DSpace Collection: Finance Working Papers

A Reference Point Theory of Mergers and Acquisitions

Mon, 16 Nov 2009 19:02:00 GMT

Title: A Reference Point Theory of Mergers and Acquisitions

Wurgler, Jeffrey; Pan, Xin; Baker, Malcolm

Abstract: The use of judgmental anchors or reference points in valuingcorporations affects several basic aspects of merger and acquisitionactivity including offer prices, deal success, market reaction, andmerger waves. Offer prices are biased toward the 52-week high, a highlysalient but largely irrelevant past price, and the modal offer price isexactly that reference price. An offer’s probability of acceptancediscontinuously increases when the offer exceeds the 52-week high;conversely, bidder shareholders react increasingly negatively as theoffer price is pulled upward toward that price. Merger waves occur whenhigh recent returns on the stock market and on likely targets make iteasier for bidders to offer the 52-week high.

How Much of the Diversification Discount Can be Explained by Poor Corporate Governance?

Mon, 16 Nov 2009 18:14:35 GMT

Title: How Much of the Diversification Discount Can be Explained by PoorCorporate Governance?

Yermack, David; Hoechle, Daniel; Schmid, Markus; Walter, Ingo

Abstract: We investigate whether the diversification discount is simply a proxyfor poor corporate governance. We find that the negative value impact ofdiversification is amplified by adverse governance variables such as lowCEO ownership, low board independence, and board classification, andthat approximately 25% to 30% of the diversification discount can beattributed to suboptimal governance choices by conglomerate firms. Ourmethodology includes a dynamic panel GMM estimator that accounts for theendogeneity of the diversification decision and corporate governance,plus an event study analysis of diversifying mergers. Even aftercontrolling for governance, the diversification discount remainsnegative and significant.

Stockholder and Bondholder Reactions To Revelations of Large CEO Inside Debt Holdings: An Empirical Analysis

Mon, 16 Nov 2009 18:12:51 GMT

Title: Stockholder and Bondholder Reactions To Revelations of Large CEO InsideDebt Holdings: An Empirical Analysis

Yermack, David; Chenyang, Wei

Abstract: We conduct an event study of stockholders’ and bondholders’reactions to companies’ initial reports of their CEOs’inside debt positions, as required by SEC disclosure regulations thatbecame effective early in 2007. Results show that bond prices rise,equity prices fall, and the volatility of both securities drops at thetime of disclosures by firms whose CEOs have sizeable pensions ordeferred compensation. The results indicate a transfer of value fromequity toward debt, as well as an overall destruction of enterprisevalue, when a CEO’s inside debt holdings are large.

The Role of Banks in Dividend Policy

Wed, 29 Jul 2009 22:58:59 GMT

Title: The Role of Banks in Dividend Policy

Allen, Linda; Gottesman, Aron; Saunders, Anthony; Tang, Yi

Abstract: We document a significant inverse relationship between a firm’sdividend payouts and reliance on bank loan financing. Banks limitdividend payouts to shareholders in order to protect the integrity oftheir senior claims on the firm’s assets. Moreover, dividendpayouts decline in the presence of monitoring by relationship banks,which acts as an effective governance mechanism, thereby reducing thegains from pre-committing to costly dividend payouts. Bank monitoringand corporate governance (insider stake and institutional blockholdings) are complementary mechanisms to resolve firm agency problems,both reducing the firm’s reliance on dividend policy.

Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis

Thu, 02 Jul 2009 22:58:59 GMT

Title: Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidencefrom the Sub-prime Crisis

Archarya, Viral V.; Merrouche, Ouarda

Abstract: Using data on the behavior of large settlement banks in the UK and theSterling Money Markets before and during the sub-prime crisis of2007-08, we provide evidence of precautionary hoarding of liquidity andits e ect on inter-bank borrowing rates. Our evidence consists of threepieces. First, we document that liquidity holdings of the largesettlement banks in the UK experienced on average a 30% increase in theperiod immediately following 9th August, 2007, the widely accepted dateof money-market "freeze" during the sub-prime crisis. Second,we show that following this structural break, bank liquidity had aprecautionary nature in that it rose on calendar days predicted to havea large amount of uctuations in payment and settlements activity andmore so for banks that made larger losses during the crisis. Third,using the payment and settlements activity as an instrument, weestablish a causal e ect of bank liquidity on overnight inter-bankrates, in both secured and unsecured markets, an e ect that is virtuallyabsent in the period before the crisis. Importantly, precautionaryhoardings by some settlement banks raised lending rates for allsettlement banks, suggestive of a contagion-style systemic riskoperating through inter-bank rates. Finally, variability in overnightinter-bank rates appears to have a ected rates and volumes in householdas well as corporate lending.

The New Case for Functional Separation in Wholesale Financial Services

Thu, 30 Jul 2009 22:58:59 GMT

Title: The New Case for Functional Separation in Wholesale Financial Services

Walter, Ingo

Abstract: This paper reexamines the separation of commercial and investmentbanking in the context of modern wholesale financial environment,dominated by a small cohort of “systemic” institutions. Thepaper traces the pathology of regulation and deregulation from thewatershed events of the 1930s to the systemic financial failures of therecent past. It then considers the structure, conduct and performance ofthe wholesale financial industry and how firms that cannot be allowed tocollapse get that way. Based on the industrial organization of globalwholesale finance, the paper then examines the available regulatorytechniques, and makes some judgments as to their relative promise inpromoting future financial stability with least possible dislocation offinancial efficiency, proposing benchmarks for the calibration ofproposals for regulatory reform. The paper then evaluates functionalseparation and carve-outs of high-risk activities that cannot defensiblybe conducted within systemic financial firms in the real world of powerpolitics and regulatory capture. The paper concludes that blanketcondemnation of the functional-separation features of the 1930sfinancial reforms is unwarranted in the light of ongoing experience, andthat it is time to revisit this issue in reconfiguring the globalwholesale financial architecture.

Trust and Delegation

Sun, 16 Aug 2009 22:58:59 GMT

Title: Trust and Delegation

Brown, Stephen J.; Liang, Bing; Goetzmann, William N; Schwarz, Christopher

Abstract: Due to imperfect transparency and costly auditing, trust is an essentialcomponent of financial intermediation. In this paper we study acomprehensive sample of due diligence reports from a major hedge funddue diligence firm. A routine feature of due diligence is an assessmentof integrity. We find that misrepresentation about past legal andregulatory problems is frequent (21%), as is incorrect or unverifiablerepresentations about other topics (28%). Misrepresentation, the failureto use a major auditing firm and the use of internal pricing aresignificantly related to legal and regulatory problems, indices ofoperational risk. Due diligence (DD) reports are costly and are onlyperformed when a fund is seriously considered for investment. It isimportant to control for this conditioning which would otherwise biascross-sectional analysis. We find that DD reports are typically issuedon high return funds three months after the historical performance haspeaked. DD reports are also issued at the point of highest cash flowinto the fund. This pattern is consistent with return chasing behaviorby institutional hedge fund investors.

