http://hdl.handle.net/2451/25928 Search the Channel search http://archive.nyu.edu/simple-search http://hdl.handle.net/2451/26665 Title: WHAT HAPPENED TO LIQUIDITY WHEN WORLD WAR I SHUT THE NYSE?<br/><br/>Silber, William L.<br/><br/>Abstract: The suspension of trading on the New York Stock Exchange for more thanfour months following the outbreak of World War I fostered a substitutemarket on New Street as a source of liquidity. The New Street marketsuffered from a lack of price transparency because its transactions werenot disseminated on the NYSE ticker and its quotations were blacklistedat the leading newspapers. This paper shows that despite the impairedinformation flow and the somewhat wider bid-ask spreads compared withthe New York Stock Exchange, New Street offered economically meaningfulliquidity services. The absence of price transparency turned anindividual stock&rsquo;s reputation for liquidity into an importantvariable in explaining the structure of bid-ask spreads on New Street. http://hdl.handle.net/2451/26666 Title: Uncovering the Risk&ndash;Return Relation in the Stock Market<br/><br/>Guo, Hui; Whitelaw, Robert F.<br/><br/>Abstract: There is an ongoing debate in the literature about the apparent weak ornegative relation between risk (conditional variance) and return(expected returns) in the aggregate stock market. We develop andestimate an empirical model based on the ICAPM to investigate thisrelation. Our primary innovation is to model and identify empiricallythe two components of expected returns&ndash;the risk component and thecomponent due to the desire to hedge changes in investmentopportunities. We also explicitly model the effect of shocks to expectedreturns on ex post returns and use implied volatility from tradedoptions to increase estimation efficiency. As a result, the coefficientof relative risk aversion is estimated more precisely, and we find it tobe positive and reasonable in magnitude. Although volatility risk ispriced, as theory dictates, it contributes only a small amount to thetime-variation in expected returns. Expected returns are drivenprimarily by the desire to hedge changes in investment opportunities. Itis the omission of this hedge component that is responsible for thecontradictory and counter-intuitive results in the existing literature. http://hdl.handle.net/2451/26661 Title: TURNING OVER TURNOVER<br/><br/>Cremers, K.J. Martijn; Mei, Jianping<br/><br/>Abstract: The methodology of Bai and Ng (2002, 2003) for decomposing large paneldata into systematic and idiosyncratic components is applied to bothreturns and turnover. Combining this with a GLS-based principalcomponents approach, we demonstrate that their procedure works well forboth returns and turnover despite the presence of severeheteroscedasticity and non-stationarity in turnover of individualstocks. We then test Lo and Wang&rsquo;s (2000) theoreticalmodel&rsquo;s restriction that returns and turnover should have the samenumber of systematic factors. This is strongly rejected by the data,suggesting stock price and trading volume may not be compatible underthe existing multi-factor asset pricing-trading framework. We alsodemonstrate that several commonly used turnover measures may understatethe price impact of stock trading. http://hdl.handle.net/2451/27440 Title: Time Series and Cross-sectional Variations of Expected Returns<br/><br/>Dai, Qiang<br/><br/>Abstract: The paper develops a general equilibrium stochastic growth model of amulti-sector economy subject to i.i.d. taste shocks. Each sectorproduces one good, and each firm has a linear production technology andfaces a quadratic capital adjustment cost. The model contains a standardintertemporal capital asset pricing theory of consumption and portfoliodemands with dynamically complete and frictionless markets and astandard q-theory of investment under uncertainty. We show that theequilibrium stochastic investment opportunity set is driven by therelative shares of firms' nominal capital stocks, and the equilibriumdynamics of the state vector is driven by firms' relative investmentintensities. Key implications of the model includes (i) the expectedequity returns are endogenously predictable both over time and in thecross-section; and (ii) the &quot;value anomaly&quot; arises in arational expectations equilibrium due to a negative (positive) hedgingdemand for value (growth) stocks against the risk of cross-sectionaldispersion of firms' nominal capital stocks. http://hdl.handle.net/2451/26663 Title: THE VALUATION OF MUTUAL FUND CONTRACTS<br/><br/>Boudoukh, Jacob; Richardson, Matthew; Stanton, Richard; Whitelaw, Robert<br/><br/>Abstract: Combining insights from the contingent claims and the asset-backedsecurities literatures, we study the economics of value creation in theasset management business. In particular, we provide a theoretical modeland a closed form formula for the value of fund fees in the presence ofthe well known flow-performance relation, giving rise to interestingnonlinearities and volatility-related effects. The theoretical modelsheds light on the role of fees, asset growth, asset and benchmarkvolatility, and the intensity of the flow-performance relation. Tobetter understand the role of changing fund characteristics such as ageand size on the fund value and fund risk, we estimate the empiricalrelation between returns and flows conditional on these characteristicsfor various asset classes. We study these effects using Monte Carlosimulations for various economically meaningful parameter values forspecific asset classes. Measuring value as a fraction of assets undermanagement, we find that both value and risk, systematic andidiosyncratic, decline in size and age. In addition, value is a complex,non-monotonic function of the fee charged on the fund. http://hdl.handle.net/2451/26623 Title: THE MYTH OF LONG-HORIZON PREDICTABILITY<br/><br/>Boudoukh, Jacob; Richardson, Matthew; Whitelaw, Robert F.<br/><br/>Abstract: The prevailing view in finance is that the evidence for long-horizonstock return predictability is significantly stronger than that forshort horizons. We show that for persistent regressors, a characteristicof most of the predictive variables used in the literature, theestimators are almost perfectly correlated across horizons under thenull hypothesis of no predictability. For example, for the persistencelevels of dividend yields, the analytical correlation is 99% between the1- and 2-year horizon estimators and 94% between the 1- and 5-yearhorizons, due to the combined effects of overlapping returns and thepersistence of the predictive variable. Common sampling error acrossequations leads to ordinary least squares coefficient estimates and R2sthat are roughly proportional to the horizon under the null hypothesis.This is the precise pattern found in the data. The asymptotic theory iscorroborated, and the analysis extended by extensive simulationevidence. We perform joint tests across horizons for a variety ofexplanatory variables, and provide an alternative view of the existing evidence. http://hdl.handle.net/2451/27414 Title: The Last Great Arbitrage: Exploiting the Buy-and-Hold Mutual Fund Investor<br/><br/>Boudoukh, Jacob; Richardson, Matthew P.; Subrahmanyam, Marti<br/><br/>Abstract: This paper demonstrates that an an institutional feature inherent in amultitude of mutual funds managing billions in assets generates fundNAVs that reflect stale prices. Since, in many cases, investors cantrade at these NAVs with little or no transactions costs, there is anobvious trading opportunity. Simple, feasible strategies generate Sharperatios that are sometimes one hundred times greater than the Sharperatio of the underlying fund. These opportunities are especiallyprevalent in international funds that buy Japanese or European equitiesand in funds that invest in thinly traded securities in the U.S. Whenimplemented, the gains from these strategies are matched by o settinglosses incurred by buy-and-hold investors in these funds. In oneparticular example, we explore the consequences of trading betweendifferent Vanguard mutual funds, motivated via the rules inherent inUniversity 403B plans. Compared to an equal-weighted buy-and-holdportfolio of international Vanguard funds with a 25% cumulative return,the strategy discussed in this paper produces a 139% return while beingin the stock market less than 25% of the time! http://hdl.handle.net/2451/26656 Title: THE INVESTMENT PERFORMANCE AND MARKET SIZE OF DEFAULTED BONDS AND BANKLOANS IN 2003: OUTLOOK FOR 2004/2005<br/><br/>Altman, Edward I.; Kumar, Rohit http://hdl.handle.net/2451/26660 Title: THE INVESTMENT BEHAVIOR OF PRIVATE EQUITY FUND MANAGERS<br/><br/>Ljungqvist, Alexander; Richardson, Matthew<br/><br/>Abstract: Using a unique dataset of private equity funds over the last twodecades, this paper analyzes the investment behavior of private equityfund managers. Based on recent theoretical advances, we link the timingof funds&rsquo; investment and exit decisions, and the subsequentreturns they earn on their portfolio companies, to changes in the demandfor private equity in a setting where the supply of capital is&lsquo;sticky&rsquo; in the short run. We show that existing fundsaccelerate their investment flows and earn higher returns wheninvestment opportunities improve and the demand for capital increases.Increases in supply lead to tougher competition for deal flow, andprivate equity fund managers respond by cutting their investmentspending. These findings provide complementary evidence to recent papersdocumenting the determinants of fund-level performance in private equity. http://hdl.handle.net/2451/26622 Title: THE INFORMATION IN LONG-MATURITY FORWARD RATES: IMPLICATIONS FOREXCHANGE RATES AND THE FORWARD PREMIUM ANOMALY<br/><br/>Boudoukh, Jacob; Richardson, Matthew; Whitelaw, Robert F.