Recent anderson_fin_rw items

Motivating entrepreneurial activity in a firm

Thu, 28 Jul 2005 00:00:00 +0000

We consider the problem of motivating privately informed managers to engage in entrepreneurial activity to improve the quality of the firm's investment opportunities. The firm's investment and compensation policy must balance the manager's incentives to provide entrepreneurial effort and to report her private information truthfully. The optimal policy is to underinvest (compared to first-best) and provide weak incentive pay in low-quality projects and overinvest (compared to first-best) and provide strong incentive pay in high-quality projects. We also show that, unlike the standard agency model, uncertainty and incentives can be positively related.

Dollar Cost Averaging

Thu, 28 Jul 2005 00:00:00 +0000

Dollar Cost Averaging is a strategy for purchasing equity securities that is widely recommended by professional investment advisors and commentators, but which has been virtually ignored by academic theorists and textbook writers. In this paper we explore whether the strategy is but another instance of irrational behavior by individual investors, or whether it is an investment heuristic that has survival value in an environment in which security prices exhibit mean reversion behavior that has only belatedly been recognized by academic theorists. Our evidence supports the view that the individual investors who follow this strategy in purchasing individual stocks to add to an existing portfolio are better off than if they followed the 'rational' strategies traditionally recommended by academics.

Option Pricing Kernels and the ICAPM

Thu, 28 Jul 2005 00:00:00 +0000

We estimate the parameters of pricing kernels that depend on both aggregate wealth and state variables that describe the investment opportunity set, using FTSE 100 and S&P 500 index option returns as the returns to be priced. The coefficients of the state variables are highly significant and remarkably consistent across specifications of the pricing kernal, and across the two markets. The results provided further strong evidence, which is consistent with Merton's (1973a) Intertemporal Capital Asset Pricing Model, that state variables in addition to market risk are priced.

"The perpetual American put option for jump-diffusions with applications"

Thu, 28 Jul 2005 00:00:00 +0000

In this paper, we solve an optimal stopping problem with an infinite time horizon, when the state variable follows a jump-diffusion. Under certain conditions our solution can be interpreted as the price of an American perpetual put option, when the underlying asset follows this type of process.

We present several examples demonstrating when the solution can be interpreted as a perpetual put price. This takes us into a study of how to risk adjust jump-diffusions. One key observation is that the probabililty distribution under the risk adjusted measure depends on the equity premium, which is not the case for the standard, continuous version. This difference may be utilized to find intertemporal, equilibrium equity premiums, for example

Our basic solution is exact only when jump sizes can not be negative. We investigate when our solution is an approximation also for negative jumps.

Various market models are studied at an increasing level of complexity, ending...

On the Consistency of the Lucas Pricing Formula

Mon, 6 Jun 2005 00:00:00 +0000

In order to find the real market value of an asset in an exchange economy, one would typically apply the formula appearing in Lucas(1978), developed in a discrete time framework. This theory has also been extended to continuous time models, in which case the same pricing formula has been universally applied. While the discrete time theory is rather transparent, there has been some confusion regarding the continuous time analogue. In particular, the continuous time pricing formula must contain a certain type of a square covariance term that does not readily follow from the discrete time formulation. As a result, this term has sometimes been missing in situations where it should have been included. In this paper we reformulate the discrete time theory in such a way that this covariance term does not come as a mystery in the continuous time version. It is shown that this term is also of importance in the equivalent martingale measure approach to pricing. In most real life situations...

Equilibrium in Marine Mutual Insurance Markets with Convex Operating Costs

Mon, 6 Jun 2005 00:00:00 +0000

The paper analyzes the possibility of reaching an equilibrium in a market of marine mutual insurance syndicates, called Protection and Indemnity Clubs, or P&I Clubs for short, displaying economies of scale. Our analysis rationalizes some empirically documented findings, and points out an interesting future scenario. We find an equilibrium in a market of mutual marine insurers, in which some smaller clubs, having operating costs above average, may grow larger relative to the other clubs in order to become more cost effective, and where medium to larger cost efficient clubs may stay unchanged or some even downsize relative to the others. Some of the very large clubs suffering from diseconomies of scale may have a motive to further increase relative to the other clubs. According to observations, most clubs have, during the last decade, expanded significantly in size measured by gross tonnage of entered ships, some clubs have merged, but very few seem to have decreased their...

Risk and Return in Fixed Income Arbitage: Nickels in Front of a Steamroller?

Fri, 3 Jun 2005 00:00:00 +0000

We conduct an analysis of the risk and return characteristics of a number of widely used fixed income arbitrage strategies. We find that the strategies requiring more “intellectual capital” to implement tend to produce significant alphas after controlling for bond and equity market risk factors. We show that the risk-adjusted excess returns from these strategies are related to capital flows into fixed income arbitrage hedge funds. In contrast with other hedge fund strategies, we find that many of the fixed income arbitrage strategies produce positively skewed returns. These results suggest that there may be more economic substance to fixed income arbitrage than simply “picking up nickels in front of a steamroller.”

Asset Pricing in Markets with Illiquid Assets

Fri, 3 Jun 2005 00:00:00 +0000

Many important classes of assets are illiquid in the sense that they cannot always be traded immediately. Thus, a portfolio position in these types of illiquid investments becomes at least temporarily irreversible. We study the asset-pricing implications of illiquidity in a two-asset exchange economy with heterogeneous agents. In this market, one asset is always liquid. The other asset can be traded initially, but then not again until after a “blackout” period. Illiquidity has a dramatic effect on optimal portfolio decisions. Agents abandon diversification as a strategy and choose highly polarized portfolios instead. The value of liquidity can represent a large portion of the equilibrium price of an asset. We present examples in which a liquid asset can be worth up to 25 percent more than an illiquid asset even though both have identical cash flow dynamics. We also show that the expected return and volatility of an asset can change significantly as the asset becomes relatively...

