How Does Information Quality Affect Stock Returns
TL;DR: In this paper, the authors investigated the relationship between the precision of public information about economic growth and stock market returns and showed that higher precision of signals tends to increase the risk premium, when signals are imprecise, and return volatility is U-shaped with respect to investors' risk aversion.
Abstract: Using a simple dynamic asset pricing model, this paper investigates the relationship between the precision of public information about economic growth and stock market returns. After fully characterizing expected returns and conditional volatility, I show that (i) higher precision of signals tends to increase the risk premium, (ii) when signals are imprecise the equity premium is bounded above independently of investors' risk aversion, (iii) return volatility is U-shaped with respect to investors' risk aversion, and (iv) the relationship between conditional expected returns and conditional variance is ambiguous. IN MODERN FINANCIAL MARKETS, investors are flooded with a variety of information: corporations' earnings reports, revisions of macroeconomic indexes, policymakers' statements, and political news. These pieces of information are processed by investors to update their projections of the economy's future growth rate, inflation rate, and interest rate. In turn, these changes in investors' expectations affect stock market prices. However, even though it is clear that asset prices react to new information, several questions arise regarding the relationship between the quality of information that investors receive and asset returns. For example, what kind of effect does a noisy signal on the "health" of the economy have on stock market prices? If information is noisy, is there a risk premium? Or is the risk premium completely independent of the quality of information investors receive? Also, how does the precision of the signals affect stock market volatility? If signals are more precise, does stock market volatility decrease or increase? Finally, can we infer how good investors' information is from the behavior of stock market returns? In this paper I study a dynamic asset pricing model where I try to answer the above questions. Specifically, I assume that stock dividends are generated by a diffusion process whose drift rate is unknown to investors and may
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TL;DR: A comprehensive analysis of the ownership and control structure of East Asian corporations, with West European corporations as benchmarks, is presented in this article, where the authors find evidence of systematic expropriation of the outside shareholders of corporations at the base of extensive corporate pyramids.
Abstract: Whereas most U.S. corporations are widely held, the predominant form of ownership in East Asia is control by a family, which often supplies a top manager. These features of "crony capitalism" are actually more pronounced in Western Europe. In both regions, the salient agency problem is expropriation of outside shareholders by controlling shareholders. Dividends provide evidence on this. Group-affiliated corporations in Europe pay higher dividends than in Asia, dampening insider expropriation. Dividend rates are higher in Europe, but lower in Asia, when there are multiple large shareholders, suggesting that they dampen expropriation in Europe, but exacerbate it in Asia. (JEL G34, G35) Failures in East Asian corporate governance have recently attracted wide attention through being blamed for the East Asian financial crisis. Based only on journalistic anecdotes, the accusations of "crony capitalism" met regional scepticism and are now being shrugged off as East Asian economies recover. This paper provides a comprehensive analysis of the ownership and control structure of East Asian corporations, with West European corporations as benchmarks. We document that the problems of East Asian corporate governance are, if anything, more severe and intractable than suggested by commentators at the height of the financial crisis. These problems we locate in an extraordinary concentration of control, whereby eight groups control more than one-quarter of the corporations in the nine most advanced East Asian economies. This control is obscured behind layers of corporations, hence insulated against the forces of competition on less-thantransparent capital markets. By examining how dividend behavior is related to the structure of ownership and control, we find evidence of systematic expropriation of the outside shareholders of corporations at the base of extensive corporate pyramids. Thus, the controlling share
1,333 citations
TL;DR: For example, the authors show that ambiguity-averse investors tend to take a worst-case assessment of quality when processing news of uncertain quality, and as a result, they react more strongly to bad news than to good news.
Abstract: When ambiguity-averse investors process news of uncertain quality, they act as if they take a worst-case assessment of quality. As a result, they react more strongly to bad news than to good news. They also dislike assets for which information quality is poor, especially when the underlying fundamentals are volatile. These effects induce ambiguity premia that depend on idiosyncratic risk in fundamentals as well as skewness in returns. Moreover, shocks to information quality can have persistent negative effects on prices even if fundamentals do not change. FINANCIAL MARKET PARTICIPANTS ABSORB a large amount of news, or signals, every day. Processing a signal involves quality judgments: News from a reliable source should lead to more portfolio rebalancing than news from an obscure source. Unfortunately, judging quality itself is sometimes difficult. For example, stock picks from an unknown newsletter without a track record might be very reliable or entirely useless—it is simply hard to tell. Of course, the situation is different when investors can draw on a lot of experience that helps them interpret signals. This is true especially for “tangible” information, such as earnings reports, that lends itself to quantitative analysis. By looking at past data, investors may become quite confident about how well earnings forecast returns. This paper focuses on information processing when there is incomplete knowledge about signal quality. The main idea is that, when quality is difficult to judge, investors treat signals as ambiguous. They do not update beliefs in standard Bayesian fashion, but behave as if they have multiple likelihoods in mind when processing signals. To be concrete, suppose that θ is a parameter that an investor wants to learn. We assume that a signal s is related to the parameter by a family of likelihoods: s = θ + � , � ∼ N � 0, σ 2 s � , σ 2 s ∈ � σ 2
749 citations
TL;DR: In this article, the authors developed a simple approach to valuing stocks in the presence of learning about average pro-tability, and showed that the market-to-book ratio increases with uncertainty about average probability of a stock's performance.