Energizing Bidder's Choice in Financial Assets Auctions - An Experimental Investigation

Tue, 06 Oct 2009 21:52:58 GMT

Title: Energizing Bidder's Choice in Financial Assets Auctions - AnExperimental Investigation

Brenner, Menachem; Galai, Dan; Sade, Orly

Abstract: The objective of this paper is to investigate the preferences ofpotential bidders in choosing between uniform and discriminatory auctionpricing methods. Many financial assets, particularly government bonds,are issued in an auction. Uniform and discriminatory pricing constitutethe two most popular mechanisms used in public auctions. Theoreticalpapers have not been able to provide an unequivocal preference of onemechanism over the other. This study investigates both bidder choice andthe impact of that choice on the outcome of the auction by allowingbidders to choose between the two alternative systems. The majority ofthe bidders in the survey prefer uniform pricing. Those preferringuniform auctions tend to bid more aggressively than those preferringdiscriminatory. On average, the proceeds to the issuer were higher underthe uniform price mechanism.

Efficient Recapitalization

Fri, 18 Sep 2009 21:31:48 GMT

Title: Efficient Recapitalization

Philippon, Thomas; Schnabl, Philipp

Abstract: We analyze public interventions to alleviate debt overhang among privaterms when the government has limited information and limited resources.We compare the e¢ ciency of buying equity, purchasing existingassets, and providing debt guarantees. With sym- metric information, allthe interventions are equivalent. With asymmetric information betweenrms and the government, buying equity dominates the two other interven-tions. We solve for the optimal intervention, and show how it can beimplemented with subordinated loans and warrants.

Post-Chapter 11 Bankruptcy Performance: Avoiding Chapter 22

Thu, 03 Sep 2009 17:56:13 GMT

Title: Post-Chapter 11 Bankruptcy Performance: Avoiding Chapter 22

Altman, Edward; Kant, Tushar; Rattanaruengyot, Thongchai

Abstract: Forty years ago, I developed a method of predicting bankruptcies by U.S.[public] companies that makes use of equity market values as well asfundamental financial and operating data. Since that time, my“Z-Score” model has become one of the most widely usedmethods for assessing the creditworthiness of manufacturing companiesthroughout the world. And it continues to be used by both financescholars and practitioners in a variety of ways, including credit anddebt analysis, investment decisions, merger and acquisition screens,audit-risk analysis, and receivables management. It has also been usedby corporate managers and their advisers when managing turnarounds ofdistressed companies. This article extends the use of bankruptcyprediction models to a new application: the assessment of the health ofindustrial companies as they emerge from the Chapter 11 bankruptcyprocess, including the probability that the companies will have to filefor bankruptcy again—the so-called “Chapter 22”phenomenon. Using a modified Z-Score model, I find significant economicdifferences between those companies that emerge from Ch. 11 and surviveas going concerns and those that later file again. In particular,companies that filed a second Chapter 11 had significantly higherleverage and lower profitability shortly after emerging the first time.The predictive ability of this modified Z-Score suggests it can be usedas a effective tool for evaluating the quality and efficacy of thebankruptcy reorganization plan.

The re-emergence of distressed exchanges in corporate restructurings

Thu, 03 Sep 2009 17:53:58 GMT

Title: The re-emergence of distressed exchanges in corporate restructurings

Altman, Edward; Karlin, Brenda

Abstract: In 2008 and 2009, bondholders of ailing companies were affected by areemergence of an important corporate restructuring strategy, known as aDistressed Exchange. Fourteen companies in 2008 completed this desperateattempt to avoid a formal bankruptcy filing – about twice as manyas any single year in the last 25 years, involving twice as much indollar amount than in the entire prior history (1984-2007). And, in justthe first four months of 2009, nine firms have already completeddistressed exchanges. The recovery rate to bondholders participating indistressed exchanges over the last 25 years is significantly higher thanrecoveries on other, more dramatic types of default – namelypayment defaults and bankruptcies. But, there is no guarantee that adistressed exchange will permanently immunize the firm from furtherdistress, with almost 50% of all companies completing distressedexchanges prior to 2008 ultimately filing for bankruptcy.

Creditor rights and corporate risk-taking

Thu, 03 Sep 2009 17:52:14 GMT

Title: Creditor rights and corporate risk-taking

Acharya, Viral; Amihud, Yakov; Litov, Lubomir

Abstract: We analyze the link between creditor rights and firms’ investmentpolicies, proposing that stronger creditor rights in bankruptcy reducecorporate risk-taking. In cross-country analysis, we find that strongercreditor rights induce greater propensity of firms to engage indiversifying acquisitions, which result in poorer operating andstock-market abnormal performance. In countries with strong creditorrights, firms also have lower cash flow risk and lower leverage, andthere is greater propensity of firms with low-recovery assets to acquiretargets with high-recovery assets. These relationships are strongest incountries where management is dismissed in reorganization, and areobserved in time-series analysis around changes in creditor rights. Ourresults question the value of strong creditor rights as they have anadverse effect on firms by inhibiting management from undertaking risky investments.

Securitization and Real Investment in Incomplete Markets

Thu, 03 Sep 2009 17:50:50 GMT

Title: Securitization and Real Investment in Incomplete Markets

Subrahmanyam, Marti; Gaur, Vishal; Seshadri, Sridhar

Abstract: We study the impact of financial innovations on real investmentdecisions within the framework of an incomplete market economy comprisedof fi rms, investors, and an intermediary. The fi rms face uniqueinvestment opportunities that arise in their business operations and canbe undertaken at given reservation prices. The cash flows thus generatedare not spanned by the securities traded in the fi nancial market, andcannot be valued uniquely. The intermediary purchases claims againstthese cash flows, pools them together, and sells tranches of primary orsecondary securities to the investors. We derive necessary and suffcientconditions under which projects are undertaken due to the intermediary'sactions, and firms are amenable to the pool proposed by theintermediary, compared to the no-investment option or the option offorming alternative pools. We also determine the structure of the newsecurities created by the intermediary and identify how it exploits thearbitrage opportunities available in the market. Our results haveimplications for valuation of real investments, synergies among them,and their fi nancing mechanisms. We illustrate these implications usingan example of inventory decisions under random demand.