Hubris, Learning, and M&A Decisions

Thu, 12 May 2005 00:00:00 +0000

Are CEOs unable to learn? This surprising question deserves to be raised in the light of the declining pattern of cumulative abnormal returns observed in M&A programs. This paper shows that this pattern is the expected ex post empirical evidence for rational risk averse CEOs. Our theoretical argument is that from deal to deal, rational CEOs become more aggressive in the bidding process. They concede increasing fractions of expected synergies to the target shareholders in order to win the bidding game. For CEOs infected by hubris, the learning process should allow them to progressively correct over-optimism and overconfidence, if they survive.

Valuing American Options by Simulation: A Simple Least-Squares Approach

Mon, 9 May 2005 00:00:00 +0000

This article presents a simple yet powerful new approach for approximating the value of American options by simulation. The key to this approach is the use of least squares to estimate the conditional expected payoff to the optionholder from continuation. This makes this approach readily applicable in path-dependent and multifactor situations where traditional finite difference techniqes cannot be used. We illustrate this technique with several realistic examples including valuing an option when the underlying asset follows a jump-diffusion process and valuing an American swaption in a 20-factor string model of the term structure.

The Joint Dynamics of Liquidity, Returns, and Volatility Across Small and Large Firms

Thu, 14 Apr 2005 00:00:00 +0000

This paper explores liquidity spillovers in market-capitalization based portfolios of NYSE stocks. Return, volatility, and liquidity dynamics across the small and large cap sector are modeled by way of a vector autoregression model, using data that spans more than 3000 trading days. We find that volatility and liquidity innovations in either sector are informative in predicting liquidity shifts in the other. Impulse responses indicate the existence of persistent liquidity, return, and volatility spillovers across the large and small cap sectors. Lead and lag patterns across small and large cap stocks are stronger when spreads in the large cap sector are wider. Consistent with the notion that private informational trading in large cap stocks is transmitted to other stocks with a lag, order flows in large cap stocks decile significantly predict both transaction price-based and mid-quote returns of small cap deciles when large-cap spreads are high.

Pricing Microfinance Loans and Loan Guarantees using Biased Loan Write-off Data

Tue, 12 Apr 2005 00:00:00 +0000

We present a simple, easy to implement methodology for pricing microfinance loans and loan guarantees using publicly available data on loan write-offs by Micro Finance Institutions (MFIs). Our methodology takes into account the selection bias inherent in available data in that MFIs that do not report loan write-off data are less likely to be better performers. Our quantitative analysis is consistent with pricing seen in a recent securitization deal. Our analysis suggests how securitization and loan guarantees can greatly expand the supply of funds for microfinance loans.

Homeownership as a Constraint on Asset Allocation

Fri, 8 Apr 2005 00:00:00 +0000

Personal preferences and financial incentives make homeownership desirable for most families. Once a family purchases a home they find it impractical (costly) to frequently change their ownership of residential real estate. Thus, by deciding how much home to buy, a family constrains their ability to adjust their asset allocation between residential real estate and other assets. To analyze the impact of this constraint on consumption, welfare, and post-retirement wealth, we first investigate a representative individual’s optimal asset allocation decisions when they are subject to a “homeownership constraint.” Next, we perform a “thought experiment” where we assume the existence of a market where a homeowner can sell, without cost, a fractional interest in their home. Now the housing choice decision does not constrain the individual’s asset allocations. By comparing these two cases, we estimate the differences in post-retirement wealth and the welfare gains potentially realizable...

Jump and Volatility Risk and Risk Premia: A New Model and Lessons from S&P 500 Options

Fri, 8 Apr 2005 00:00:00 +0000

We use a novel pricing model to filter times series of diffusive volatility and jump intensity from S&P 500 index options. These two measures capture the ex-ante risk assessed by investors. We find that both components of risk vary substantially over time, are quite persistent, and correlate with each other and with the stock index. Using a simple general equilibrium model with a representative investor, we translate the filtered measures of ex-ante risk into an ex-ante risk premium. We find that the average premium that compensates the investor for the risks implicit in option prices, 10.1 percent, is about twice the premium required to compensate the same investor for the realized volatility, 5.8 percent. Moreover, the ex-ante equity premium that we uncover is highly volatile, with values between 2 and 32 percent. The component of the premium that corresponds to the jump risk varies between 0 and 12 percent.

Parametric Portfolio Policies: Exploiting Characteristics in the Cross Section of Equity Returns

Fri, 8 Apr 2005 00:00:00 +0000

We propose a novel approach to optimizing portfolios with large numbers of assets. We model directly the portfolio weight in each asset as a function of the asset’s characteristics. The coefficients of this function are found by optimizing the investor’s average utility of the portfolio’s return over the sample period. Our approach is computationally simple, easily modified and extended, produces sensible portfolio weights, and offers robust performance in and out of sample. In contrast, the traditional approach of first modeling the joint distribution of returns and then solving for the corresponding optimal portfolio weights is not only diffcult to implement for a large number of assets but also yields notoriously noisy and unstable results. Our approach also provides a new test of the portfolio choice implications of equilibrium asset pricing models. We present an empirical implementation for the universe of all stocks in the CRSP-Compustat dataset, exploiting the size,...