<br/><br/>Abstract: The forward premium anomaly is one of the most robust puzzles infinancial economics. We recast the underlying parity relation in termsof cross-country differences between forward interest rates rather thanspot interest rates with dramatic results. These forward interest ratedifferentials have statistically and economically significant forecastpower for annual exchange rate movements, both in- and out-of-sample,and the signs and magnitudes of the corresponding coefficients areconsistent with economic theory. Forward interest rates also forecastfuture spot interest rates and future inflation. Thus, we attribute muchof the forward premium anomaly to the anomalous behavior of shortterminterest rates, not to a breakdown of the link between fundamentals andexchange rates. http://hdl.handle.net/2451/26650 Title: THE IMPACT OF MUTUAL FUND FAMILY MEMBERSHIP ON INVESTOR RISK<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Green, T. Clifton<br/><br/>Abstract: Many investors confine their mutual fund holdings to a single fundfamily, either for simplicity or through restrictions placed by theirretirement savings plan. We find evidence that mutual fund returns aremore closely correlated within than between fund families. As a result,restricting investment to one fund family leads to a greater totalportfolio risk than diversifying across fund families. The increasedcorrelation is due primarily to common stock holdings, but is also moregenerally related to families having similar exposures to economicsectors or industries. Fund families also show a propensity to focus onhigh risk or low risk strategies, which leads to a greater dispersion ofrisk across restricted investors. An investor considering adding anadditional fund either inside or outside the family would need tobelieve the inside fund offered an additional 50 to 70 basis points inreturn to achieve the same Sharpe ratio. http://hdl.handle.net/2451/27441 Title: The Declining Information Content of Dividend Announcements and theEffect of Institutional Holdings<br/><br/>Amihud, Yakov; Li, Kefei<br/><br/>Abstract: We propose an explanation for the &quot;disappearing dividend&quot;phenomenon: the decline in the information content of dividendannouncements. This reduces the propensity of firms to pay or increasedividends, since dividends are costly. The decline in the informationcontent of dividend, is partly because of the rise in stockholding byinstitutional investors that are more sophisticated and informed. Ourresults show a decline in the stock price reaction to announcements ofdividend changes since the mid 1970s. Across firms, the price reactionto dividend news is smaller in firms with high institutional holdings.Institutional investors exploit their superior information by buyingbefore dividend increases and selling afterwards. And, firms with highinstitutional holdings are less likely to raise dividends. http://hdl.handle.net/2451/26671 Title: The cash flow, return and risk characteristics of private equity<br/><br/>Ljungqvist, Alexander; Richardson, Matthew<br/><br/>Abstract: Using a unique dataset of private equity funds over the last twodecades, this paper analyzes the cash flow, return, and riskcharacteristics of private equity. Unlike previous studies, we havedetailed cash flow data for each fund, rather than aggregate oraccounting returns. We also know the exact timing of investments andcapital returns to investors and the number and types of companies eachfund invested in. We document the draw down and capital return schedulesfor the typical private equity fund, and show that it takes severalyears for capital to be invested, and over ten years for capital to bereturned to generate excess returns. We provide several determiningfactors for these schedules, including existing investment opportunitiesand competition amongst private equity funds. In terms of performance,we document that private equity generates excess returns on the order offive to eight percent per annum relative to the aggregate public equitymarket. Moreover, while we estimate the betas of the private equityfunds&rsquo; portfolios to be greater than one, we show that on arisk-adjusted basis the excess value of the typical private equity fundis on the order of 24 percent relative to the present value of theinvested capital. One interpretation of this magnitude is that itrepresents compensation for holding a 10-year illiquid investment. http://hdl.handle.net/2451/26662 Title: THE ADEQUACY OF INVESTMENT CHOICES OFFERED BY 401K PLANS<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Blake, Christopher R.<br/><br/>Abstract: Defined-contribution plans represent a major organizational form forinvestors&rsquo; retirement savings. Today more than one third of allworkers are enrolled in 401K plans. In a 401K plan, participants selectassets from a set of choices designated by an employer. For over half of401K-plan participants, retirement savings represent their solefinancial asset. Yet to date there has been no study of the adequacy ofthe choices offered by 401K plans. This paper analyzes the adequacy andcharacteristics of the choices offered to 401K-plan participants forover 400 plans. We find that, for 62% of the plans, the types of choicesoffered are inadequate, and that over a 20-year period this makes adifference in terminal wealth of over 300%. We find that funds includedin the plans are riskier than the general population of funds in thesame categories. We study the characteristics of plans that areassociated with adequate investment choices, including an analysis ofthe use of company stock, plan size, and the use of outside consultants.When we examine one category of investment choices, S&amp;P 500 indexfunds, we find that the index funds chosen by 401K-plan administratorsare on average inferior to the S&amp;P 500 index funds selected by theaggregate of all investors. http://hdl.handle.net/2451/26651 Title: STOCK MARKET VALUATIONS AND FOREIGN DIRECT INVESTMENT<br/><br/>Baker, Malcolm; Foley, C. Fritz; Wurgler, Jeffrey<br/><br/>Abstract: We outline and test two theories of foreign direct investment based oncapital market mispricing. The &ldquo;cheap assets&rdquo; or&ldquo;fire-sale&rdquo; theory considers FDI inflows as the purchase ofundervalued host country assets, while the &ldquo;cheap financialcapital&rdquo; theory views FDI outflows as a natural use of therelatively low-cost capital available to overvalued firms in the sourcecountry. The results are consistent with the cheap financial capitaltheory: FDI flows are unrelated to host country stock market valuations,as measured by the aggregate market-to-book-value ratio, but arestrongly positively related to source country valuations and negativelyrelated to future source country stock returns, especially when capitalaccount restrictions limit cross-country arbitrage. http://hdl.handle.net/2451/27427 Title: Spiders: Where are the Bugs?<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Comer, George; Li, Kai http://hdl.handle.net/2451/26654 Title: RISK MANAGEMENT WITH BENCHMARKING<br/><br/>Basak, Suleyman; Shapiro, Alex; Tepla, Lucie<br/><br/>Abstract: Portfolio theory must address the fact that, in reality, portfoliomanagers are evaluated relative to a benchmark, and therefore adopt riskmanagement practices to account for the benchmark performance. Wecapture this risk management consideration by allowing a pre-specifiedshortfall from a target benchmark-linked return, consistent with growinginterest in such practice. In a dynamic setting, we demonstrate how arisk-averse portfolio manager optimally under- or over-performs a targetbenchmark under different economic conditions, depending on his attitudetowards risk and choice of the benchmark. The analysis thereforeillustrates how investors can achieve their desired gain/losscharacteristics for funds under management through an appropriatecombined choice of the benchmark and money manager. We consider avariety of extensions, and also highlight the ability of our setting toshed some light on documented return patterns across segments of themoney management industry. http://hdl.handle.net/2451/27421 Title: Risk Management with Benchmarking<br/><br/>Basak, Suleyman<br/><br/>Abstract: Portfolio theory must address the fact that in reality, portfoliomanagers are evaluated relative to a benchmark, and therefore adopt riskmanagement practices to account for the benchmark performance. Wecapture this risk management consideration by allowing a prespecifiedshortfall from a target benchmark-linked return, consistent with growinginterest in such practice. In a dynamic setting, we demonstrate how arisk averse portfolio manager optimally under- or overperforms a targetbenchmark under different economic conditions, depending on his attitudetowards risk and choice of the benchmark. Investors can thereforeachieve their desired gain/loss characteristics for funds undermanagement through an appropriate combined choice of the benchmark andmoney manager. http://hdl.handle.net/2451/27415 Title: Risk and Return: Some New Evidence<br/><br/>Guo, Hui; Whitelaw, Robert<br/><br/>Abstract: We develop a structural asset pricing model to investigate therelationship between stock market risk and return. The structural modelis estimated using the conditional market variance implied by S&amp;P100 index option prices. Relative risk aversion is precisely identifiedand is found to be positive, with point estimates ranging from 3.06 to4.01. However, the implied volatility data only spans the periodNovember 1983 to May 1995. As a robustness check, the structural modelis also examined with postwar monthly data, in which the conditionalmarket variance is estimated. We again find a positive and significantrisk-return relation and get similar point estimates for relative riskaversion. Additionally, we document some facts about stock marketreturn. First, stock price movements are primarily driven by changes ininvestment opportunities, not by changes in market volatility. Second,there is some evidence of a leverage effect. Third, relative riskaversion is quite stable over time. http://hdl.handle.net/2451/26621 Title: RECONCILING THE RETURN PREDICTABILITY EVIDENCE IN-SAMPLE FORECASTS,OUT-OF-SAMPLE FORECASTS, AND PARAMETER INSTABILITY<br/><br/>Lettau, Martin; Nieuwerburgh, Stijn Van<br/><br/>Abstract: Evidence of stock return predictability by financial ratios is stillcontroversial, as documented by inconsistent results for in-sample andout-of-sample regressions and by substantial parameter instability. Thispaper shows that these seemingly incompatible results can be reconciledif the assumption of a fixed steady-state mean of the economy isrelaxed. We find strong empirical evidence in support of shifts in thesteady-state and propose simple methods to adjust financial ratios forsuch shifts. The forecasting relationship of adjusted price ratios andfuture returns is statistically significant, stable over time, andpresent in out-of-sample tests. We also show that shifts in thesteady-state are responsible for the parameter instability and poorout-of-sample performance of unadjusted price ratios that are found inthe data. Our conclusions hold for a variety of financial ratios and arerobust to changes in the