Illiquidity or Credit Deterioration: A Study of Liquidity in the US Corporate Bond Market during Financial Crises

Thu, 03 Sep 2009 17:48:31 GMT

Title: Illiquidity or Credit Deterioration: A Study of Liquidity in the USCorporate Bond Market during Financial Crises

Subrahmanyam, Marti; Friewald, Nils; Jankowitsch, Rainer

Abstract: We use a unique data-set to study liquidity effects in the US corporatebond market, covering more than 30,000 bonds. Our analysis explorestime-series and cross-sectional aspects of corporate bond yield spreads,with the main focus being on the quanti fication of the impact ofliquidity factors, while controlling for credit risk. Our time periodstarts in October 2004 when detailed transaction data from the TradeReporting and Compliance Engine (TRACE) became available. In particular,we examine three diff erent regimes during our sample period, theGM/Ford crisis in 2005 when a segment of the corporate bond market was affected, the sub-prime crisis since mid-2007, which was much morepervasive across the corporate bond market, and the period in between,when market conditions were more normal. We employ a wide range ofliquidity measures and fi nd in our time-series analysis that liquidityeff ects explain approximately one third of market-wide corporate yieldspread changes, in general, and are even more pronounced during periodsof crisis. In particular, the price dispersion measure proposed byJankowitsch, Nashikkar and Subrahmanyam (2008) explains about half ofthe aggregate bond yield spread changes during the sub-prime crisis. Ourdata-set allows us to examine in greater detail liquidity e ffects invarious segments of the market: financial sector fi rms which have beenparticularly aff ected by the crisis vs. industrial firms, investmentgrade vs. speculative grade bonds, and retail vs. institutional trades.In addition, our cross-sectional analysis shows that liquidity explainsa large part of the variation in yield spreads across bonds, afteraccounting for credit risk. These results yield important insightsregarding the liquidity drivers of corporate yield spreads, particularlyduring periods of crisis.

Background Risk and Trading in a Full-Information Rational Expectations Economy

Thu, 03 Sep 2009 17:45:49 GMT

Title: Background Risk and Trading in a Full-Information Rational Expectations Economy

Subrahmanyam, Marti; Stapleton, Richard; Zeng, Qi

Abstract: In this paper we assume that investors have the same information, buttrade due to the evolution of their non-market wealth. In ourformulation, investors rebalance their portfolios in response to changesin their expected non-market wealth, and hence trade. We assume anincomplete market in which risky non-market wealth is non-hedgeable andindependent of the market risk and thus represents an additivebackground risk. Investors who experience positive shocks to theirexpected wealth buy more stocks from those who experience less positive shocks.

Crash Risk in Currency Markets

Thu, 03 Sep 2009 17:44:06 GMT

Title: Crash Risk in Currency Markets

Gabaix, Xavier; Farhi, Emmanuel; Fraiberger, Samuel; Ranciere, Romain; Verdelhan, Adrien

Abstract: How much of carry trade excess returns can be explained by the presenceof disaster risk? To answer this question, we propose a simplestructural model which includes both Gaussian and disaster risk premiaand can be estimated even in samples that do not contain disasters. Themodel points to a novel estimation procedure based on currency optionswith potentially different strikes. We implement this procedure on alarge set of countries over the 1996-2008 period, forming portfolios ofhedged and unhedged carry trade excess returns by sorting currencies ontheir forward discounts. We find that disaster risk premia account forabout 25% of carry trade excess returns in advanced countries.

Do Hedge Funds Trade on Private Information? Evidence from Syndicated Lending

Thu, 03 Sep 2009 17:41:38 GMT

Title: Do Hedge Funds Trade on Private Information? Evidence from Syndicated Lending

Saunders, Anthony; Massoud, Nadia; Nandy, Debarshi; Song, Keke

Abstract: This paper investigates important contemporary issues relating to hedgefund involvement in the syndicated loan market. In particular, weinvestigate the potential conflicts of interest that arise due to thelack of regulation relating to hedge funds permissible dual holding ofloans and short positions in the equity of borrowing firms. We findevidence of possible trading on private information in the equity of thehedge fund borrowers prior to the public announcements of both loanorigination and loan renegotiation (amendments). In addition, ourresults show that hedge funds are more likely to lend to highlyleveraged, low credit quality firms in comparison to bank lenders. Ourresults have important implications for the current debate regardingregulation of the hedge fund industry.

The Role of Banks in Dividend Policy

Thu, 03 Sep 2009 17:38:59 GMT

Title: The Role of Banks in Dividend Policy

Saunders, Anthony; Allen, Linda; Gottesman, Aron; Tang, Yi

Abstract: We document a significant inverse relationship between a firm’sdividend payouts and reliance on bank loan financing. Banks limitdividend payouts to shareholders in order to protect the integrity oftheir senior claims on the firm’s assets. Moreover, dividendpayouts decline in the presence of monitoring by relationship banks,which acts as an effective governance mechanism, thereby reducing thegains from pre-committing to costly dividend payouts. Bank monitoringand corporate governance (insider stake and institutional blockholdings) are complementary mechanisms to resolve firm agency problems,both reducing the firm’s reliance on dividend policy.

The Impact of Investor Protection Law on Corporate Policy: Evidence from the Blue Sky Laws

Mon, 22 Jun 2009 22:09:20 GMT

Title: The Impact of Investor Protection Law on Corporate Policy: Evidence fromthe Blue Sky Laws

Agrawal, Ashwini

Abstract: Recent studies have debated the impact of investor protection laws onfirms’ corporate policies. I exploit the passage of state investorprotection statutes (“blue sky laws”) in the U.S. in theearly 20th century to estimate the effects of investor protection law onfirm financing decisions and investment activity. Regression estimatesindicate that the passage of investor protection statutes causes firmsto pay out greater dividends, issue more equity, and grow in size. Theintroduction of investor protection law is also associated withimprovements in operating performance and market valuations. Additionalanalysis suggests that alternative hypotheses for the measured changesin corporate policy and performance have limited explanatory power.Overall, the evidence is strongly supportive of theoretical models whichpredict that investor protection laws have a significant impact on firmfinancing and investment policy.

The 2007-2009 Financial Crisis and Executive Compensation: Analysis and a Proposal for a Novel Structure

Wed, 17 Jun 2009 22:38:27 GMT

Title: The 2007-2009 Financial Crisis and Executive Compensation: Analysis anda Proposal for a Novel Structure

Landskroner, Yoram; Raviv, Alon

Abstract: During the 2007-2009 crises financial institutions have come underincreasing pressure from regulators, politicians and shareholders tochange their compensation practices in order to remove the incentive forshort term excessive risk taking. In this paper we analyze first how thecommon executive compensation, which is composed of equity-basedcompensation (stocks and executive stock options) and a fixed cashcompensation, leads to a concave relationship between assets risk andcompensation value and creates an incentive for the executive to choosecorner solutions that either lead to an excessive risk taking or to afreeze out of the lending activity to the public. This paper’smain contribution is a novel component, for executive compensation, thatis paid only if the value of the firm assets is located in somepredetermined range. This new form of compensation motivates theexecutive to take an intermediate (internal solution) level of assetsrisk because of the convex relationship between assets risk andcompensation value.

The Psychology of Pricing in Mergers and Acquisitions

Thu, 28 May 2009 22:08:41 GMT

Title: The Psychology of Pricing in Mergers and Acquisitions

Wurgler, Jeffrey; Pan, Xin; Baker, Malcolm

Abstract: Psychology-driven pricing practices are evident in mergers andacquisitions. In particular, offer prices are highly influenced by thetarget’s 52-week high stock price. This price likely serves as apsychological anchor—a starting point from which actual bid pricesdo not sufficiently adjust to reflect only current information (Tverskyand Kahneman (1974)). Bidders who pursue targets with 52-week highs thatare well above their current prices experience more negative offerannouncement effects; their investors appear to perceive such bids asmore likely to be overpaying. The probability of deal success isdiscontinuously increased by offering the target a price above its52-week high, indicating that psychology-driven prices have real effects.