Option Strategies: Good Deals and Margin Calls

Fri, 8 Apr 2005 00:00:00 +0000

We investigate the risk and return of a wide variety of trading strategies involving options on the S&P 500. We consider naked and covered positions, straddles, strangles, and calendar spreads, with different maturities and levels of moneyness. Overall, we ﬁnd that strategies involving short positions in options generally compensate the investor with very high Sharpe ratios, which are statistically signiﬁcant even after taking into account the non-normal distribution of returns. Furthermore, we ﬁnd that the strategies’ returns are substantially higher than warranted by asset pricing models. We also ﬁnd that the returns of the strategies could only be justiﬁed by jump risk if the probability of market crashes were implausibly higher than it has been historically. We conclude that the returns of option strategies constitute a very good deal. However, exploiting this good deal is extremely diffcult. We ﬁnd that trading costs and margin requirements severely condition the implementation...

Using Option Pricing Theory to Infer About Historical Equity Premiums

Fri, 11 Mar 2005 00:00:00 +0000

In this paper we make use of option pricing theory to infer about historical equity premiums. This we do by comparing the prices of an American perpetual put option computed using two different models: One is the standard model with continuous, zero expectation, Gaussian noise, the other is a very similar model, except that the zero expectation noise is of Poissonian type. Since a Poisson random variable is infinitely divisible, by the central limit theorem it is approximately normal. The interesting fact that makes this comparison worthwhile, is that the probability distribution under the risk adjusted measure turns out to depend on the equity premium in the Poisson model, while this is not so for the standard, Brownian motion version. This difference is utilized to find the intertemporal, equilibrium equity premium. We apply this technique to the US equity data of the last century, and find an indication that the risk premium on equity was about two and a half per cent if...

A Theory of Socialistic Internal Capital Markets

Fri, 4 Mar 2005 00:00:00 +0000

We develop a model of a two-division firm in which the “strong” division has,on average, higher quality investment projects than the “weak” division. We show that the firm optimally biases its project selection policy in favor of the weak division and this bias is stronger when there is a greater spread in average project quality. The cost of such a policy is that the firm sometimes funds an inferior project but the benefit is that it motivates the manager of the strong division to set (and meet) more aggressive cash flow targets.

Information, Diversification, and Cost of Capital

Tue, 1 Mar 2005 00:00:00 +0000

We investigate the effects of information and diversification on cost of capital in a noisy rational expectations model. Assuming a factor structure for risky asset payoffs and two classes of investors, informed and uninformed, we show that in large economies the APT (Ross, 1976) holds and i) information from private signals about idiosyncratic shocks has no effect on cost of capital and ii) information from private signals about systematic factors affects cost of capital only through factor risk premiums; there is no effect on factor loadings. These results imply that there are no cross-sectional effects of information on cost of capital within large economies.

Risk, Return and Dividends

Tue, 1 Mar 2005 00:00:00 +0000

We characterize the joint dynamics of expected returns, stochastic volatility, and prices. In particular, with a given dividend process, one of the processes of the expected return, the stock volatility, or the price-dividend ratio fully determines the other two. For example, the stock volatility determines the expected return and the price-dividend ratio. By parameterizing one, or more, of expected returns, volatility, or prices, common empirical specifications place strong, and sometimes inconsistent, restrictions on the dynamics of the other variables. Our results are useful for understanding the risk-return trade-off, as well as characterizing the predictability of stock returns.

Corruption, Firm Governance, and the Cost of Capital

Mon, 28 Feb 2005 00:00:00 +0000

We develop a model of a firm owned by shareholders and administered by managers who may be either honest or dishonest. When managers have an informational advantage but shareholders retain control, dishonest managers can make false reports that distort investment and thereby reduce firm cash flows. When dishonest managers have privileged access to both information and control, firm value is further reduced and profits are diminished especially in the worst states of the world. Ine®ective corporate governance combined with corruption (dishonesty) thus increases firms’ exposure to systematic risk. In a cross-country empirical test of the model, we find that corruption substantially increases firm betas, particularly in countries with weak shareholder rights. Moving from the level of corruption in Canada to that in South Korea raises industry-adjusted betas by 0.35.

Illiquid Assets and Optimal Portfolio Choice

Fri, 17 Dec 2004 00:00:00 +0000

Illiquid Assets and Optimal Portfolio Choice

Liquidity and Arbitrage

Mon, 8 Nov 2004 00:00:00 +0000

Since arbitrage involves trading, it is potentially impeded by market frictions and costs. We study whether stock market liquidity is related to the efficacy of arbitrage. Specifically, we examine the joint time-series of the NYSE Composite index futures basis and aggregate liquidity on the NYSE for a relatively long time-period, over 3000 trading days, and find that the basis and liquidity are jointly determined. Contemporaneous innovations in the absolute basis and in bid-ask spreads are positively correlated. There is also evidence of two-way Granger causality between short-term absolute bases and effective spreads. Impulse response functions indicate that shocks to the absolute basis are significantly informative in predicting spreads.