Abstract: We develop a simple approach to valuing stocks in the presence of learning about average pro¢tability.The market-to-book ratio (M/B) increases with uncertainty about average pro¢tability, especially for ¢rms that pay no dividends. M/B is predicted to decline over a ¢rm’s lifetime due to learning, with steeper decline when the ¢rm is young. These predictions are con¢rmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm pro¢tability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades. THE PAST TWO DECADES HAVE WITNESSED an unprecedented surge in the number of newly listed ¢rms on the major U.S. stock exchanges. According to Fama and French (2001b), over 550 new ¢rms per year appeared between the years 1980 and 2000, on average, compared to less than 150 ¢rms in the previous two decades. Some of these new ¢rms command valuations that might seem too high to be justi¢ed by reasonable assumptions about expected future pro¢tability. For example, more than 1 in 10 of all ¢rms listed between the years 1962 and 2000 are worth more than seven times their book value at the end of their year of listing, and almost 1 in 50 ¢rms is worth more than 20 times its book value. Naturally, investors attempting to value the newly listed ¢rms are confronted with substantial uncertainty about their future pro¢tability.We argue that this uncertainty contributes to the high valuations of young ¢rms, and that the resolution of this uncertainty over time tends to be accompanied by a decline in the valuation ratios. The basic idea is simple. Let B denote a ¢rm’s book equity today (at time 0) and g its constant growth rate, so the value of book equity at time T is B exp(gT ). Assuming that competition eliminates the ¢rm’s expected abnormal earnings by T, the ¢rm’s market value at T equals its book value, and the market value today is the expected book value at T discounted at some known rate r .I fg is unknown
741 citations
TL;DR: This work finds that considerable heterogeneity exists in the network embeddedness of open source projects and project managers, and uses latent class regression analysis to show that multiple regimes exist and that some of the effects ofnetwork embeddedness are positive under some regimes and negative under others.
Abstract: The community-based model for software development in open source environments is becoming a viable alternative to traditional firm-based models. To better understand the workings of open source environments, we examine the effects of network embeddedness---or the nature of the relationship among projects and developers---on the success of open source projects. We find that considerable heterogeneity exists in the network embeddedness of open source projects and project managers. We use a visual representation of the affiliation network of projects and developers as well as a formal statistical analysis to demonstrate this heterogeneity and to investigate how these structures differ across projects and project managers. Our main results surround the effect of this differential network embeddedness on project success. We find that network embeddedness has strong and significant effects on both technical and commercial success, but that those effects are quite complex. We use latent class regression analysis to show that multiple regimes exist and that some of the effects of network embeddedness are positive under some regimes and negative under others. We use project age and number of page views to provide insights into the direction of the effect of network embeddedness on project success. Our findings show that different aspects of network embeddedness have powerful but subtle effects on project success and suggest that this is a rich environment for further study.
495 citations
TL;DR: In this article, the authors reexamine the time-series relation between the conditional mean and variance of stock market returns and find strong support for a positive intertemporal mean-variance relation at both the country level and the world market level.
Abstract: We reexamine the time-series relation between the conditional mean and variance of stock market returns. To proxy for the conditional mean return, we use the implied cost of capital, computed using analyst forecasts. The usefulness of this proxy is shown in simulations. In empirical analysis, we construct the time series of the implied cost of capital for the G-7 countries. We find strong support for a positive intertemporal mean-variance relation at both the country level and the world market level. Some of our evidence is consistent with international integration of the G-7 financial markets.
452 citations
References
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Book•
01 Jan 1997TL;DR: In this paper, Campbell, Lo, and MacKinlay present an attempt by three well-known and well-respected scholars to fill an acknowledged void in the empirical finance literature, a text covering the burgeoning field of empirical finance.
Abstract: This book is an ambitious effort by three well-known and
well-respected scholars to fill an acknowledged void in the
literature—a text covering the burgeoning field of empirical finance.
As the authors note in the preface, there are several excellent books
covering financial theory at a level suitable for a Ph.D. class or as
a reference for academics and practitioners, but there is little or
nothing similar that covers econometric methods and applications.