Global, Local, and Contagious Investor Sentiment

Tue, 26 May 2009 22:58:59 GMT

Title: Global, Local, and Contagious Investor Sentiment

Wurgler, Jeffrey; Baker, Malcolm; Yuan, Yu

Abstract: We construct indexes of investor sentiment for six major stock marketsand decompose them into one global and six local indexes. Relativemarket sentiment is correlated with the relative prices of dual-listedcompanies, validating the indexes. Both global and local sentiment arecontrarian predictors of the time series of major markets' returns. Theyare also contrarian predictors of the time series of cross-sectionalreturns within major markets: When sentiment from either global or localsources is high, future returns are low on various categories ofdifficult to arbitrage and difficult to value stocks. Sentiment appearsto be contagious across markets based on tests involving capital flows,and this presumably contributes to the global component of sentiment.

Mutual Fund’s R^2 as Predictor of Performance

Thu, 26 Feb 2009 15:26:34 GMT

Title: Mutual Fund’s R^2 as Predictor of Performance

Amihud, Yakov; Goyenko, Ruslan

Abstract: We propose that fund performance is predicted by its R^2, obtained byregressing its return on the Fama-French-Carhart four benchmarkportfolios. Lower R2, or higher idiosyncratic risk relative to totalrisk, measures selectivity or active management. We show that lagged R2has significant negative predictive coefficient in predicting alpha orInformation Ratio. This is consistent with Cremers and Petajisto’s(2008) results on the effect of selectivity. Funds ranked into laggedlowest-quintile R2 and highest-quintile alpha produce significant alphaof 2.8%. Also, both fund RMSE and return volatility predict thefollowing year’s performance with significant positive andnegative coefficients, respectively. Across funds, R^2 is an increasingfunction of fund size and a decreasing function of its age, its managertenure and its past performance, but better performance induces funds tosubsequently increase their R^2.

The Wealth-Consumption Ratio

Wed, 11 Feb 2009 15:51:30 GMT

Title: The Wealth-Consumption Ratio

Van Nieuwerburgh, Stijn; Lustig, Hanno; Verdelhan, Adrien

Abstract: To measure the wealth-consumption ratio, we estimate an exponentiallyaffine model of the stochastic discount factor on bond yields and stockreturns. We use that discount factor to compute the no-arbitrage priceof a claim to aggregate US consumption. Our estimates indicate thattotal wealth is much safer than stock market wealth. The consumptionrisk premium is only 2.2 percent, substantially below the equity riskpremium of 6.9 percent. As a result, our estimate of thewealth-consumption ratio is much higher than the price-dividend ratio onstocks throughout the post-war period. The high wealth-consumption ratioimplies that the average US household has a lot of wealth, most of ithuman wealth. A variance decomposition of the wealth-consumption ratioshows less return predictability than for stocks, and some of the returnpredictability is for future interest rates not future excess returns.We conclude that the properties of the average US household’sportfolio are more similar to those of a long-maturity bond than thoseof stocks. The differences that we find between the risk-returncharacteristics of equity and total wealth suggest that equity is aspecial asset class.

Technological Change and the Growing Inequality in Managerial Compensation

Wed, 11 Feb 2009 15:49:12 GMT

Title: Technological Change and the Growing Inequality in Managerial Compensation

Van Nieuwerburgh, Stijn; Lustig, Hanno; Syverson, Chad

Abstract: Three of the most fundamental changes in US corporations since the early1970s have been (1) the increased importance of organizational capitalin production, (2) the increase in managerial income inequality andpay-performance sensitivity, and (3) the secular decrease in labormarket reallocation. Our paper develops a simple explanation for thesechanges: a shift in the composition of productivity growth away fromvintage-specific to general growth. This shift has stimulated theaccumulation of organizational capital in existing firms and reduced theneed for reallocating workers to new firms. We characterize the optimalmanagerial compensation contract when firms accumulate organizationalcapital but risk-averse managers cannot commit to staying with the firm.A calibrated version of the model reproduces the increase in managerialcompensation inequality and the increased sensitivity of pay toperformance in the data over the last three decades.

On the Economic Sources of Stock Market Volatility

Mon, 09 Feb 2009 19:25:14 GMT

Title: On the Economic Sources of Stock Market Volatility

Engle, Robert; Ghysels, Eric; Sohn, Bumjean

Abstract: We revisit the relation between stock market volatility andmacroeconomic activity using a new class of component models thatdistinguish short run from secular movements. We combine insights fromEngle and Rangel (2007) and the recent work on mixed data sampling(MIDAS), as in e.g. Ghysels, Santa-Clara, and Valkanov (2005). The newclass of models is called GARCH-MIDAS, since it uses a mean revertingunit daily GARCH process, similar to Engle and Rangel (2007), and aMIDAS polynomial which applies to monthly, quarterly, or bi-annualmacroeconomic or financial variables. We study long historical dataseries of aggregate stock market volatility, starting in the 19thcentury, as in Schwert (1989). We formulate models with the long termcomponent driven by inflation and industrial production growth that areat par in terms of out-of-sample prediction for horizons of one quarterand out-perform more traditional time series volatility models at longerhorizons. Hence, imputing economic fundamentals into volatility modelspays off in terms of long horizon forecasting. We also find that at adaily level, inflation and industrial production growth, account forbetween 10 % and 35 % of one-day ahead volatility prediction. Hence,macroeconomic fundamentals play a significant role even at shorthorizons. Unfortunately, all the models - purely time series ones aswell as those driven by economic variables - feature structural breaksover the entire sample spanning roughly a century and a half of dailydata. Consequently, our analysis also focuses on subsamples - pre-WWI,the Great Depression era, and post-WWII (also split to examine the socalled Great Moderation). Our main findings remain valid across subsamples.

Priced Risk and Asymmetric Volatility in the Cross-Section of Skewness

Mon, 09 Feb 2009 19:22:46 GMT

Title: Priced Risk and Asymmetric Volatility in the Cross-Section of Skewness

Engle, Robert; Mistry, Abhishek

Abstract: We investigate the sources of skewness in aggregate risk-factors and thecross-section of stock returns. In an ICAPM setting with conditionalvolatility, we find theoretical time series predictions on therelationships among volatility, returns, and skewness for priced riskfactors. Market returns resemble these predictions; however, size,book-to- market, and momentum factor returns show alternative behavior,leading us to conclude these factors are not priced risks. We linkaggregate risk and skewness to individual stocks and find empiricallythat the risk aversion effect manifests in individual stock skewness.Additionally, we find several firm characteristics that explain stockskewness. Smaller firms, value firms, highly levered firms, and firmswith poor credit ratings have more positive skewness.