Two Trees

Fri, 1 Oct 2004 00:00:00 +0000

We solve a model with two “Lucas trees.” Each tree has i.i.d. dividend growth. The investor has log utility and consumes the sum of the two trees’ dividends. This model produces interesting asset-pricing dynamics, despite its simple ingredients. Investors want to rebalance their portfolios after any change in value. Since the size of the trees is fixed, however, prices must adjust to oﬀset this desire. As a result, expected returns, excess returns, and return volatility all vary through time. Returns display serial correlation, and are predictable from price-dividend ratios in the time series and in the cross section. Return volatility can be greater than the volatility of cash flows, giving the appearance of “excess volatility.” Returns can be cross-correlated even when the cash flows are independent, giving the appearance of “contagion” or “spurious comovement.”

Revenue Implications of Multi-Item Multi-Unit Auction Designs: Empirical Evidence from the U.S. Treasury Buyback Auctions

Wed, 29 Sep 2004 00:00:00 +0000

We study an important recent series of multi-item multi-unit auctions conducted by the U.S. Treasury in retiring $67.5 billion of its debt. Consistent with auction theory, we find that bidders earn a small volatility-related expected profit as compensation for bearing the risk of the “winner’s curse.” We find that the Treasury is penalized for being “spread too thin” when including multiple bonds in a buyback auction. Thus, the multi-item design of the auction may not have been optimal from the Treasury’s perspective. In contrast, there is no evidence that the multi-unit aspect of the buyback affected the Treasury’s costs. These results have a number of implications for current models of multi-item and multi-unit auctions.

How do Analyst Recommendations Respond to Major News?

Mon, 23 Aug 2004 00:00:00 +0000

This study examines how analysts respond to public information when setting their stock recommendations. Specifically, for a sample of stocks that experience large stock price movements, we model the determinants of analysts’ recommendation changes. Using an ordered probit model based on all available IBES stock recommendations from 1993 to 1999, we find evidence of an asymmetry following large positive and negative returns. Large stock price changes are associated with more frequent changes in analyst’s recommendations. Following large stock price increases, analysts are equally likely to upgrade or downgrade. Following large stock price declines, however, analysts are much more likely to downgrade the company’s stock. This asymmetry exists even after accounting for investment banking relationships and herding behavior. Further, this asymmetry cannot be explained by differences in the predictability of future returns. This result suggests that recommendation changes...

The Value of Private Information

Mon, 23 Aug 2004 00:00:00 +0000

We study the consumption-investment problem of a CRRA agent who possesses private information about the future prospects of a stock. We compute the value of the information to the agent by comparing the utility equivalent with and without the information of the agent. The value of private of information to the agent depends linearly on the wealth of agents and decreases with both the propensity to intermediate consumption and the risk aversion. Agents with low coefficients of relative risk aversion value private information more highly. Consistent with the empirical literature, the optimal portfolio holdings of informed agents are correlated with expected returns on the risky asset.

A Delegated Agent Asset-pricing model

Mon, 2 Aug 2004 00:00:00 +0000

Asset pricing theory has traditionally made predictions about risk and return, but has been silent on the actual process of investment. Today most investors delegate major investment decisions to financial professionals. This suggests that the instructions given by investors to their delegated agents and the compensation of those agents might be important determinants of capital market equilibrium. In the extreme when all investment decisions are delegated, the preferences and beliefs of individuals would be completely superseded by the objective functions of agent/managers. A provocative illustration of the difference between direct and delegated investing is provided based on active asset management relative to a benchmark index, a common objective function in practice. With the growing preponderance of delegated investing, future asset pricing theory will not only have to describe risk and return but, to be complete, must also be able to explain the observed objective functions...

13-04 Expected Returns and the Expected Growth in Rents of Commercial Real Estate

Tue, 27 Jul 2004 00:00:00 +0000

We investigate whether the cap rate, that is, the rent-price ratio in commercial real estate incorporates information about future expected real estate returns and future growth in rents. Relying on transactions data spanning several years across fifty-three metropolitan areas in the U.S., we find that the cap rate captures fluctuations in expected returns for apartments, retail, as well as industrial properties. For offices, by contrast, the cap rate does not forecast returns even though adsditional evidence reveals that expected returns on offices are also time-varying. We link this varying success of the cap rate in forecastings commercial property returns to differences in the stochastic properties of their rental growth rates. The growth in office rents has a higher correlation with expected returns and is more volatile than for other property types. Taken together, these characteristics diminish the correlation between the cap rate and the future returns to offices.

To Expense or not to Expense Employee Stock Options: The Market Reaction

Fri, 9 Jul 2004 00:00:00 +0000

During 2002 and 2003, 140 publicly traded U.S. firms announced their intention to recognize an accounting expense when stock options are granted to employees. Many similar firms elected not to expense options. We study the stock market’s reaction. There is no evidence whatsoever that expensing options reduces the stock price. To the contrary, around announcement dates, we find significant price increases for firms electing to expense options and significant price declines for industry/size/performance-matched firms that did not announce expensing at the same moment. The average relative change in market values is 3.65% during a six-day window around the announcement. The magnitude of the market’s reaction to expensing depends on agency costs, the magnitude of option expenses, and financial reporting costs. The market’s reaction does not seem to be affected by contracting costs (e.g., induced by debt covenants), growth opportunities, or potential political repercussions. Moreover,...

Paper Millionaires: How Valuable is Stock to a Stockholder Who is Restricted from Selling it?

Tue, 29 Jun 2004 00:00:00 +0000

Many firms have stockholders who face severe restrictions on their ability to sell their shares and diversify the risk of their personal wealth. We study the costs of these liquidity restrictions on stockholders using a continuous-time portfolio choice framework. The economic cost of these restrictions can be large and many stockholders would actually be better oﬀ if they could sell their restricted shares for even a fraction of their unrestricted value. These restrictions also have major eﬀects on the optimal investment and consumption strategies because of the need to hedge the illiquid stock position and smooth consumption in anticipation of the eventual lapse of the restrictions. These results provide a number of important insights about the effects of illiquidity in financial markets.