econometric technique used to estimate shiftsin the steady-state. http://hdl.handle.net/2451/26653 Title: PORTFOLIO PERFORMANCE AND AGENCY<br/><br/>Dybvig, Philip H.; Farnsworth, Heber K.; Carpenter, Jennifer<br/><br/>Abstract: The literature traditionally assumes that a portfolio manager whoexpends costly effort to generate information makes an unrestrictedportfolio choice and is paid according to a sharing rule. However, therevelation principle provides a more efficient institution. If crediblecommunication of the signal is possible, then the optimal contractrestricts portfolio choice and pays the manager a fraction of abenchmark plus a bonus proportional to performance relative to thebenchmark. If credible communication is not possible, an additionalincentive to report extreme signals may be required to remove a possibleincentive to underprovide effort and feign a neutral signal. http://hdl.handle.net/2451/27410 Title: Portfolio Performance and Agency<br/><br/>Dybvig, Philip H.; Farnsworth, Heber K.; Carpenter, Jennifer<br/><br/>Abstract: The evaluation and compensation of portfolio managers is an importantproblem for practitioners. Optimal compensation will induce managers toexpend effort to generate information and to use it appropriately in aninformed portfolio choice. Our general model points the way towardsanalysis of optimal performance evaluation and contracting in a richmodel. Optimal contracting in the model includes an important role forportfolio restrictions that are more complex than the sharing rule. Theagent's compensation gives the agent approximately to benchmark returnplus an incentive fee equal to a portfolio measure that is approximatelythe excess of return above the benchmark. This measure is often used bypractitioners but is simpler than the Jensen measure and other measurescommonly recommended in the academic literature. In addition to theexcess return above the fixed benchmark, the manager is given someadditional incentive to take a position that deviates from the benchmarkto remove an incentive to tend towards being a &quot;closetindexer.&quot; Efficient contracting involves restrictions on whatportfolio strategies can be pursued, and prior communication of theinformation gathered. http://hdl.handle.net/2451/27419 Title: Portfolio Choice with Many Risky Assets, Market Clearing and Cash Flow Predictability<br/><br/>Lynch, Anthony W.<br/><br/>Abstract: This paper examines portfolio allocations and market clearing priceswhen the representative agent can allocate across equity portfoliosformed on the basis of characteristics like size and book-to- market andportfolio cash flows are predictable. The state space is discrete andprice-consumption ratios are obtained portfolio by portfolio simply byinverting an economy-wide matrix and multiplying this matrix by aportfolio-specific vector. The economy-wide matrix has thedimensionality of the state space. The paper calibrates cash flowpredictability to the data using the consumption-wealth fraction (cay)of Lettau and Ludvigson (2000a) and dividend yield (div) as statevariables. Annual cash flow processes are calibrated for three stockportfolios and for the aggregate consumption stream. The economy'srepresentative agent possesses a relative risk aversion coefficient ofeither 5 or 10. When cash flow predictability is calibrated to the datausing cay as the predictor and risk aversion is 5, equilibrium excessreturns on the four assets are more volatile, more correlated with eachother, and have higher means than in the equivalent economy with i.i.d.cash flows. Further, the conditional second moments for returns and thecontemporaneous state variable are found to be highly state-dependent.The paper finds much smaller excess return predictability using cay inthe calibrated economy than in the data, though the relation is positivein both. Conditional Sharpe ratios are virtually invariant to state.While the representative agent's optimal portfolio is not verystate-dependent, her hedging demands are quite large and her optimalportfolio is not minimum-variance. For example, her single-periodallocation to the four risky assets is about 75% of the portfolio whileher infinite-horizon allocation is 100%. The implication is that theconditional CAPM does not hold in the conditional economy with cay asthe state variable. However, the spread in CAPM abnormal returns acrossthe three book-to-market portfolios is an order of magnitude smaller inthe calibrated economies than in the data. The spread in the data in5.6% p.a. while the largest spread in the six calibrated economiesconsidered is only 0.6% p.a. Finally, the paper has importantimplications for partial equilibrium analyses of dynamic portfolio choice. http://hdl.handle.net/2451/27429 Title: Portfolio and Consumption Decisions under Mean-Revering Returns: AnExact Solution for Complete Markets<br/><br/>Wachter, Jessica A.<br/><br/>Abstract: This paper solves, in closed form, the optimal portfolio choice problemfor an investor with utility over consumption under mean-revertingreturns. Previous solutions either require approximations, numericalmethods, or the assumption that the investor does not consume over hislifetime. This paper breaks the impasse by assuming that markets arecomplete. The solution leads to a new understanding of hedging demandand of the behavior of the approximate log-linear solution. Theportfolio allocation takes the form of a weighted average and is shownto be analogous to duration for coupon bonds. Through this analogy, thenotion of investment horizon is extended to that of an investor whoconsumes at multiple points in time. http://hdl.handle.net/2451/26667 Title: POLITICAL NEWS AND STOCK PRICES: THE CASE OF SADDAM HUSSEIN CONTRACTS<br/><br/>Amihud, Yakov; Wohl, Avi<br/><br/>Abstract: This paper studies the association between the market&rsquo;sexpectations of Saddam Hussein&rsquo;s fall from power, as reflected in&ldquo;Saddam contract&rdquo; prices, and stock prices, oil prices andexchange rates. During the war, a rise in the probability ofSaddam&rsquo;s fall, which also indicated a speedy end to the war, waspositively and significantly associated with stock prices, strengthenedthe dollar against the Euro, and lowered oil prices. Before the war, arise in the probability of Saddam&rsquo;s fall, which may also haveindicated the probability of a costly war breaking out, lowered stockprices, which adjusted gradually to this information. http://hdl.handle.net/2451/26633 Title: PARTICIPANT REACTION AND THE PERFORMANCE OF FUNDS OFFERED BY 401(K) PLANS<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Blake, Christopher R.<br/><br/>Abstract: This is the first study to examine both how well plan administratorsselect funds and how participants react to plan administrator decisions.We find that on average administrators select funds that outperformrandomly selected funds of the same type. When administrators changeofferings, they choose funds that did well in the past, but after thechange deleted funds do better than added funds. Plan participants reactstrongly to past performance in their allocation decisions. Thisaccentuates the changes in allocation caused by returns. Participantallocations do no better than na&iuml;ve allocation rules such as equalinvestment in each offering. http://hdl.handle.net/2451/27413 Title: Ownership Structure, Income Distribution, and Competitive Equilibrium: ATheory of Business Cycles, Human Capital, and Asset Returns<br/><br/>Dai, Qiang<br/><br/>Abstract: In this paper, I present a theory of dynamic economic growth, businesscycles, and asset pricing that integrates (1) Marx's idea (andemphasized by Klein) of a two-class heterogeneity of the ownershipstructure of physical capital and human capital in a capitalist society,(2) Keynes' idea of sticky wages, and (3) the existence of a competitiveequilibrium with intertemporal consumption and portfolio decisions byrisk-averse capitalists facing a contractual labor cost. The aggregatelabor income as a function of recent history of aggregate outputs isdetermined by the prevailing mode of income distribution. I focus on amodern capitalist economy in which the income distribution is notdictated by the capitalists (as in the formative years of capitalismwhich was the subject of inquiry by Adam Smith, David Ricardo, and KarlMax), but rather is determined by the economic and political consensusreached between the capitalists and workers through a legal andpolitical framework featuring strong labor unions, anti-trust laws, andprogressive tax codes. Three main implications for the macro-economyare presented. First, my theory endogenizes completely thethree-equation Klein model of consumption function, savings function,and the wage demand function. Second, I show that cyclic behavior isdriven entirely by the assumed form of income distribution. Productionand labor income shocks do not drive, but help sustain the cyclicbehavior by preventing the economy from converging to the steady statemean. Third, I show that the Marxian doctrine that the &quot;rate ofsurplus value&quot; remains constant and the &quot;organic compositionof capital&quot; keeps rising is inconsistent with the predictions of mymodel, and the difference is traced to the different assumptions onincome distribution, and leads to different conclusions on the stabilityof capitalist economies. By assuming that capital markets clear inequilibrium, I determine the risk premium for both production and laborincome risks, and consequently asset returns and the value of humancapital - all endogenously. A special case of the model isobservationally equivalent to the stochastic habit formation model ofDai (2000), and thus inherits its ability to simultaneously explain theequity premium puzzle, riskless rate puzzle, and the expectationspuzzle. In general, the labor market need not clear, due to the onlyfriction in the model: the longevity of the labor contract. http://hdl.handle.net/2451/27430 Title: Optimum Centralized Portfolio Construction with Decentralized Portfolio Management<br/><br/>Elton, Edwin J.; Gruber, Martin J.