Semiparametric vector MEM

Mon, 09 Feb 2009 19:19:16 GMT

Title: Semiparametric vector MEM

Engle, Robert; Cipollini, Fabrizio; Gallo, Giampiero

Abstract: In financial time series analysis we encounter several instances ofnon–negative valued processes (volumes, trades, durations,realized volatility, daily range, and so on) which exhibit clusteringand can be modeled as the product of a vector of conditionallyautoregressive scale factors and a multivariate iid innovation process(vector Multiplicative Error Model). Two novel points are introduced inthis paper relative to previous suggestions: a more generalspecification which sets this vector MEM apart from an equation byequation specification; and the adoption of a GMM-based approach whichbypasses the complicated issue of specifying a general multivariatenon–negative valued innovation process. A vMEM for volumes, numberof trades and realized volatility reveals empirical support for adynamically interdependent pattern of relationships among the variableson a number of NYSE stocks.

Term structure of risk, the role of Known and Unknown Risks and Non-stationary Distributions

Mon, 09 Feb 2009 19:17:26 GMT

Title: Term structure of risk, the role of Known and Unknown Risks andNon-stationary Distributions

Engle, Robert; Colacito, Riccardo

Abstract: In this paper we document the presence of a term structure of risk andwe propose how to measure it using alternative models to forecastvolatility and the Value at Risk at different horizons. We then quantifythe benefits of an investor that is aware of the existence of a termstructure of risk in the context of an asset allocation exercise.

A component model for dynamic correlations

Mon, 09 Feb 2009 19:15:50 GMT

Title: A component model for dynamic correlations

Engle, Robert; Colacito, Riccardo; Ghysels, Eric

Abstract: The idea of component models for volatility is extended to dynamiccorrelations. We propose a model of dynamic correlations with a short-and long-run component specification. We call this class of modelsDCC-MIDAS as the key ingredients are a combination of the Engle (2002)DCC model, the Engle and Lee (1999) component GARCH model to replace theoriginal DCC dynamics with a component specification and the Engle,Ghysels, and Sohn (2006) GARCH-MIDAS component specification that allowsus to extract a long-run correlation component via mixed data sampling.We provide a comprehensive econometric analysis of the new class ofmodels, including conditions for positive semi-definiteness, and provideextensive empirical evidence that supports the model specification.

Dynamic Equicorrelation

Mon, 09 Feb 2009 19:13:49 GMT

Title: Dynamic Equicorrelation

Engle, Robert; Kelly, Bryan

Abstract: A new covariance matrix estimator is proposed under the assumption thatat every time period all pairwise correlations are equal. Thisassumption, which is pragmati- cally applied in various areas offinance, makes it possible to estimate arbitrarily large covariancematrices with ease. The model, called DECO, is a special case of the CCCand DCC models which involve first adjusting for individual volatilitiesand then estimating the correlations. A QMLE result shows that DECO cancontinue to give consistent parameter estimates when the equicorrelationassumption is violated. Generalizations to block equicorrelationstructures, models with exogenous variables, and alternativespecifications are explored and diagnostic tests are proposed.Estimation is evaluated by Monte Carlo and using US stock return data.

A Cross-Sectional Investigation of the Conditional ICAPM

Mon, 09 Feb 2009 19:12:01 GMT

Title: A Cross-Sectional Investigation of the Conditional ICAPM

Engle, Robert; Bali, Turan

Abstract: This paper provides a cross-sectional investigation of the conditionaland unconditional intertemporal capital asset pricing model (ICAPM). Theresults indicate that estimating the conditional ICAPM with a pooledpanel of time series and cross-sectional data in a multivariateGARCH-in-mean framework is crucial in identifying the positiverisk-return tradeoff. Different from the traditional literature, thepaper decomposes the aggregate stock market portfolio into tenbook-to-market portfolios and then estimates a cross-sectionallyconsistent slope coefficient on the conditional variance-covariancematrix. The riskaversion coefficient, restricted to be the same acrossall portfolios, is estimated to be positive and highly significant. Thisis the first study testing the cross-sectional consistency of theintertemporal relation by estimating the multivariate GARCH-in-meanmodel with different slopes. The statistical results indicate theequality of slope coefficients across all portfolios, supporting theempirical validity and sufficiency of the conditional ICAPM. The paperalso provides evidence that the time-varying conditional covariances canexplain the value premium because the average risk-adjusted returndifference between the value and growth portfolios is economically andstatistically insignificant within the conditional ICAPM framework.

A MEM-based Analysis of Volatility Spillovers in East Asian Financial Markets

Mon, 09 Feb 2009 19:09:41 GMT

Title: A MEM-based Analysis of Volatility Spillovers in East Asian Financial Markets

Engle, Robert; Gallo, Giampiero; Velucchi, Margherita

Abstract: Transmission mechanisms in financial markets reflect the degree ofintegration of capital markets, as well as the relative importance ofreal economies. Market volatility has components which may behavedifferently across quiet and turbulent periods, but appear to behave insimilar ways from market to market. In this paper we suggest aMultiplicative Error Model (MEM) approach to study volatility spilloversamong a set of markets, using as a proxy, the market daily range. Wemodel the dynamics of the expected volatility of one market includinginteractions with the past daily ranges of other markets, building afully interdependent model. We analyze eight East Asian markets in theperiod 1995-2006, devoting particular attention to the treatment of the1997-1998 turbulent period. We find no evidence of independent marketswhile several interdependence relationships can be stressed. Hong Kongturns out to be the most important market while Taiwan seems to havesuffered quite limited effects from the crisis. Impulse responsefunctions and multiperiod forecast profiles are developed and suggest abuild-up in the spillover effects.

Fire Sales, Foreign Entry and Bank Liquidity

Fri, 06 Feb 2009 18:45:57 GMT

Title: Fire Sales, Foreign Entry and Bank Liquidity

Acharya, Viral; Shin, Hyun Song; Yorulmazer, Tanju

Abstract: Bank liquidity is a crucial determinant of the severity of bankingcrises. We consider the effect of fire sales and foreign entry duringcrises on banks' ex-ante choice of liquid asset holdings. In a settingwith limited pledgeability of risky cash flows and differentialexpertise between banks and outsiders in employing banking assets, themarket for assets clears only at fire-sale prices following the onset ofa crisis - and outsiders may enter the market if prices fallsufficiently low. While fire sales make it attractive for banks to holdliquid assets, foreign entry reduces this incentive. We show that inthis setting, bank liquidity is counter-cyclical whereas bank capitalmeasured as bank profits is pro-cyclical. We derive conditions underwhich privately optimal levels of bank liquidity are higher or lowerthan benchmark levels that maximize total output of the banking sector.We present and discuss evidence on bank liquidity that is consistentwith model predictions.

Labor Laws and Innovation

Fri, 06 Feb 2009 18:43:07 GMT

Title: Labor Laws and Innovation

Acharya, Viral; Baghai-Wadji, Ramin; Subramanian, Krishnamurthy

Abstract: Can stringent labor laws be e¢ cient? Possibly, if they providefirms with a commitment device to not punish employees' short-runfailures and thereby spur the pursuit of value-maximizing innovativeactivities. In this paper, we provide empirical evidence that stronglabor laws indeed appear to have an ex ante positive incentive effect byencouraging the innovative pursuits of firms and their employees. Usingpatents and citations as proxies for innovation and a time-varying indexof labor laws, we find that innovation is fostered by stringent laborlaws, especially by laws governing dismissal of employees. We providethis evidence using levels-on-levels, changes-on-changes, and finallydifference-in-difference regressions that exploit staggeredcountry-level law changes. We also find that stringent labor lawsdisproportionately influence innovation in the more innovation-intensivesectors of the economy. Finally, we find that while the overall effectof stringent labor laws is to dampen economic growth, laws that governdismissal of employees are an exception: stringent laws governingdismissal promote economic growth, consistent with the evidence thatthey encourage firm-level innovation.