The Relative Valuation of Caps and Swaptions: Theory and Empirical Evidence

Tue, 29 Jun 2004 00:00:00 +0000

Although traded as distinct products, caps and swaptions are linked by no-arbitrage relations through the correlation structure of interest rates. Using a string market model framework, we solve for the correlation matrix implied by the swaptions market and examine the relative valuation of caps and swaptions. The results indicate that swaption prices are generated by four factors and that implied correlations are generally lower than historical correlations. We find evidence that long-dated swaptions are priced inconsistently and that there were major distortions in the swaptions market during the hedge-fund crisis of late 1998. We also find that cap prices periodically deviate significantly from the no-arbitrage values implied by the swaptions market.

Losing Money on Arbitrages: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities

Tue, 29 Jun 2004 00:00:00 +0000

In theory, an investor can make infinite profits by taking unlimited positions in an arbitrage. In reality, however, investors must satisfy margin requirements which completely change the economics of arbitrage. We derive the optimal investment policy for a risk-averse investor in a market where there are arbitrage opportunities. We show that it is often optimal to underinvest in the arbitrage by taking a smaller position than margin constraints allow. In some cases, it is actually optimal for an investor to walk away from a pure arbitrage opportunity. Even when the optimal policy is followed, the arbitrage strategy may underperform the riskless asset or have an unimpressive Sharpe ratio. Furthermore, the arbitrage portfolio typically experiences losses at some point before the final convergence date. These results have important implications for the role of arbitrageurs in financial markets.

ELECTRICITY FORWARD PRICES: A High-Frequency Empirical Analysis

Tue, 29 Jun 2004 00:00:00 +0000

We conduct an empirical analysis of electricity forward prices using a high-frequency data set of hourly spot and day-ahead forward prices. We find that there are significant risk premia in electricity forward prices. These premia vary systematically throughout the day and are directly related to economic risk factors such as the volatility of unexpected changes in prices and demand as well as the risk of price spikes. In contrast to the popular post-Enron view that electricity markets are easily manipulated, these results support the hypothesis that electricity forward prices are determined rationally by risk-averse economic agents.

The MIDAS Touch: Mixed Data Sampling Regression Models

Tue, 22 Jun 2004 00:00:00 +0000

We introduce Mixed Data Sampling (henceforth MIDAS) regression models. The regressions involve time series data sampled at different frequencies. Technically speaking MIDAS models specify conditional expectations as a distributed lag of regressors recorded at some higher sampling frequencies. We examine the asymptotic properties of MIDAS regression estimation and compare it with traditional distributed lag models. MIDAS regressions have wide applicability in macroeconomics and �nance.

Bidding and Performance in Repo Auctions: Evidence from ECB Open Market Operations

Mon, 17 May 2004 00:00:00 +0000

Repo auctions are multiunit auctions regularly used by central banks to inject liquidity into the banking sector. Banks have a fundamental need to participate because they have to satisfy reserve requirements. Superficially, repo auctions resemble treasury auctions; the format and rules are similar and there is an active secondary market for the underlying asset. However, using a bidder level dataset of the European Central Bank’s main repo auctions, we find evidence that the economic issues in repo auctions may be very diﬀerent. Unlike what has been documented in the treasury auctions literature, we find no evidence that private information and the winner’s curse are important issues. Instead our findings suggest that bidders are more concerned with the loser’s nightmare, collateral, and future interest rate reductions by the ECB. Small and large bidders use diﬀerent strategies, with large bidders performing better.

Strategic Behavior and Underpricing in Uniform Price Auctions: Evidence from Finnish Treasury Auctions

Mon, 17 May 2004 00:00:00 +0000

We contribute to the debate on the optimal design of multiunit auctions by developing and testing robust implications of the leading theory of uniform price auctions on the bid distributions submitted by individual bidders. The theory, which emphasizes market power, has little support in a dataset of Finnish Treasury auctions. A reason may be that the Treasury acts strategically by determining supply after observing bids, apparently taking into account that the auctions are part of a repeated game between the Treasury and the primary dealers. Bidder behavior and underpricing are aﬀected by the volatility of bond returns in a way that suggests bidders adjust for the winner’s curse.

THE MARKET PRICE OF RISK IN INTEREST RATE SWAPS: THE ROLES OF DEFAULT AND LIQUIDITY RISKS

Mon, 17 May 2004 00:00:00 +0000

We study how the market prices the default and liquidity risks incorporated into one of the most important credit spreads in the financial markets–interest rate swap spreads. Our approach consists of jointly modeling the Treasury, repo, and swap term structures using a general five-factor aﬃne credit framework and estimating the parameters by maximum likelihood. We find that the credit spread is driven by changes in a persistent liquidity process and a rapidly mean-reverting default intensity process. Although both processes have similar volatilities, we find that the credit premium priced into swap rates is primarily compensation for liquidity risk. The term structure of liquidity premia increases steeply with maturity. In contrast, the term structure of default premia is almost flat. However, both liquidity and default premia vary significantly over time.