<br/><br/>Abstract: Many financial institutions employ outside portfolio managers to managepart or all of their investable assets. These institutions includepension funds, private endowments (e.g., colleges and charities), andprivate trusts. Pension funds are the largest and most likelyorganizations to employ several outside managers, each of whom manages apart of the overall portfolio. In this paper we will use the pensionfund manager as the prototype of the centralized decision-maker tryingto optimally manage a set of decentralized decision-makers but theanalysts is general. If the centralized decision-maker (CDM) is a meanvariance maximizer, the CDM could construct a portfolio using standardportfolio theory and estimates of mean return, variances, andcovariances between the portfolios constructed by a group ofdecentralized managers. However, this overall portfolio is unlikely tobe optimum since the individually managed portfolios themselves wereconstructed without taking into account the portfolios of the othermanagers. The purpose of this article is to set up a structure thatleads to the optimum portfolio from the viewpoint of the CDM when thereare multiple managers and their portfolios are constructed withoutreference to each other. http://hdl.handle.net/2451/27439 Title: Optimum Centralized Portfolio Construction with Decentralized Portfolio Management<br/><br/>Elton, Edwin J.; Gruber, Martin J.<br/><br/>Abstract: Many financial institutions employ outside portfolio managers to managepart or all of their investable assets. These institutions includepension funds, private endowments (e.g., colleges and charities), andprivate trusts. In 1999, the investment company institute estimated thatthese institutions managed 5.2 trillion dollars in assets. Most of theseinstitutions employed outside managers to invest these funds. Therelevancy of this problem has been widely recognized in thepractitioners literature on portfolio. Furthermore, it is recognized inthe prudent man law that spells out the responsibilities of thecentralized decision maker delegating management responsibility.2 Forexample the New York State law in estate power and trust states. Pensionfunds are the largest and most likely organizations to employ severaloutside managers, each of whom manages a part of the overall portfolio.In this paper we will use the pension fund manager as the prototype ofthe centralized decision-maker trying to optimally manage a set ofdecentralized portfolio managers but the analysts is general. http://hdl.handle.net/2451/27417 Title: Optimal Consumption and Portfolio Allocation under Mean-RevertingReturns: An Exact Solution for Complete Markets<br/><br/>Wachter, Jessica A.<br/><br/>Abstract: This paper solves, in closed form, the optimal portfolio choice problemfor an investor with utility over consumption under mean-revertingreturns. Previous solutions either require approximations, numericalmethods, or the assumption that the investor does not consume over hislifetime. This paper breaks the impasse by assuming that markets arecomplete. The solution leads to a new understanding of hedging demandand the behavior of approximate log-linear solutions. The portfolioallocation takes the form of a weighted average and is shown to beanalogous to duration for coupon bonds. Through this analogy, the notionof investment horizon is extended to that of an investor who consumes atmultiple points in time. http://hdl.handle.net/2451/27433 Title: On the Nature of Trading: Do Speculators Leave Footprints?<br/><br/>Silber, William L.<br/><br/>Abstract: The paper describes how two types of traders, marketmakers andspeculators, establish their positions and manage their risk exposure.We show that balance sheets are insufficient to determine whether atrader is a marketmaker or a speculator. On the other hand, tradingrecords describing the evolution of a position over time can identifywhat trading strategy was pursued. Knowing the trading strategy helps toevaluate contract compliance, risk exposure, and capital requirements oftrading firms. Understanding and verifying trader behavior is especiallyimportant because leveraged trading firms, and individual traders, havetraditional incentives to mask their risk-taking activities. Withoutproper monitoring, traders can substitute risky speculation for lessrisky marketmaking to reap potential payoffs. http://hdl.handle.net/2451/27442 Title: Offsetting the Incentives: Risk Shifting, and Benefits of Benchmarkingin Money Management<br/><br/>Basak, Suleyman; Pavlova, Anna; Shapiro, Alex<br/><br/>Abstract: Money managers are rewarded for increasing the value of assets undermanagement, and predominately so in the mutual fund industry. Thiscompensation scheme gives the manager an implicit incentive to exploitthe well-documented positive fund-flows to relative-performancerelationship by manipulating her risk exposure. It also provides herwith an explicit incentive to manage the fund in accordance with her ownappetite for risk. In a dynamic asset allocation framework, we show thatas the year-end approaches, the interplay of these incentives inducesthe manager to optimally closely mimic the index, relative to which herperformance is evaluated, when the fund's year-to-date return is justsufficient to cause a higher expected flow. As she falls behind, shegradually increases her risk exposure (via leverage or short selling),reaching an extremum at a critical level of underperformance. Thispolicy results in economically significant deviations from investor'sdesired risk exposure, substantially impairing them. To better aligninvestors' and managers' incentives, investors or regulators can imposea benchmarking restriction on the fund manager, prohibiting a shortfallrelative to a certain reference portfolio to exceed a pre-specifiedlevel. The restriction tempers deviations from the investors' desiredrisk exposure in the states in which the manager is tempted to deviatethe most, and hence is beneficial. The analysis reveals how this riskmanagement restriction should be designed for the highest benefit to theinvestors. Our findings complement and refine results in the relatedliterature on risk taking incentives of mutual fund managers, and are atodds with previous work arguing against benchmarking. http://hdl.handle.net/2451/26657 Title: OFFSETTING THE INCENTIVES: RISK SHIFTING AND BENEFITS OF BENCHMARKING INMONEY MANAGEMENT<br/><br/>Basak, Suleyman; Pavlova, Anna; Shapiro, Alex<br/><br/>Abstract: Money managers are rewarded for increasing the value of assets undermanagement, and predominantly so in the mutual fund industry. This givesthe manager an implicit incentive to exploit the well-documentedpositive fund-flows to relative-performance relationship by manipulatingher risk exposure. In a dynamic portfolio framework, we show that as theyear-end approaches, the ensuing convexities in the manager&rsquo;sobjective induce her to closely mimic the index, relative to which herperformance is evaluated, when the fund&rsquo;s year-to-date return issufficiently high. As her relative performance falls behind, she choosesto deviate from the index by either increasing or decreasing thevolatility of her portfolio. The maximum deviation is achieved at acritical level of underperformance. It may be optimal for the manager toreach such deviation via selling the risky asset despite its positiverisk premium. Under multiple sources of risk, with both systematic andidiosyncratic risks present, we show that optimal managerial riskshifting may not necessarily involve taking on any idiosyncratic risk.Costs of misaligned incentives to investors resulting from themanager&rsquo;s policy are economically significant. We then demonstratehow a simple risk management practice that accounts for benchmarking canameliorate the adverse effects of managerial incentives. http://hdl.handle.net/2451/27418 Title: Mutual Fund Survivorship<br/><br/>Carhart, Mark M.; Carpenter, Jennifer N.; Lynch, Anthony W.; Musto, David K.<br/><br/>Abstract: This paper offers a comprehensive study of survivorship issues, in thecontext of mutual fund research, using the mutual fund data set ofCarhart (1997). We find that funds in our sample disappear primarilybecause of multi-year poor performance. Then we demonstrate analyticallythat this survival rule typically causes the survivor bias in averageperformance to increase in the length of the sample period, though it ispossible to construct counterexamples. In the data, we find a strongpositive relation between the survivor bias in average performance andsample period length. The bias is economically small at 17 basis pointsper annum for one-year samples, but a significantly larger one percentper annum for samples longer than fifteen years. We also find evidenceof performance persistence in our sample and, consistent with thepresence of a multi-period survival rule, we find that the persistenceis weakened by survivorship bias. Finally, we explain how the relationbetween performance and fund characteristics can be affected by the useof a survivor-only sample and show that the magnitudes of the biases inthe slope coefficients are large for fund size, expenses, turnover andload fees in our sample. Because survivorship issues are relevant formany data sets used in finance, the analysis in this paper has potentialapplications in areas of financial economics beyond just mutual fund research. http://hdl.handle.net/2451/26685 Title: Multiple Risky Assets, Transaction Costs and Return Predictability:Implications for Portfolio Choice<br/><br/>Lynch, Anthony W.; Tan, Sinan<br/><br/>Abstract: Our paper contributes to the dynamic portfolio choice and transactioncost literatures by considering a multiperiod CRRA individual who facestransaction costs and who has access to multiple risky assets, all withpredictable returns. We numerically solve the individual&rsquo;smultiperiod problem in the presence of transaction costs andpredictability. In particular, we characterize the investor&rsquo;soptimal portfolio choice with proportional and fixed transaction costs,and with return predictability similar to that observed for the U.S.stock market. We also perform some comparative statics to betterunderstand the nature of the no-trade region with more than one riskyasset. Throughout our focus is on the case with two risky assets. Wealso perform some utility comparisons. The calibration exercise revealssome interesting results about the relative attractiveness of the threeequity portfolios calibrated. With proportional transaction costs andi.i.d. returns, we numerically find the rebalancing rule to be ano-trade region for the portfolio weights with rebalancing to theboundary. With zero correlation, the no-trade region is a rectangleirrespective of the investor&rsquo;s age. When the correlation of therisky assets is non-zero, the no-trade region becomes a parallelogram.With positive correlation, the parallelogram distorts the associatedrectangle in such a way as to take advantage