The Internal Governance of Firms

Fri, 06 Feb 2009 18:39:46 GMT

Title: The Internal Governance of Firms

Acharya, Viral; Myers, Stewart; Rajan, Raghuram

Abstract: We develop a model of internal governance where the self-serving actionsof top management are limited by the potential reaction of subordinates.We find that internal governance can mitigate agency problems and ensurefirms have substantial value, even without any external governance.Internal governance seems to work best when both top management andsubordinates are important to value creation. We then allow forgovernance provided by external financiers and find situations whereexternal governance, even if crude and uninformed, complements internalgovernance in improving efficiency. Interestingly, this allows us todevelop a theory of dividend policy, where dividends are paid byself-interested CEOs to maintain a balance between internal and externalcontrol. Finally, we explore how the internal organization of firms maybe structured to enhance the role of internal governance. Our papercould explain why young firms with limited external oversight, and firmsin countries with poor external governance, can have substantial value,and why improving external governance may not be a panacea for allgovernance problems.

Corporate Governance and Value Creation: Evidence from Private Equity

Fri, 06 Feb 2009 18:35:43 GMT

Title: Corporate Governance and Value Creation: Evidence from Private Equity

Acharya, Viral; Hahn, Moritz; Kehoe, Conor

Abstract: We examine deal-level data on private equity transactions in the UKinitiated during the period 1996 to 2004 by mature private equityhouses. We un-lever the deal-level equity return and adjust for(un-levered) return to quoted peers to extract a measure of"alpha" or abnormal performance of the deal. The alpha issignificantly positive on average and robust during sector downturns. Inthe cross-section of deals, higher alpha is related to greaterimprovement in EBITDA to Sales ratio (margin) and greater growth inEBITDA multiple during the private phase, relative to that of quotedpeers. In particular, deals with higher alpha either grow their marginsmore substantially, and/or grow multiples more substantially, whilstexpanding their revenues only in line with the sector. Based oninterviews with general partners involved with the deals, we find thatdeals with higher alpha and higher margin growth are associated withgreater intensity of engagement of private equity houses during theearly phase of the deal, employment of value-creation initiatives forproductivity and organic growth, and complementing top management withexternal support. Overall, our results are consistent with matureprivate equity houses creating value for portfolio companies throughactive ownership and governance.

Creditor rights and corporate risk-taking

Fri, 06 Feb 2009 18:30:52 GMT

Title: Creditor rights and corporate risk-taking

Acharya, Viral; Amihud, Yakov; Litov, Lubomir

Abstract: We analyze the link between creditor rights and firms’ investmentpolicy, proposing that stronger creditor rights in bankruptcy reducecorporate risk-taking. Employing country-level data, we find thatstronger creditor rights are associated with a greater propensity offirms to engage in diversifying mergers, and this propensity changes inresponse to changes in the country creditor rights. Also, in countrieswith stronger creditor rights, operating risk of firms is lower, andacquirers with low-recovery assets prefer targets with high-recoveryassets. These relationships are strongest in countries where managementis dismissed in reorganization, suggesting a managerial agency effect.Our results question the value of strong creditor rights, which may haveadverse effect on firms by inhibiting them from undertaking risky investments.

Rollover Risk and Market Freezes

Fri, 06 Feb 2009 18:28:02 GMT

Title: Rollover Risk and Market Freezes

Acharya, Viral; Gale, Douglas; Yorulmazer, Tanju

Abstract: The sub-prime crisis of 2007 and 2008 has been characterized by a suddenfreeze in the market for short-term, secured borrowing. We present amodel that can explain a sudden collapse in the amount that can beborrowed against assets with little credit risk. The borrowing in thismodel takes the form of asset-backed commercial paper that has to berolled over several times before the underlying assets mature and theirtrue value is revealed. In the event of default, the creditors (holdersof commercial paper) can seize the collateral. We assume that there is asmall cost of liquidating the assets. The debt capacity of the assets(the maximum amount that can be borrowed using the assets as collateral)depends on how information about the quality of the asset is revealed.In one scenario, there is a constant probability that "badnews" is revealed each period and, in the absence of bad news, thevalue of the assets is high. We call this the "optimistic"scenario because, in the absence of bad news, the expected value of theassets is increasing over time. By contrast, in another scenario, thereis a constant probability that "good news" is revealed eachperiod and, in the absence of good news, the value of the assets is low.We call this the "pessimistic" scenario because, in theabsence of good news, the expected value of the assets is decreasingover time. In the optimistic scenario, the debt capacity of the assetsis equal to the fundamental value (the expected NPV), whereas in thepessimistic scenario, the debt capacity is below the fundamental valueand is decreasing in the liquidation cost and frequency of rollovers. Inthe limit, as the number of rollovers becomes unbounded, the debtcapacity goes to zero even for an arbitrarily small default risk. Ourmodel explains why markets for rollover debt, such as asset-backedcommercial paper, may experience sudden freezes. The model also providesan explicit formula for the haircut in secured borrowing or repo transactions.

A Theory of Slow-Moving Capital and Contagion

Fri, 06 Feb 2009 18:24:49 GMT

Title: A Theory of Slow-Moving Capital and Contagion

Acharya, Viral; Shin, Hyun Song; Yorulmazer, Tanju

Abstract: Fire sales that occur during crises beg the question of why sufficientoutside capital does not move in quickly to take advantage of firesales, or in other words, why outside capital is so"slow-moving". We propose an answer to this puzzle in thecontext of an equilibrium model of capital allocation. Keeping capitalin liquid form in anticipation of possible fire sales entails costs interms of foregone profitable investments. Set against this, those sameprofitable investments are rendered illiquid in future due to agencyproblems embedded with expertise. We show that a robust consequence ofthis trade-off between making investments today and waiting forarbitrage opportunities in future is the combination of occasional firesales and limited stand-by capital that moves in only if fire-salediscounts are sufficiently deep. An extension of our model to severaltypes of investments gives rise to a novel channel for contagion wheresufficiently adverse shocks to one type can induce fire sales in othertypes that are fundamentally unrelated, provided arbitrage activity inthese investments is sourced from a common pool of capital.