Dynamic Portfolio Selection by Augmenting the Asset Space

Thu, 1 Apr 2004 00:00:00 +0000

We present a novel approach to dynamic portfolio selection that is no more difficult to implement than the static Markowitz model. The idea is to expand the asset space to include simple (mechanically) managed portfolios and compute the optimal static portfolio in this extended asset space. The intuition is that a static choice among managed portfolios is equivalent to a dynamic strategy. We consider managed portfolios of two types: “conditional” and “timing” portfolios. Conditional portfolios are constructed along the lines of Hansen and Richard (1987). For each variable that affects the distribution of returns and for each basis asset, we include a portfolio that invests in the basis asset an amount proportional to the level of the conditioning variable. Timing portfolios invest in each basis asset for a single period and therefore mimic strategies that buy and sell the asset through time. We apply our method to a problem of dynamic asset allocation across stocks, bonds,...

Order Flow Patterns around Seasoned Equity Offerings and their Implications for Stock Price Movements

Mon, 22 Mar 2004 00:00:00 +0000

In this study, we employ order imbalance measures to provide evidence that there exists an individual/institutional dichotomy in reactions to seasoned equity offerings (SEOs). The evidence supports the notion that small, possibly naıve, individual investors keep trading SEO stocks aggressively while the returns of these stocks reverse in the post-issue period. Investors appear to be tardy in adjusting their overoptimism, and their trades systematically lag the return response. It appears to take more than two years for small individual investors to adequately revise their overoptimistic views. Consequently, the SEO portfolios that individual investors buy on net strongly underperform relative to the size-matching nonissuer portfolios as well as to the SEO portfolios that institutional investors buy on net in the post-issue period.

European M&A Regulation is Protectionist

Tue, 16 Mar 2004 00:00:00 +0000

Why do regulatory authorities scrutinize mergers and acquisitions? The authorities themselves claim to be combating monopoly power and protecting consumers, but the last two decades of empirical research has found little supporting evidence for such laudatory motives. An alternative is that M&A regulation is actually designed to protect privileged firms. In this paper, we provide a test of protectionism by studying whether European regulatory intervention is more likely when European firms are harmed by increased competition. Our findings are unambiguous: European regulation is protectionist. The results are robust to a variety of statistical difficulties, including endogeneity between investor valuations and regulatory actions.

International Capital Markets and Foreign Exchange Risk

Wed, 18 Feb 2004 00:00:00 +0000

The relation between the volatilities of pricing kernels associated with di�erent currencies and the volatility of the exchange rate between the currencies is derived under the assumption of integrated capital markets, and the volatilities of the pricing kernels are related to the foreign exchange risk premium. Time series of pricing kernel volatilities are estimated from panel data on bond yields for five major currencies using a parsimonious term structure model that allows for time varying pricing kernel volatilities. The resulting estimates are used to test hypotheses about the relation between the volatilities of the pricing kernels in di�erent currencies and the volatility of the exchange rate. As predicted, time variation in foreign exchange risk premia is found to be related to time variation in both the volatility of the pricing kernels and the volatility of exchange rates: the estimated pricing kernel volatilities can account for the forward premium puzzle in an ‘average’...

How Did It Happen?

Wed, 18 Feb 2004 00:00:00 +0000

Between January 1980 and August 2000 American stock prices as measured by the S&P500 index rose by 1239%; over the same period the dividends on the shares underlying the index rose by only 188%, while the earnings rose by 254%. Between August 2000 and February 2003 the price index fell by 44% and, at the time of writing, some three and a half years later, the index is still some 25% below its August 2000 level, despite the fact that long term interest rates have fallen by around 100 basis points, and the fall is much greater if measured in terms of foreign currency such as the Euro. As Figure 1 shows, American stock price behavior at the turn of the millennium had all the characteristics of a classic bubble;2 prices climbed much faster than dividends or earnings, particularly starting from the beginning of 1995. What caused this?

Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit-Default Swap Market, previously titled: "The Credit-Default Swap Market: Is Credit Protection Priced Correctly?"

Sun, 1 Feb 2004 00:00:00 +0000

We use the information in credit-default swaps to obtain direct measures of the size of the default and nondefault components in corporate spreads. We find that the majority of the corporate spread is due to default risk. This result holds for all rating categories and is robust to the definition of the riskless curve. We also find that the nondefault component is time varying and strongly related to measures of bond-specific illiquidity as well as to macroeconomic measures of bond-market liquidity.

What Drives Equity Market Non-participation?

Fri, 16 Jan 2004 00:00:00 +0000

This paper produces endogenous equity market non-participation in an economy with uninsurable labor income risk and heterogeneous skill levels. Prudence and impatience generate stationary household wealth levels that depend on income. Skill, and therefore labor income, heterogeneity leads to wealth heterogeneity, with high skill households accumulating high wealth and low skill households accumulating low wealth. A HARA class utility with subsistence consumption requirement generates decreasing RRA with respect to household wealth. Consequently, low skill households also have significantly higher local RRA. In addition low skill households have less human capital and therefore have lower diversification demand for stocks. Low wealth, high RRA and low diversification demand predicts that low skill households do not hold stocks in the face of a moderate ownership cost. In addition, the model predicts a humped lifecycle wealth accumulation pattern and a humped lifecycle stock...