Perhaps the closest existing text is the recent addition to the Wiley
Series in Financial and Quantitative Analysis. written by Cuthbertson
(1996). The major difference between the books is that Cuthbertson
focuses exclusively on asset pricing in the stock, bond, and foreign
exchange markets, whereas Campbell, Lo, and MacKinlay (henceforth CLM)
consider empirical applications throughout the field of finance,
including corporate finance, derivatives markets, and market
microstructure. The level of anticipation preceding publication
can be partly measured by the fact that at least three reviews
(including this one) have appeared since the book arrived. Moreover,
in their reviews, both Harvey (1998) and Tiso (1998) comment on the
need for such a text, a sentiment that has been echoed by numerous
finance academics.
7,169 citations
TL;DR: This paper showed that an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.
6,141 citations
TL;DR: In this article, the authors examine the stochastic behavior of equilibrium asset prices in a one-good, pure exchange economy with identical consumers, and derive a functional equation for price as a function of the physical state of the economy.
Abstract: THIS PAPER IS A THEORETICAL examination of the stochastic behavior of equilibrium asset prices in a one-good, pure exchange economy with identical consumers. The single good in this economy is (costlessly) produced in a number of different productive units; an asset is a claim to all or part of the output of one of these units. Productivity in each unit fluctuates stochastically through time, so that equilibrium asset prices will fluctuate as well. Our objective will be to understand the relationship between these exogenously determined productivity changes and market determined movements in asset prices. Most of our attention will be focused on the derivation and application of a functional equation in the vector of equilibrium asset prices, which is solved for price as a function of the physical state of the economy. This equation is a generalization of the Martingale property of stochastic price sequences, which serves in practice as the defining characteristic of market "efficiency," as that term is used by Fama [7] and others. The model thus serves as a simple context for examining the conditions under which a price series' failure to possess the Martingale property can be viewed as evidence of non-competitive or "irrational" behavior. The analysis is conducted under the assumption that, in Fama's terms, prices "fully reflect all available information," an hypothesis which Muth [13] had earlier termed "rationality of expectations." As Muth made clear, this hypothesis (like utility maximization) is not "behavioral": it does not describe the way agents think about their environment, how they learn, process information, and so forth. It is rather a property likely to be (approximately) possessed by the outcome of this unspecified process of learning and adapting. One would feel more comfortable, then, with rational expectations equilibria if these equilibria were accompanied by some form of "stability theory" which illuminated the forces which move an economy toward equilibrium. The present paper also offers a convenient context for discussing this issue. The conclusions of this paper with respect to the Martingale property precisely replicate those reached earlier by LeRoy (in [10] and [11]), and not surprisingly, since the economic reasoning in [10] and the present paper is the same. The
4,860 citations
TL;DR: In this paper, a class of recursive, but not necessarily expected utility, preferences over intertemporal consumption lotteries is developed, which allows risk attitudes to be disentangled from the degree of inter-temporal substitutability, leading to a model of asset returns in which appropriate versions of both the atemporal CAPM and the inter-time consumption-CAPM are nested as special cases.
Abstract: This paper develops a class of recursive, but not necessarily expected utility, preferences over intertemporal consumption lotteries An important feature of these general preferences is that they permit risk attitudes to be disentangled from the degree of intertemporal substitutability Moreover, in an infinite horizon, representative agent context these preference specifications lead to a model of asset returns in which appropriate versions of both the atemporal CAPM and the intertemporal consumption-CAPM are nested as special cases In our general model, systematic risk of an asset is determined by covariance with both the return to the market portfolio and consumption growth, while in each of the existing models only one of these factors plays a role This result is achieved despite the homotheticity of preferences and the separability of consumption and portfolio decisions Two other auxiliary analytical contributions which are of independent interest are the proofs of (i) the existence of recursive intertemporal utility functions, and (ii) the existence of optima to corresponding optimization problems In proving (i), it is necessary to define a suitable domain for utility functions This is achieved by extending the formulation of the space of temporal lotteries in Kreps and Porteus (1978) to an infinite horizon framework A final contribution is the integration into a temporal setting of a broad class of atemporal non-expected utility theories For homogeneous members of the class due to Chew (1985) and Dekel (1986), the corresponding intertemporal asset pricing model is derived
4,218 citations
Book•
01 Jan 1966
TL;DR: In this paper, the Basic Limit Theorem of Markov Chains and its applications are discussed and examples of continuous time Markov chains are presented. But they do not cover the application of continuous-time Markov chain in matrix analysis.
Abstract: Preface. Elements of Stochastic Processes. Markov Chains. The Basic Limit Theorem of Markov Chains and Applications. Classical Examples of Continuous Time Markov Chains. Renewal Processes. Martingales. Brownian Motion. Branching Processes. Stationary Processes. Review of Matrix Analysis. Index.
3,881 citations