Endogenous Information Flows and the Clustering of Announcements

Fri, 06 Feb 2009 18:21:36 GMT

Title: Endogenous Information Flows and the Clustering of Announcements

Acharya, Viral; DeMarzo, Peter; Kremer, Ilan

Abstract: We consider the release of information by a firm when the manager hasdiscretion regarding the timing of its release. While it is well knownthat firms appear to delay the release of bad news, we examine howexternal information about the state of the economy (or the industry)affects this decision. We develop a dynamic model of strategicdisclosure in which a firm may privately receive information at a timethat is random (and independent of the state of the economy). Becauseinvestors are uncertain regarding whether and when the firm has receivedinformation, the firm will not necessarily disclose the informationimmediately. We show that bad news about the economy can trigger theimmediate release of information by firms. Conversely, good news aboutthe economy can slow the release of information by firms. As a result,the release of negative information tends to be clustered. Surprisingly,this result holds only when firms can preempt the arrival of externalinformation by disclosing their own information first. These resultshave implications for conditional variance and skewness of stock andmarket returns.

Does Hedging Affect Commodity Prices? The Role of Producer Default Risk

Fri, 06 Feb 2009 18:19:30 GMT

Title: Does Hedging Affect Commodity Prices? The Role of Producer Default Risk

Acharya, Viral; Lochstoer, Lars; Ramadorai, Tarun

Abstract: Do hedging and speculative activity in commodity futures affect spotprices? Yes, when commodity producers have hedging needs. We build amodel in which producers are risk-averse to future cash flow variabilityand hedge using futures contracts. Increases in speculative demand forfutures reduces the cost of hedging, allowing producers to hedge moreand hold larger inventories. This pushes spot prices higher. Reductionsin speculative demand for futures have the opposite effects. The dataprovide support for the hedging channel we identify - oil and gasproducers - hedging demands (proxied by their default risk), forecastspot prices, futures prices and producers' inventories.

Is CEO Pay Really Inefficient? A Survey of New Optimal Contracting Theories

Fri, 06 Feb 2009 16:46:27 GMT

Title: Is CEO Pay Really Inefficient? A Survey of New Optimal Contracting Theories

Gabaix, Xavier; Edmans, Alex

Abstract: Bebchuk and Fried (2004) argue that executive compensation is set byCEOs themselves rather than boards on behalf of shareholders, since manyfeatures of observed pay packages may appear inconsistent with standardoptimal contracting theories. However, it may be that simple models donot capture several complexities of real-life settings. This articlesurveys recent theories that extend traditional frameworks toincorporate these dimensions, and show that the above features can befully consistent with efficiency. For example, optimal contractingtheories can explain the recent rapid increase in pay, the low level ofincentives and their negative scaling with firm size, pay-for-luck, thewidespread use of options (as opposed to stock), severance pay and debtcompensation, and the insensitivity of incentives to risk.

Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns

Fri, 06 Feb 2009 16:00:24 GMT

Title: Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns

Whitelaw, Robert; Bali, Turan; Cakici, Nusret

Abstract: Motivated by existing evidence of a preference among investors forassets with lottery-like payoffs and that many investors are poorlydiversified, we investigate the significance of extreme positive returnsin the cross-sectional pricing of stocks. Portfolio-level analyses andfirm-level cross-sectional regressions indicate a negative andsignificant relation between the maximum daily return over the past onemonth(MAX) and expected stock returns. Average raw and risk-adjustedreturn differences between stocks in the lowest and highest MAX decilesexceed 1% per month. These results are robust to controls for size,book-to-market, momentum, short-term reversals, liquidity, and skewness.Of particular interest, including MAX generally subsumes or reverses thepuzzling negative relation between returns and idiosyncratic volatilityrecently documented in Ang et al. (2006, 2008).

Competition and the Structure of Vertical Relationships in Capital Markets

Fri, 06 Feb 2009 15:53:28 GMT

Title: Competition and the Structure of Vertical Relationships in Capital Markets

Ljungqvist, Alexander; Asker, John

Abstract: We document that firms appear disinclined to share underwriters withother firms in the same industry. We show that this disinclination isevident only when firms engage in product-market competition. This leadsus to suggest that concerns about information leakage may motivate thepatterns we see in the data. We discuss how these effects help usunderstand how the investment banking industry is structured, how bankscompete, and how prices are set. At each step we exploit sources ofexogenous variation that correspond to specific margins on which theeffects of interest directly influence incentives and choices.

Informational Hold-up and Performance Persistence in Venture Capital

Fri, 06 Feb 2009 15:50:35 GMT

Title: Informational Hold-up and Performance Persistence in Venture Capital

Ljungqvist, Alexander; Hochberg, Yael; Vissing-Jorgensen, Annette

Abstract: We propose and test a theory of learning and informational hold-up inthe venture capital market. The model predicts that higher returns onthe current fund increase the probability that a VC will raise afollow-on fund, the size of the follow-on fund, and the performance feeinvestors are charged in the follow-on fund. If learning is asymmetric,such that incumbent investors learn more about fund manager skill thanpotential new investors, the model also predicts persistence in returns,poor performance among first-time funds, persistence in investors fromfund to fund, and over-subscription in follow-on funds raised bysuccessful fund managers. Our empirical evidence is consistent withthese predictions. The model provides a unified framework forunderstanding a series of empirical facts about the venture capital industry.

Testing Asymmetric-Information Asset Pricing Models

Fri, 06 Feb 2009 15:45:41 GMT

Title: Testing Asymmetric-Information Asset Pricing Models

Ljungqvist, Alexander; Kelly, Bryan

Abstract: We test models of asset pricing under asymmetric information usingplausibly exogenous variation in the supply of information caused by theclosure or restructuring of brokerage firms’ research operations.Consistent with predictions derived from a Grossman and Stiglitz-typemodel, share prices and uninformed investors’ demands fall asinformation asymmetry increases. Cross-sectional tests support thecomparative statics. Prices and uninformed demand experience largerdeclines, the more investors are uninformed, the larger and morevariable is turnover, the more uncertain is the asset’s payoff,and the noisier is the better-informed investors’ signal. We showthat prices fall because expected returns become more sensitive to aliquidity-risk factor.

Risk Premia in International Equity Markets Revisited

Fri, 06 Feb 2009 15:34:19 GMT

Title: Risk Premia in International Equity Markets Revisited

Brown, Stephen; Hiraki, Takato; Arakawa, Kiyoshi; Ohno, Saburo

Abstract: Recent evidence suggests that global equity markets are becoming morerisky. We find that much of the apparent increase in internationalvariance and covariance of returns can be attributed to systematicvariations in global risk premia correlated across markets, rather thanto any fundamental change in the risk attributes of these markets. Thisresult has interest both for practitioners and for those interested inmodeling global asset prices.

Tractability and Detail-Neutrality in Incentive Contracting

Tue, 03 Feb 2009 18:04:40 GMT

Title: Tractability and Detail-Neutrality in Incentive Contracting

Gabaix, Xavier; Edmans, Alex

Abstract: This paper identifies a broad class of situations in which the contractis both attainable in closed form and "detail-neutral". Thecontract's functional form is independent of the noise distribution andreservation utility; moreover, when the cost of effort is pecuniary, thecontract is linear in output regardless of the agent's utility function.Our contract holds in both continuous time and a discrete-time, multi-period setting where action follows noise in each period. The tractablecontracts of Holmstrom and Milgrom (1987) can thus be achieved insettings that do not require exponential utility, Gaussian noise orcontinuous time. Our results also suggest that incentive schemes neednot depend on complex details of the particular setting, a number ofwhich (e.g. agent's risk aversion) are difficult for the principal toobserve. The proof techniques use the notion of relative dispersion andsubdifferentials to avoid relying on the first-order approach, and maybe of methodological interest.