The Cross-Section of Analyst Recommendations

Fri, 16 Jan 2004 00:00:00 +0000

We analyze the relation between analyst attributes (years of experience, reputation of the analysts’ brokerage houses) and the short- and long-term price reactions to recommendations made by the analysts. We find that in the long-term, the recommendation changes of highly experienced analysts outperform those of low-experience ones. In addition, investors appear to overreact to dramatic upgrades of low-ability analysts, and underreact to small upgrades by high-ability analysts. These results are consistent with the Griﬃn and Tversky (1992) argument that agents place too much emphasis on the strength of the signal (the dramatic nature of the event) and insuﬃcient emphasis on the weight (the ability of the analyst making the recommendation). The study helps promote an understanding of the analyst industry and its interaction with the investing population.

Bond Pricing with Default Risk

Fri, 16 Jan 2004 00:00:00 +0000

We price corporate debt from a structural model of ﬁrm default. We assume that the capital market brings about eﬃcient ﬁrm default when the continuation value of the ﬁrm falls below the value it would have after bankruptcy restructuring. This characterization of default makes the model more tractable and parsimonious than the existing structural models. The model can be applied in conjunction with a broad range of default-free interest rate models to price corporate bonds. Closed-form corporate bond prices are derived for various parametric examples. The term structures of yield spreads and durations predicted by our model are consistent with the empirical literature. We illustrate the empirical performance of the model by pricing selected corporate bonds with varied credit ratings.

Changing Motives for Share Repurchases

Fri, 19 Dec 2003 00:00:00 +0000

Net share repurchases have increased both in absolute terms and relative to cash dividends. Share repurchases during 1975-87 were predominantly fixed price tender offers and Dutch auctions, mainly signaling undervaluation. By 1994 open market repurchases (OMRs) represented over 95% of repurchase activity. Event returns were 10% to 15% for the early period. OMRs during the 1980s had initial event returns of about 3.5%, but had four-year buy-and- hold returns of 12% and higher. By the mid 1980s share repurchases took the form of multi- year programs with annual levels as high as $2-$3 billion. Econometric studies of the 1990s are consistent with the hypothesis that a major motive was to offset the dilution effects of the exercise of stock options. Dividend patterns were related to permanent components of cash flow patterns while share repurchases were associated with more transitory cash flow changes. Dividend paying firms were almost two-third of publicly traded, non- financial,...

A Unifying Theory of Value Based Management

Thu, 27 Nov 2003 00:00:00 +0000

We identify four alternative performance metrics used in value based management (VBM). (1) Basic is an intrinsic value analysis (IVA), the discounted cash flow (DCF) methodology. (2) We show that this framework will be consistent with returns to shareholder (RTS, capital gains plus dividends) measured over appropriate time horizons. (3) Economic profit (EP) [also called economic value added (EVA®)] takes from the DCF free cash flow valuation, net operating profits after taxes (NOPAT), divided by invested capital to obtain the return on operating invested capital (ROIC) less a cost of capital estimate (k); the difference multiplied times operating capital. (4) The relationship between the market value of the firm’s financial instruments and the book value of the firm’s operating assets can be expressed equivalently as market value added (MVA), the q ratio, and the market-to-book ratio. We test the relationships of alternative financial accounting performance metrics versus market...

A Model of R&D Valuation and the Design of Research Incentives

Fri, 24 Oct 2003 00:00:00 +0000

We develop a real options model of R&D valuation, which takes into account the uncertainty in the quality of the research output, the time and cost to completion, and the market demand for the R&D output. The model is then applied to study the problem of pharmaceutical under-investment in R&D for vaccines to treat diseases affecting the developing regions of the world. To address this issue, world organizations and private foundations are willing to sponsor vaccine R&D, but there is no consensus on how to administer the sponsorship effectively. Different research incentive contracts are examined using our valuation model. Their effectiveness is measured in the following four dimensions: cost to the sponsor, the probability of development success, the consumer surplus generated and the expected cost per person successfully vaccinated. We find that, in general, purchase commitment plans (pull subsidies) are more effective than cost subsidy plans (push subsidies),...

Interpersonal Effects in Consumption: Evidence from the Automobile Purchases of Neighbors

Thu, 2 Oct 2003 00:00:00 +0000

This study analyzes the automobile purchase behavior of all residents of two Finnish provinces over several years. It finds that a consumer's purchases are strongly influenced by the purchases of his neighbors, particularly purchases in the recent past and by neighbors who are geographically most proximate. Most of the evidence points to information sharing rather than envy as a generator of consumer preferences.

Comovement as an Investment Tool

Thu, 2 Oct 2003 00:00:00 +0000

This paper develops a new tool for discovering mispriced securities based on an analysis of comovement in asses prices. Recent research in finance has demonstrated that comovement can be due to the trading patterns of noise traders as well as underlying economic fundamentals. Because comovement can be measured much more accurately than expected returns, it can be used to identify securities for which the influence of noise traders is high. Those are situations in which mispricing is most likely to exist. Therefore, analysis of comovement can provide important information about potential mispricing.

The Arbitrage Pricing Theory: Estimation and Applications

Wed, 6 Aug 2003 00:00:00 +0000

The pricing equation of Ross' (1976) APT model is derived using estimable parameters. Estimation errors are discussed in the framework of elementary perturbation analysis. Theoretically, a simple link is provided among the mean-variance efficient set mathematics, mutual fund separations, discrete and continuous time CAPM, option pricing model, term structure of interest rate, capital budgeting, portfolio ranking, Modigliani Miller theorems with the APT.

