital has resulted in lower strategy returns. However, consistent with theories of limited arbitrage, we show that strategy-level capital flows are influenced by past strategy returns and strategy return volatility and that arbitrage capital is most limited during times when strategies perform best. This suggests that the growth of arbitrage capital may not completely eliminate returns to these strategies. (JEL G02, G12, G14, G23)
TL;DR: This paper studied investor networks in the stock market, through the lens of information network theory, and identified traders who are similar in their trading behavior as linked in an empirical investor network (EIN), which is consistent with several predictions from the theory of information networks.
Abstract: We study investor networks in the stock market, through the lens of information network theory. We use a unique account level dataset of all trades on the Istanbul Stock Exchange in 2005, to identify traders who are similar in their trading behavior as linked in an empirical investor network (EIN). This empirical investor network is consistent with several predictions from the theory of information networks. The EIN is relatively stable over time, some investors systematically trade before their neighbors in the network, centrally placed investors earn higher profits, and the cross sectional distributions of profits and trading volume are heavy-tailed with similar tail exponents. We also identify several theoretical challenges for future research.
TL;DR: In this paper, a two-tongues metric is proposed to distinguish strategic motives (e.g., generating small-investor purchases and pleasing management) from non-strategic motives (genuine overoptimism).
Abstract: Why do security analysts issue overly positive recommendations? We propose a novel approach to distinguish strategic motives (e.g., generating small-investor purchases and pleasing management) from nonstrategic motives (genuine overoptimism). We argue that nonstrategic distorters tend to issue both positive recommendations and optimistic forecasts, while strategic distorters "speak in two tongues," issuing overly positive recommendations but less optimistic forecasts. We show that the incidence of strategic distortion is large and systematically related to proxies for incentive misalignment. Our "two-tongues metric" reveals strategic distortion beyond those indicators and provides a new tool for detecting incentives to distort that are hard to identify otherwise.
TL;DR: In this paper, a self-reinforcing positive relationship between price informativeness and liquidity is shown to be a source of fragility, and a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and prices of other assets.
Abstract: Liquidity providers often learn information about an asset from prices of other assets. We show that this generates a self-reinforcing positive relationship between price informativeness and liquidity. This relationship causes liquidity spillovers and is a source of fragility: a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and price informativeness (a liquidity crash). This feedback loop provides a new explanation for comovements in liquidity and liquidity dry-ups. It also generates multiple equilibria.
TL;DR: A special issue of the Review of Financial Studies dedicated to entrepreneurial finance and innovation and highlights some of the promising topics for future research in this area was published in 2010 as mentioned in this paper, which combines papers presented at the June 2010 EFIC conference.
Abstract: The increasingly large role played by financial intermediaries, such as venture capitalists and angels, in nurturing entrepreneurial firms and in promoting product market innovation has led to great research interest in the area of entrepreneurial finance and innovation. This paper introduces the special issue of the Review of Financial Studies dedicated to entrepreneurial finance and innovation and highlights some of the promising topics for future research in this area. The special issue combines papers presented at the June 2010 �Entrepreneurial Finance and Innovation (EFIC)� conference, which was jointly sponsored by the Kauffman Foundation and the Review of Financial Studies, with other related papers.
TL;DR: In this article, the authors argue that resource allocation within firms' internal capital markets provides an important force countervailing financial market dislocation and argue that the weaker division obtains too much (little) capital, as though it is 12% (9%) more productive than it really is.
Abstract: We argue and demonstrate that resource allocation within firms' internal capital markets provides an important force countervailing financial market dislocation. We estimate a structural model of internal capital markets to separately identify and quantify the forces driving the reallocation decision and illustrate how these forces interact with external capital market stress. The weaker (stronger) division obtains too much (little) capital, as though it is 12% (9%) more (less) productive than it really is. Out-of-sample simulated data are consistent with the actual data showing that internal capital markets offset financial market stress during the recent financial crisis by 16%–30%.