of the associatedsubstitutability across the two assets that the positive correlationinduces. The converse is true for negative correlation. Turning to theallocations with return predictability, our numerical results stronglysuggest that it is the conditional return correlation that determinesthe nature of the distortion to the no-trade parallelogram. Irrespectiveof the investor&rsquo;s age, the distortion always mirrors the no-tradeparallelogram distortion that we find in the i.i.d. case for returncorrelation of the same sign. The no-trade region is always larger latein life than early in life. However, the difference in no-trade areabetween early and late in life is less pronounced when returns arepredictable, consistent with intuition that the benefits fromrebalancing today are more short-lived when returns are predictable thanin the i.i.d. case. http://hdl.handle.net/2451/26638 Title: MARKET LIQUIDITY AND FUNDING LIQUIDITY<br/><br/>Brunnermeier, Markus K.; Pedersen, Lasse Heje<br/><br/>Abstract: We provide a model that links a security&rsquo;s market liquidity&mdash; i.e., the ease of trading it &mdash; and traders&rsquo; fundingliquidity &mdash; i.e., their availability of funds. Traders providemarket liquidity and their ability to do so depends on their funding,that is, their capital and the margins charged by their financiers. Intimes of crisis, reductions in market liquidity and funding liquidityare mutually reinforcing, leading to a liquidity spiral. The modelexplains the empirically documented features that market liquidity (i)can suddenly dry up (i.e. is fragile), (ii) has commonality acrosssecurities, (iii) is related to volatility, (iv) experiences&ldquo;flight to liquidity&rdquo; events, and (v) comoves with themarket. Finally, the model shows how the Fed can improve current marketliquidity by committing to improve funding in a potential future crisis. http://hdl.handle.net/2451/26652 Title: LABOR INCOME DYNAMICS AT BUSINESS-CYCLE FREQUENCIES: IMPLICATIONS FORPORTFOLIO CHOICE<br/><br/>Lynch, Anthony W.; Tan, Sinan<br/><br/>Abstract: A large recent literature has focused on multiperiod portfolio choicewith labor income, and while the models are elaborate along severaldimensions, they all assume that the joint distribution of shocks tolabor income and asset returns is i.i.d.. Calibrating this jointdistribution to U.S. data, these papers obtain three results not foundempirically for U.S. households: young agents choose a higher stockallocation than old agents; young agents choose a higher stockallocation when poor than when rich; and, young agents always hold somestock. This paper asks whether allowing the conditional jointdistribution to depend on the business cycle can allow the model togenerate equity holdings that better match those of U.S. households,while keeping the unconditional distribution the same as in the data.Calibrating the business-cycle variation in the first two moments oflabor income growth to U.S. data leads to large reductions in stockholdings by young agents with low wealth-income ratios. The reductionsare so large that young, poor agents now hold less stock than bothyoung, rich agents and old agents, and also hold no stock a largefraction of the time. Our results suggest that the predictability oflabor-income growth at a business-cycle frequency plays an importantrole in a young agent&rsquo;s decision-making about herportfolio&rsquo;s stock holding. http://hdl.handle.net/2451/27432 Title: Investor Sentiment in Japanese and U.S. Daily Mutual Fund Flows<br/><br/>Brown, Stephen J.; Goetzmann, William N.; Hiraki, Takato; Shiraishi, Noriyoshi; Watanabe, Masahiro<br/><br/>Abstract: We find evidence that is consistent with the hypothesis that dailymutual fund flows may be instruments for investor sentiment about thestock market. We use this finding to construct a new index of investorsentiment, and validate this index using data from both the UnitedStates and Japan. In both markets exposure to this factor is priced, andin the Japanese case, we document evidence of negative correlationsbetween &ldquo;Bull&rdquo; and &ldquo;Bear&rdquo; domestic funds. Theflows to bear foreign funds in Japan display some evidence of negativecorrelation to domestic and foreign equity funds, suggesting that thereis a foreign vs. domestic sentiment factor in Japan that does not appearin the contemporaneous U.S. data. By contrast, U.S. mutual fundinvestors appear to regard domestic and foreign equity mutual funds aseconomic substitutes. http://hdl.handle.net/2451/26659 Title: INVESTOR SENTIMENT AND THE CROSS-SECTION OF STOCK RETURNS<br/><br/>Baker, Malcolm; Wurgler, Jeffrey<br/><br/>Abstract: We examine how investor sentiment affects the cross-section of stockreturns. Theory predicts that a broad wave of sentiment willdisproportionately affect stocks whose valuations are highly subjectiveand are difficult to arbitrage. We test this prediction by studying howthe cross-section of subsequent stock returns varies with proxies forbeginning-of-period investor sentiment. When sentiment is low,subsequent returns are relatively high on smaller stocks, highvolatility stocks, unprofitable stocks, non-dividend-paying stocks,extreme-growth stocks, and distressed stocks, consistent with an initialunderpricing of these stocks. When sentiment is high, on the other hand,these patterns attenuate or fully reverse. The results are consistentwith theoretical predictions and are unlikely to reflect an alternativeexplanation based on compensation for systematic risks. http://hdl.handle.net/2451/26637 Title: INSIDE INFORMATION AND THE OWN COMPANY STOCK PUZZLE<br/><br/>Nieuwerburgh, Stijn Van<br/><br/>Abstract: U.S. investors allocate 30-40% of their financial asset portfolio in thestock of the company stock they work for. Such a portfolio flies in theface of standard portfolio theory, which prescribes that an investorshould hold less of a financial asset that is positively correlated withher undiversified labor income. Nevertheless, we propose a rationalexplanation that prescribes a long position in own company stock.Precisely because the own company stock is positively correlated withthe investor's labor income, any information the investor learns abouther earnings is a partial information advantage in her own companystock. When confronted with a choice of what information to acquire,employees may choose to learn about their own firm. Learning lowers theemployee's risk of holding own-firm equity, which raises itsrisk-adjusted returns and makes a long position optimal. http://hdl.handle.net/2451/26655 Title: INFORMATIONLESS TRADING<br/><br/>Brown, Stephen J.; Gallagher, David R.; Steenbeek, Onno; Swan, Peter L.<br/><br/>Abstract: The recent paper by Goetzmann et al. (2002) suggests that fund managerssubject to a performance review have an adverse incentive to engage inportfolio strategies that have the unfortunate attribute that they canexpose the fund investor to significant downside risk. Weisman (2002)uses the term &ldquo;informationless investing&rdquo; to describe thisbehavior, and argues that these strategies are &ldquo;peculiar to theasset management industry in general, and the hedge fund industry inparticular&rdquo; and that these strategies &ldquo;can produce theappearance of return enhancement without necessarily providing any valueto an investor.&rdquo; Just how prevalent are these practices in thefund management business? On the basis of a unique database of dailytransactions and holdings of a set of forty successful Australian equitymanagers, we find evidence that individual managers do engage in thistrading behavior, particularly when they form part of a team within alarge decentralized money management operation and are compensated inthe form of an annual bonus based on performance. This result is broadlyconsistent with the theoretical and empirical results of the principalagent literature which highlight the adverse consequences for the longterm objectives of principals where agents are compensated based onobservable short term performance. It is also consistent with recentresults from the behavioral finance literature which suggest that agentsnarrowly focus on individual security gambles independent of overallportfolio value considerations. http://hdl.handle.net/2451/26640 Title: INFORMATION IMMOBILITY AND THE HOME BIAS PUZZLE<br/><br/>Nieuwerburgh, Stijn Van; Veldkamp, Laura<br/><br/>Abstract: Many explanations for home or local bias rely on information asymmetry:investors know more about their home assets. A criticism of thesetheories is that asymmetry should disappear when information istradable. This criticism is flawed. If investors have asymmetric priorbeliefs, but choose how to allocate limited learning capacity beforeinvesting, they will not necessarily learn foreign information.Investors want to exploit increasing returns to specialization: Thebigger the home information advantage, the more desirable are homeassets; but the more home assets investors expect to own, the higher thevalue of additional home information. Even with a tiny home informationadvantage, and even when foreign information is no harder to learn, manyinvestors will specialize in home assets, remain uninformed aboutforeign assets, and amplify their initial information asymmetry. Themore investors can learn, the more home biased their portfolios become.The model's predictions are consistent with observed patterns of foreigninvestment, returns, and portfolio flows. http://hdl.handle.net/2451/26635 Title: INFORMATION ACQUISITION AND PORTFOLIO UNDER-DIVERSIFICATION<br/><br/>Nieuwerburgh, Stijn Van; Veldkamp, Laura<br/><br/>Abstract: We develop a rational model of investors who choose which assetpayo&reg;s to acquire informa- tion about, before forming portfolios.Scale economies in information acquisition lead investors to specializein learning about a set of highly-correlated assets. Knowing more aboutthese assets makes them less risky and more desirable to hold.Bene&macr;ts to specialization compete with bene&macr;ts todiversi&macr;cation. The resulting asset portfolios appearunder-diversi&macr;ed from the perspective of standard theory, but areoptimal. In equilibrium, information is a strategic substitute becauseassets that many investors learn about have low expected returns.Increasing returns, combined with strategic substitutability leadsex-ante identical investors to specialize in di&reg;erent information,and hold different portfolios. Information choice rationalizes investingin a diversified fund and a set of highly-correlated assets, anallocation observed in the data but usually deemed anomalous. http://hdl.handle.net/2451/27426 Title: Incentive Fees and Mutual Funds<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Blake, Christopher R.