The Efficiency of Search Strategies: A Numerical and Analytical Comparison of Strategies Assuming no or Restricted Knowledge of the Underlying Distributions

Wed, 6 Aug 2003 00:00:00 +0000

The Efficiency of Search Strategies: A Numerical and Analytical Comparison of Strategies Assuming no or Restricted Knowledge of the Underlying Distributions

Progressive Taxation and the Inequality of After-Tax Income

Wed, 6 Aug 2003 00:00:00 +0000

Progressive Taxation and the Inequality of After-Tax Income

On Leasing, Borrowing and Financial Risk

Wed, 6 Aug 2003 00:00:00 +0000

On Leasing, Borrowing and Financial Risk

Risk and Performance Measures in Investment Portfolios

Wed, 6 Aug 2003 00:00:00 +0000

Risk and Performance Measures in Investment Portfolios

Why Corporations Should (or Should Not) Purchase Insurance

Wed, 6 Aug 2003 00:00:00 +0000

Why Corporations Should (or Should Not) Purchase Insurance

The Impact on Firm Value of Capital Structure Change, Some Estimates

Wed, 6 Aug 2003 00:00:00 +0000

This study develops a model based on current corporate finance theories which explains stock returns associated with the announcement of issuer exchange offers. The major independent variables are changes in leverage multiplied by senior security claims outstanding and changes in debt tax shields. Parameter estimates are statistically significant and consistent in sign and relative magnitude with model predictions. Overall, 55 percent of the variance in stock announcement period returns is explained. The evidence is consistent with tax-based theories of optimal capital structure, a positive debt level information effect, and leverage induced wealth transfers across security classes.

Necessary and Sufficient Conditions for Achieving Stockholder Unanimity over the Production of Information

Wed, 6 Aug 2003 00:00:00 +0000

The conditions under which stockholders will be unanimous in the choice of their firm's plan for the production of goods are well-known: no technological externalities, a competitive market in the production of goods, and spanning of the marginal returns of the production process by existing securities in the marketplace. However, not well-known are the conditions which give stockholder unanimity over the amount of information that the firm should produce. It is shown here that even if the conditions giving unanimity in the production of goods are satisfied, the additional conditions of homogenous beliefs and risk neutral behavior are necessary to achieve unanimity in the production of information.

Changes in Credit Policy: Reconciliation and Extensions

Wed, 6 Aug 2003 00:00:00 +0000

Changes in Credit Policy: Reconciliation and Extensions

Sunk Costs and Competitive Bidding

Wed, 6 Aug 2003 00:00:00 +0000

Sunk Costs and Competitive Bidding

The Impact of Enhanced Risk on Capital Budgeting Decisions

Wed, 6 Aug 2003 00:00:00 +0000

The Impact of Enhanced Risk on Capital Budgeting Decisions

The Role of Capital Expenditures in Signalling Firm Value

Wed, 6 Aug 2003 00:00:00 +0000

This paper analyzes the case of an entrepreneur who is the sole initial owner of a firm and who has private information as to the firm's true value. It is shown here that it is possible for the entrepreneur's chosen level of capital expenditures for the firm's production process to perfectly signal his private information, with the market's assessment of his firm's value positive function of the expenditure level. The assessment is also demonstrated to be affected by the number of shares that the entrepreneur retains in the firm. In this sense it can be said that the investment and entrepreneurial shareholding level jointly signal the value of the firm, with investment serving as the "true" signal. Among other results it is shown, in contrast to a conclusion of a study by Leland and Pyle, that in this equilibrium, with shareholdings and investment jointly serving as signals, the number of shares retained by the entrepreneur need not be positively correlated with the favorableness...

A Note on Capital Budgeting and the Three R's

Wed, 6 Aug 2003 00:00:00 +0000

A Note on Capital Budgeting and the Three R's

Taxes and the Pricing of Treasury Bill Futures Contracts

Wed, 6 Aug 2003 00:00:00 +0000

Taxes and the Pricing of Treasury Bill Futures Contracts

The Informational Impact of Auditor Choice

Tue, 5 Aug 2003 00:00:00 +0000

A change in auditors is commonly observed in firms which are selling shares nationally for the first time. One impetusfor this is said to come from underwriters who advise their clients to switch from a local to national auditing firm known for higher quality standards in order to receive a higher price for the shares sold. This statement implicitly reflects the belief that the audit quality chosen by a firm's owner will convey to the market something about the firm's intrinsic value. In this paper a model is presented which gives theoretical support to this belief. Under plausible condition it is shown that owners of firms with higher true value will choose higher quality quality audits than will those in firms of lower true value. Investors, observing this relation, will then assign higher market values to those firms that choose higher quality audits.

Stock Issues and Investment Policy When Firms Have Information That Investors Do not Have: A Note

Tue, 5 Aug 2003 00:00:00 +0000

In their article Stock Issues and Investment Policy When Firms Have Information That Investors Do not Have, Myers and Majluf(1981) show that there exist situations where positive net present value projects may be passed up if they have to be financed externally. It is shown here that if projects are marketable and if the managers can pass along their information to a buying firm, then the present value rule will not break down, and further more, the buying firm need not carry slack.

Inflation Measurement and Tests of Asset Pricing Models

Mon, 4 Aug 2003 00:00:00 +0000

The results reported in this paper reveal that the Black version of the CAPM is not robust with respect to the change in the construction of the Consumer Price Index that occurred in January 1983. Specifically, both the measure of inflation risk and the market price of inflation risk change substantially when a reconstructed version of the new CPI is substituted for the old CPI. This finding raises the question of whether macroeconomic data are sufficiently precise to permit the development of meaningful tests of competing asset pricing models.

The Jensen Measure and Errors in Variables: A Note