<br/><br/>Abstract: The purpose of this article is to examine the impact of incentive feeson mutual fund performance. The paper proceeds as follows. In the firstsection we examine the characteristics and the use of incentive fees inthe mutual fund industry. In the second section we explore the theory ofthe effect of incentive fees on manager behavior. In the third sectionwe discuss our data. In the fourth section we examine empirical resultsconcerning fees earned, risk-adjusted performance, the effect ofincentive fees on risk, and new cash flows into funds using incentive fees. http://hdl.handle.net/2451/26630 Title: IMPROVED ESTIMATES OF CORRELATION AND THEIR IMPACT ON THE OPTIMUM PORTFOLIOS<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Spitzer, Jonathan F.<br/><br/>Abstract: To implement mean variance analysis one needs a technique forforecasting correlation coefficients. In this article we investigate theability of several techniques to forecast correlation coefficientsbetween securities. We find that separately forecasting the averagelevel of pairwise correlations and individual pair-wise differences fromthe average improves forecasting accuracy. Furthermore, forminghomogenous groups of firms on the basis of industry membership or firmattributes (eg. Size) improves forecast accuracy. Accuracy is evaluatedin two ways: First, in terms of the error in estimating futurecorrelation coefficients. Second, in the characteristics of portfoliosformed on the basis of each forecasting technique. The ranking offorecasting techniques is robust across both methods of evaluation andthe better techniques outperform prior suggestions in the literature offinancial economics. http://hdl.handle.net/2451/27420 Title: Illiquidity and Stock Returns: Cross-Section and Time-Series Effects<br/><br/>Amihud, Yakov<br/><br/>Abstract: New tests are presented on the effects of stock illiquidity on stockreturn. Over time, expected market illiquidity positively affects exante stock excess return (usually called &ldquo;risk premium&rdquo;).This complements the positive cross-sectional return-illiquidityrelationship. The illiquidity measure here is the average daily ratio ofabsolute stock return to dollar volume, which is easily obtained fromdaily stock data for long time series in most stock markets. Illiquidityaffects more strongly small firms stocks, suggesting an explanation forthe changes &ldquo;small firm effect&rdquo; over time. The impact ofmarket illiquidity on stock excess return suggests the existence ofilliquidity premium and helps explain the equity premium puzzle. http://hdl.handle.net/2451/27423 Title: Habit Formation and Returns on Bonds and Stocks<br/><br/>Wachter, Jessica A.<br/><br/>Abstract: This paper proposes a habit formation model that explains the failure ofthe expectations hypothesis documented by Campbell and Shiller (1991)and Fama and Bliss (1987). The model also produces positive excessreturns on long-term bonds, an upward sloping average yield curve, andallows for realistic levels of time-variation in the mean of consumptiongrowth. The model generates a novel empirical prediction: Long lags ofconsumption growth predict the short-term interest rate with a negativesign. This prediction is shown to be strongly supported by the data. http://hdl.handle.net/2451/26644 Title: GOVERNMENT BONDS AND THE CROSS-SECTION OF STOCK RETURNS<br/><br/>Baker, Malcolm; Wurgler, Jeffrey<br/><br/>Abstract: We document that U.S. government bonds comove more strongly with&ldquo;bond-like stocks&rdquo; stocks of large, mature, low-volatility,profitable, dividend-paying firms that are neither high growth nordistressed. This pattern may be caused by common shocks to real cashflows, rationally required returns, or flights to quality in which dropsin investor sentiment increase the demand for both government bonds andbond-like stocks. Consistent with both the required returns andsentiment channels, we find a common predictable component in bonds andbondlike stocks. Consistent with the sentiment channel, we find thatbonds and bond-like stocks comove with inflows into government bond andconservative stock mutual funds. http://hdl.handle.net/2451/26658 Title: FUND FAMILIES AS DELEGATED MONITORS OF MONEY MANAGERS<br/><br/>Gervais, Simon; Lynch, Anthony W.; Musto, David K.<br/><br/>Abstract: Because a money manager learns more about her skill from her managementexperience than outsiders can learn from her realized returns, sheexpects inefficiency in future contracts that condition exclusively onrealized returns. A fund family that learns what the manager learns canreduce this inefficiency cost if the family is large enough. Thefamily&rsquo;s incentive is to retain any given manager regardless ofher skill but, when the family has enough managers, it adds value byboosting the credibility of its retentions through the firing of others.As the number of managers grows the efficiency loss goes to zero. http://hdl.handle.net/2451/27412 Title: From Equity Premium Puzzle to Expectations Puzzle: General EquilibriumProduction Economy with Stochastic Habit Formation<br/><br/>Dai, Qiang<br/><br/>Abstract: This paper develops a general equilibrium model for a representativeagent, production economy with stochastic internal habit formation. Themodel describes a scale-independent economy, with a unique stochasticinvestment opportunity set. Local correlation between the stochasticinterest rate and time-varying market price of risk can be determinedendogenously and leads to correct predictions on the sign and magnitudeof several major empirical puzzles in both equity and bond markets. Inthe empirical part of the paper, we calibrate our model, simultaneously,to the equity premium puzzle, the risk-free rate puzzle, and theexpectations puzzle, and show that the three puzzles are completelyresolved under reasonable parameter values. Thus, we establish,conclusively, the inextricable link between the equity and bond markets,both theoretically and empirically. Our model subsumes the internalhabit formation models of Sundaresan (1989) and Constantinides (1990),and, perhaps somewhat surprisingly, the external habit formation modelof Campbell and Cochrane (1999). http://hdl.handle.net/2451/26646 Title: FINANCIAL MARKETS AND THE MACRO ECONOMY<br/><br/>Brenner, Menachem; Pasquariello, Paolo; Subrahmanyam, Marti<br/><br/>Abstract: The objective of this paper is to provide a deeper insight into thelinks between financial markets and the real economy. To that end, westudy the short-term anticipation and response of U.S. stock, Treasury,and corporate bond markets to the first release of U.S. macroeconomicinformation. Specifically, we focus on the impact of these announcementsnot only on the level, but also on the volatility and comovement ofthose assets&rsquo; returns. For that purpose, we estimate severalextensions of the parsimonious amended GARCH model of Engle (2002) forthe excess holding-period returns on seven portfolios of these assetclasses. We find that the process of price formation in the U.S.financial markets appears to be driven by fundamentals; yet,&ldquo;excessive&rdquo; volatility and comovement play an important rolein return dynamics as well. Further, our analysis reveals astatistically and economically significant dichotomy between thereaction of the stock and bond markets to the arrival of unexpectedfundamental information. However, we also show that stock and bondreturns tend to react to the expected component of these announcements.This evidence casts some doubts on the efficiency of the U.S. financialmarkets with respect to widely anticipated and tracked releases ofmacroeconomic data. Overall, the above results often differ from earlierstudies where the surprise portion of those releases was not identified,and shed new light on the mechanisms by which information isincorporated into prices. http://hdl.handle.net/2451/27436 Title: Fees on Fees in Funds of Funds<br/><br/>Brown, Stephen J.; Goetzmann, William N.; Liang, Bing<br/><br/>Abstract: Funds of funds are an increasingly popular avenue for hedge fundinvestment. Despite the increasing interest in hedge funds as analternative asset class, the high degree of fund specific risk and thelack of transparency may give fiduciaries pause. In addition, many ofthe most attractive hedge funds are closed to new investment. Funds offunds resolve these issues by providing investors with diversificationacross manager styles and professional oversight of fund operations thatcan provide the necessary degree of due diligence. In addition, manysuch funds hold shares in hedge funds otherwise closed to new investmentallowing smaller investors access to the most sought-after managers.However, the diversification, oversight and access comes at the cost ofa multiplication of the fees paid by the investor. It is not generallyunderstood that the incentive fee component of the fee on feearrangement may under certain circumstances exceed the realized returnon the fund. In this paper we argue that the disappointing after feeperformance of some fund of funds may be explained by the nature of thisfee arrangement. We examine an alternative fee arrangement that mayprovide better incentives at a lower cost to investors in these funds. http://hdl.handle.net/2451/27434 Title: Expected Returns and Expected Dividend Growth<br/><br/>Lettau, Martin; Ludvigson, Sydney C.<br/><br/>Abstract: We develop a consumption-based present value relation that is a functionof future dividend growth. Using data on aggregate consumption andmeasures of the dividend payments from aggregate wealth, we show thatchanging forecasts of dividend growth make an important contribution tofluctuations in the U.S. stock market, despite the failure of thedividend-price ratio to uncover such variation. In addition, thesedividend forecasts are found to covary with changing forecasts of excessstock returns. The variation in expected dividend growth we uncover ispositively correlated with &quot;business cycle&quot; variation inexpected returns, and the results suggest that a substantial fraction ofthe variation in expected dividend growth is common to variation inexpected excess returns. Movements in expected dividend growth that areentirely common to movements in expected returns have no effect on thelog dividend-price ratio. An implication of these findings is that thelog dividend-price ratio will have difficulty predicting both dividendgrowth and excess returns at business cycle frequencies. Such a failureof predictive power is not an indication that risk-premia are constant,however. On the contrary, the results presented here imply that the logdividend-price ratio will have difficulty revealing business cyclevariation in both the equity risk-premium and expected dividend growthprecisely because expected returns fluctuate at those frequencies, andcovary with changing forecasts of dividend growth. The findings implythat both the market risk-premium and expected dividend growth varyconsiderably more than what can be revealed using the log dividend-priceratio alone as a predictive variable. http://hdl.handle.net/2451/27411 Title: Expectation Puzzles, Time-varying Risk Premia, and Dynamic Models of theTerm Structure<br/><br/>Dai, Qiang; Singleton, Kenneth<br/><br/>Abstract: Though linear projections of returns on the slope of the yield curvehave contradicted the implications of the traditional &quot;expectationstheory,&quot; we show that these findings are not puzzling relative to alarge class of richer dynamic terms structure models. Specifically, weare able to match all of the key empirical findings reported by Fama andBliss and Campbell and Shiller, among others, within large subclasses ofaffine and quadractic-Gaussian term structure models. Key to thismatching are parameterizations of the market prices of risk that let usseparately &quot;control&quot; the shape of the mean yield curve and thecorrelation structure of excess returns with the slope of the yieldcurve. The risk premiums have a simple form consistent with Fama'sfindings on the predictability of forward rates, and are shown to alsobe consistent with interest rate, feedback rules used by a monetaryauthority in setting monetary policy. http://hdl.handle.net/2451/27424 Title: DotCom Mania: The Rise and Fall of Internet Stock Prices<br/><br/>Ofek, Eli; Richardson, Matthew<br/><br/>Abstract: This paper provides one potential explanation for the rise, persistenceand eventual fall of internet stock prices. Specifically, we appeal to amodel of heterogenous agents with varying degrees of beliefs about assetpayoffs who are subject to short sales constraints. In this framework,it is possible that &ldquo;optimistic&rdquo; investors overwhelm&ldquo;pessimistic&rdquo; ones, leading to prices not reflectingfundamental values about cash flows summarized by aggregate beliefs.Empirical support for this explanation is provided by exploring thebehavior of internet stock prices during the period January 1998 toNovember 2000. In particular, we document four important elements to ourstory: (i) the high level of internet stock prices given theirunderlying fundamentals, (ii) responses of stock prices to a shifttowards potentially optimistic investors, (iii) empirical resultsconsistent with shorting being at its maximum possible level forinternet stocks, and (iv) the eventual fall, or bubble bursting, ofinternet stocks being tied to the increase in the number of sellers tothe market via expiration of lockup agreements. http://hdl.handle.net/2451/26670 Title: Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors?<br/><br/>Sangvinatsos, Antonios; Wachter, Jessica<br/><br/>Abstract: We consider the consumption and portfolio choice problem of a long-runinvestor when the term structure is affine and when the investor hasaccess to nominal bonds and a stock portfolio. In the presence ofunhedgeable inflation risk, there exist multiple pricing kernels thatproduce the same bond prices, but a unique pricing kernel equal to themarginal utility of the investor. We apply our method to a three-factorGaussian model with a time-varying price of risk that captures thefailure of the expectations hypothesis seen in the data. We extend thismodel to account for time-varying expected inflation, and estimate themodel with both inflation and term structure data. The estimates implythat the bond portfolio for the long-run investor looks very differentfrom the portfolio of a mean-variance optimizer. In particular, thedesire to hedge changes in term premia generates large hedging demandsfor long-term bonds. http://hdl.handle.net/2451/26669 Title: Does Mutual Fund Performance Vary over the Business Cycle?<br/><br/>Lynch, Anthony W.; Wachter, Jessica; Boudry, Walter<br/><br/>Abstract: Conditional factor models allow both risk loadings and performance overa period to be a function of information available at the start of theperiod. Much of the literature to date has allowed risk loadings to betime-varying while imposing the assumption that conditional performanceis constant. We develop a new methodology that allows conditionalperformance to be a function of information available at the start ofthe period. This methodology uses the Euler equation restriction thatcomes out of the factor model rather than the beta pricing formulaitself. The Euler equation restrictions that we develop can be estimatedusing GMM. It is also possible to allow the factor returns to havelonger data series than the mutual fund series as in Stambaugh (1997).We use our method to assess the conditional performance of funds in theElton, Gruber and Blake (1996) mutual fund data set. Using dividendyield to track the business cycle, we find that conditional mutual fundperformance moves with the business cycle, with all fund types exceptgrowth performing better in downturns than in peaks. The converse holdsfor growth funds, which do better in peaks than in downturns. http://hdl.handle.net/2451/26668 Title: Do Asset Prices Reflect Fundamentals? Freshly Squeezed Evidence from theOJ Market<br/><br/>Boudoukh, Jacob; Richardson, Matthew; Shen, YuQing; Whitelaw, Robert F.<br/><br/>Abstract: The behavioral finance literature cites the frozen concentrated orangejuice (FCOJ) futures market as a prominent example of the failure ofprices to reflect fundamentals. This paper reexamines the relationbetween FCOJ futures returns and fundamentals, focusing primarily ontemperature. We show that when theory clearly identifies thefundamental, i.e., at temperatures close to or below freezing, there isa close link between FCOJ prices and that fundamental. Using a simple,theoretically-motivated, nonlinear, state dependent model of therelation between FCOJ returns and temperature, we can explainapproximately 50% of the return variation. This is important becausewhile only 4.5% of the days in winter coincide with freezingtemperatures, two-thirds of the entire winter return variability occurson these days. Moreover, when theory suggests no such relation, i.e., atmost temperature levels, we show empirically that none exists. The factthat there is no relation the majority of the time is good news for thetheory and for market efficiency, not bad news. In terms of residualFCOJ return volatility, we also show that other fundamental informationabout supply, such as USDA production forecasts and news about Brazilproduction, generate significant return variation that is consistentwith theoretical predictions. The fact that, even in the comparativelysimple setting of the FCOJ market, it is easy to erroneously concludethat fundamentals have little explanatory power for returns serves as animportant warning to researchers who attempt to interpret the evidencein markets where both fundamentals and their relation to prices are more complex. http://hdl.handle.net/2451/27437 Title: Do Asset Prices Reflect Fundamentals? Freshly Squeezed Evidence from theFCOJ Market<br/><br/>Boudoukh, Jacob; Richardson, Matthew; Shen, YuQing; Whitelaw, Robert F.<br/><br/>Abstract: This paper reexamines frozen concentrated orange juice (FCOJ) futuresreturns as they relate to fundamentals, in particular, temperature. Weshow that when theory clearly identities the fundamental, i.e., attemperatures close to or below freezing, there is a close link betweenFCOJ prices and that fundamental. Using a simple theoretical nonlinearmodel of the relation between FCOJ returns and temperature, we canexplain approximately 50%of the return variation. This is importantbecause while only 4.5%of the days in winter coincide with freezingtemperatures, two- thirds of the entire winter return variability occurson these days. Moreover, when theory suggests no such relation, i.e., atmost temperature levels, we show empirically that none exists. The factthat there is no relation the majority of the time is good news for thetheory and market efficiency, not bad news. In terms of other FCOJreturn volatility, we also show that other fundamental information aboutsupply, such as USDA production forecasts and news about Brazilproduction, generate significant return variation that is consistentwith theoretical predictions. The evidence in this paper suggests thatthe literature &rsquo;s conclusion about irrationality drawn from theFCOJ market have more to do with econometricians &rsquo;lack of modelingability than with the empirical facts. http://hdl.handle.net/2451/27431 Title: Delegated Monitoring of Fund Managers<br/><br/>Gervais, Simon; Lynch, Anthony W.; Musto, David K.<br/><br/>Abstract: Because a money manager learns more about her skill from her managementexperience than outsiders can learn from her realized returns, sheexpects inefficiency in future contracts that condition exclusively onrealized returns. A fund family that learns what the manager learns canreduce this inefficiency cost if the family is large enough. Thefamily&rsquo;s incentive is to retain any given manager regardless ofher skill but, when the family has enough managers, it adds value byboosting the credibility of its retentions through the firing of others.In this way, large fund families add value through crosSC-sectionalreputation. As the number of managers grows the efficiency loss goes to zero. http://hdl.handle.net/2451/26664 Title: CONFLICTS OF INTEREST AND MARKET DISCIPLINE AMONG FINANCIAL SERVICES FIRMS<br/><br/>Walter, Ingo<br/><br/>Abstract: There has been substantial public and regulatory attention of late toapparent exploitation of conflicts of interest involving financialservices firms based on financial market imperfections and asymmetricinformation. This paper proposes a workable taxonomy of conflicts ofinterest in financial services firms, and links it to the nature andscope of activities conducted by such firms, including possiblecompounding of interest-conflicts in multifunctional clientrelationships. It lays out the conditions that either encourage orconstrain exploitation of conflicts of interest, focusing in particularon the role of information asymmetries and market discipline, includingthe shareholder-impact of litigation and regulatory initiatives.External regulation and market discipline are viewed as both complementsand substitutes &ndash; market discipline can leverage the impact ofexternal regulatory sanctions, while improving its granularity thoughdetailed management initiatives applied under threat of marketdiscipline. At the same time, market discipline may help obviate theneed for some types of external control of conflict of interest exploitation. http://hdl.handle.net/2451/27416 Title: Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry<br/><br/>Brown, Stephen J.; Goetzmann, William N.; Park, James<br/><br/>Abstract: Investors in hedge funds and commodity trading advisors [CTA&rsquo;s]are naturally concerned with risk as well as return. In this paper, weinvestigate risk of hedge funds and CTA&rsquo;s in light of managerialcareer concerns. We find an association between past performance andrisk levels consistent with Brown, Harlow and Starks (1996) findings formutual fund managers. Good performers in the first half of the yearreduce the volatility of their portfolios, and poor performers increasevolatility. These &ldquo;variance strategies&quot; depend upon thefund&rsquo;s ranking relative to other funds. The importance of relativerankings as opposed to the absolute ranking suggested by analysis ofhedge fund and CTA manager contracts points to the importance ofreputation costs. These costs are best thought of in the context of thecareer concerns of managers and the relative importance of fundtermination. We analyze factors contributing to fund disappearance.Survival depends on both absolute and relative performance. Excessvolatility can also lead to termination. Finally, other things equal,the younger a fund, the more likely it is to disappear from the sample.Therefore our results strongly confirm an hypothesis of Fung and Hsieh(1997b) that reputation costs have a mitigating effect on the gamblingincentives implied by the manager contract. Particularly for youngfunds, a volatility strategy that increases the value of a performancefee option may lead to the premature death of that option throughtermination of the fund. The finding that hedge fund and CTA volatilityis conditional upon past performance has implications for investors,lenders and regulators. An important result of our finding is thatvariance strategy depends upon relative rather than absolute performance evaluation. http://hdl.handle.net/2451/26649 Title: CAN MUTUAL FUND MANAGERS PICK STOCKS? EVIDENCE FROM THEIR TRADES PRIORTO EARNINGS ANNOUNCEMENTS<br/><br/>Baker, Malcolm; Litov, Lubomir; Wachter, Jessica A.; Wurgler, Jeffrey<br/><br/>Abstract: We measure the stock-picking skill of mutual fund managers based on thereturns realized around the subsequent earnings announcements of thestocks that they hold and trade. Relative to standard methodologies,this approach exploits the most informative segments of the returns dataand ameliorates the joint hypothesis problem inherent in tests ofstock-picking skill. Consistent with skilled trading, we find that, onaverage, stocks that funds buy earn significantly higher returns atsubsequent earnings announcements than stocks that they sell. Accordingto our measures of skill, certain funds perform persistently better thanothers, and the best performers tend to have a growth objective, largesize, high turnover, and use incentive fees to motivate managers. http://hdl.handle.net/2451/27425 Title: Asset Pricing in a Neoclassical Model with Limited Participation<br/><br/>Dai, Qiang<br/><br/>Abstract: In this paper, I show that habit formation is perhaps not what it iscommonly perceived to be: an extension of preference specification forthe representative agent. Rather, it captures a dynamic interactionbetween aggregate financial income and aggregate labor income. I alsoshow that existing specifications of consumption habit can be extendedto incorporate a stochastic shock, which is interpreted as the laborincome shock. As a result of these two innovations, I show that a habitformation model can explain the equity premium, equity volatility, andrisk free rate puzzles simultaneously, and provide an equilibriumjustification for the predictability of equity and bond returns bydividend/pride ration and term spreads - all in terms of observablesample moments of aggregate dividend income and labor income growthrates and reasonable values of risk aversion coefficient and thesubjective discount rate. To substantiate these claims, I present anextension of the Breeden-Lucas CCAPM by incorporating a particular formof heterogeneity assumption and a particular form of limitedparticipation assumption. The resulting model features a richertechnological specification (from the perspective of a productioneconomy) or a richer standard assumptions of constant relative riskaversion, complete markets, and frictionless trading from theperspective of the marginal investor. http://hdl.handle.net/2451/27438 Title: Are Investors Rational? Choices Among Index Funds<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Busse, Jeffrey A.<br/><br/>Abstract: Financial theory is often based on the belief that the actions ofrational investors determine prices, which leads to the elimination ofdominated financial instruments. Recently a series of articles have beenpublished which question the rationality of investor behavior. Standardand Poor&rsquo;s 500 index funds represent one of the simplest vehiclesfor examining whether investors make rational decisions consistent withthe normal paradigm of financial economics. S&amp;P 500 index funds holdvirtually the same securities, yet they differ by more than two percentper year in the fees they charge investors and the returns they offerinvestors. In this paper, we show that the relative returns offered byalternative S&amp;P index funds are easily predictable. We show that theother important aspects of performance, risk and tax efficiency, arealso easily predictable. Despite this predictability, the relationshipbetween new cash flows and performance is much weaker than we wouldexpect based on rational behavior. Marketing and spillover account forsome, but only a small amount, of the cash flows not accounted for byperformance. We show that selecting funds based on low expenses or highpast returns leads to a portfolio that outperforms the portfolio ofindex funds selected by investors. Our results exemplify the fact that,in a market where arbitrage is not possible, dominated products can prosper. http://hdl.handle.net/2451/27422 Title: An Analysis of the Relative Performance of Japanese and Foreign Money Management<br/><br/>Brown, Stephen J.; Goetzmann, William N.; Hiraki, Takato; Shiraishi, Noriyoshi<br/><br/>Abstract: Foreign investment management firms have recently started to play amajor role in the investment trust business in Japan. In terms of assetsunder management, their size and market share have almost doubled in thepast two years. In part, the relative success of foreign managed firmsin attracting market share may be attributed to the fact that Japaneseinvestment trusts have underperformed benchmarks in quite a dramaticfashion over the past two decades. This is at best indirect evidencethat Japanese funds underperform their foreign counterparts. In a recentpaper (Brown, Goetzmann, Hiraki, Otsuki and Shiraishi 2001) we show thatthe underperformance can be attributed almost entirely to the unique taxenvironment of Japanese investment trusts. In this paper we examine therelative performance issue directly by looking at week by week returnsfor the period January 23, 1998 through to January 14, 2000. Contrary topopular perception, Japanese managers actually outperformed theirforeign counterparts over this period of time. Perhaps this indicatesthat Japanese managers are more skillful. However, the evidence suggeststhat they happened to be in the right place at the right time. Weattribute the superior performance to the asset allocation decision,rather than to any superior skill in selecting securities. http://hdl.handle.net/2451/27435 Title: An Analysis of the Relative Performance of Japanese and Foreign Money Management<br/><br/>Brown, Stephen J.; Goetzmann, William N.; Hiraki, Takato; Shiraishi, Noriyoshi<br/><br/>Abstract: Foreign investment management firms have recently started to play amajor role in the investment trust business in Japan. In terms of assetsunder management, their size and market share have almost doubled in thepast several years. In part, the relative success of foreign managedfirms in attracting market share may be attributed to the fact thatJapanese investment trusts have underperformed benchmarks in quite adramatic fashion over the past two decades. This is at best indirectevidence that Japanese funds underperform their foreign counterparts. Ina recent paper (Brown, Goetzmann, Hiraki, Otsuki and Shiraishi 2001) weshow that the underperformance can be attributed almost entirely to theunique tax environment of Japanese investment trusts, which had theeffect of heavily penalizing early withdrawals. The relaxation of theseregulations coincided with a major inflow of new money into theinvestment trust business. We examine the relative performance ofJapanese and foreign investment management firms before and after thischange in tax regulations, and find that the poor relative performanceof Japanese funds from April 2000 through December 2001 may in part beattributed to the huge inflow of new money into this sector and thestyle shifts made necessary to accommodate this flow. http://hdl.handle.net/2451/27428 Title: A First Look at the Accuracy of the CRSP Mutual Fund Database and aComparison of the CRSP and Morningstar Mutual Fund Databases<br/><br/>Elton, Edwin J.; Gruber, Martin J.; Blake, Christopher R.<br/><br/>Abstract: This paper examines problems in the CRSP Survivor Bias Free U.S. MutualFund Database (CRSP, 1998) and compares returns contained in it to thosein Morningstar. The CRSP database has an omission bias that has the sameeffects as survivorship bias. Although all mutual funds are listed inCRSP, return data is missing for many and the characteristics of thesefunds differ from the populations. The CRSP return data is biased upwardand merger months are inaccurately recorded about half the time.Differences in returns in Morningstar and CRSP are a problem for olderdata and small funds.