Using Samples of Unequal Length in Generalized Method of Moments Estimation

Mon, 02 Feb 2009 16:22:13 GMT

Title: Using Samples of Unequal Length in Generalized Method of Moments Estimation

Lynch, Anthony; Wachter, Jessica

Abstract: Many applications in financial economics use data series with differentstarting or ending dates. This paper describes estimation methods, basedon the generalized method of moments (GMM), which make use of allavailable data for each moment condition. We introduce twoasymptotically equivalent estimators that are consistent, asymptoticallynormal, and more efficient asymptotically than standard GMM. We applythese methods to estimating predictive regressions in international dataand show that the use of the full sample affects point estimates andstandard errors for both assets with data available for the full periodand assets with data available for a subset of the period. Monte Carloexperiments demonstrate that reductions hold for small-sample standarderrors as well as asymptotic ones. These methods are extended to moregeneral patterns of missing data, and are shown to be more efficientthan estimators that ignore intervals of the data, and thus moreefficient than standard GMM.

Corporate Governance, Product Market Competition, and Equity Prices

Mon, 02 Feb 2009 16:20:50 GMT

Title: Corporate Governance, Product Market Competition, and Equity Prices

Giroud, Xavier; Mueller, Holger

Abstract: This paper examines the hypothesis that firms in competitive industriesshould benefit relatively less from good governance, while firms innon-competitive industries–where lack of competitive pressurefails to enforce discipline on managers–should benefit relativelymore. Whether we look at the effects of governance on long-horizon stockreturns, firm value, or operating performance, we consistently find thesame pattern: The effect is monotonic in the degree of competition, itis small and insignificant in competitive industries, and it is largeand significant in non-competitive industries. By implication, theeffect of governance (in non-competitive industries) reported in thispaper is stronger than what has been previously reported in Gompers,Ishii, and Metrick (2003, “GIM”) and subsequent work, whodocument the average effect across all industries. For instance,GIM’s hedge portfolio–provided it only includes firms innon-competitive industries–earns a monthly alpha of 1.47%, whichis twice as large as the alpha reported in GIM. The alpha remains largeand significant even if the sample period is extended until 2006. Wealso revisit the argument that investors in the 1990s anticipated theeffect of governance, implying that the alpha earned by GIM’shedge portfolio is likely due to an omitted risk factor. We find thatwhile investors were indeed not surprised on average, theyunderestimated the effect of governance in non-competitive industries,the very industries in which governance has a significant effect in thefirst place.

Competition and Bias

Mon, 02 Feb 2009 16:19:36 GMT

Title: Competition and Bias

Kacperczyk, Marcin; Hong, Harrison

Abstract: We attempt to measure the effect of competition on bias in the contextof analyst earnings forecasts, which are known to be excessivelyoptimistic due to conflicts of interest. Our instrument for competitionis mergers of brokerage houses, which result in the firing of analystsbecause of redundancy (e.g., one of the two oil analysts is let go) andother reasons such as culture clash. We use this decrease in analystcoverage for stocks covered by both merging houses before the merger(the treatment sample) to measure the causal effect of competition onbias. We find the treatment sample simultaneously experiences a decreasein analyst coverage and an increase in optimism bias the year after themerger relative to a control group of stocks, consistent withcompetition reducing bias. The implied economic effect from our naturalexperiment is significantly larger than estimates from OLS regressionsthat do not correct for the endogeneity of coverage. And this effect ismuch more significant for stocks with little initial analyst coverage or competition.

Is a Higher Calling Enough? Incentive Compensation in the Church

Mon, 02 Feb 2009 16:18:17 GMT

Title: Is a Higher Calling Enough? Incentive Compensation in the Church

Yermack, David

Abstract: We study the compensation and productivity of more than 2,000 Methodistministers in a 43-year panel data set. The church appears to usepay-for-performance incentives for its clergy, as their compensationfollows a sharing rule by which pastors receive approximately 3 percentof the incremental revenue from membership increases. The elasticitybetween ministers’ pay and parish size is similar to the firm sizeelasticity of compensation for public company CEOs. Among a range ofpossible performance measures, those with the greatest informativenessabout pastoral effort are linked most closely to compensation.

Deductio ad absurdum: CEOs donating their own stock to their own family foundations

Mon, 02 Feb 2009 16:14:39 GMT

Title: Deductio ad absurdum: CEOs donating their own stock to their own family foundations

Yermack, David

Abstract: I study large charitable stock gifts by Chairmen and CEOs of publiccompanies. These gifts, which are not subject to insider trading law,often occur just before sharp declines in their companies’ shareprices. This timing is more pronounced when executives donate their ownshares to their own family foundations. Evidence related to reportingdelays and seasonal patterns suggests that some CEOs backdate stockgifts to increase personal income tax benefits. CEOs’ familyfoundations hold donated stock for long periods rather thandiversifying, permitting CEOs to continue voting the shares.

Price Dispersion in OTC Markets: A New Measure of Liquidity

Mon, 02 Feb 2009 16:13:05 GMT

Title: Price Dispersion in OTC Markets: A New Measure of Liquidity

Subrahmanyam, Marti; Nashikkar, Amrut; Jankowitsch, Rainer

Abstract: In this paper, we model price dispersion effects in over-the-counter(OTC) markets to show that, in the presence of inventory risk fordealers and search costs for investors, traded prices may deviate fromthe expected market valuation of an asset. We interpret this deviationas a liquidity effect and develop a new liquidity measure quantifyingthe price dispersion in the context of the US corporate bond market.This market offers a unique opportunity to study liquidity effectssince, from October 2004 onwards, all OTC transactions in this markethave to be reported to a common database known as the Trade Reportingand Compliance Engine (TRACE). Furthermore, market-wide average pricequotes are available from Markit Group Limited, a financial informationprovider. Thus, it is possible, for the first time, to directly observedeviations between transaction prices and the expected market valuationof securities. We quantify and analyze our new liquidity measure forthis market and find significant price dispersion effects that cannot besimply captured by bid-ask spreads. We show that our new measure isindeed related to liquidity by regressing it on commonly-used liquidityproxies and find a strong relation between our proposed liquiditymeasure and bond characteristics, as well as trading activity variables.Furthermore, we evaluate the reliability of end-of-day marks thattraders use to value their positions. Our evidence suggests that theprice deviations from expected market valuations are significantlylarger and more volatile than previously assumed. Overall, the resultspresented here improve our understanding of the drivers of liquidity andare important for many applications in OTC markets, in general.

The structure and formation of business groups: Evidence from Korean Chaebols

Mon, 02 Feb 2009 16:11:21 GMT

Title: The structure and formation of business groups: Evidence from Korean Chaebols

Subrahmanyam, Marti; Almeida, Heitor; Wolfenzon, Daniel; Park, Sang Yong

Abstract: In this paper we study the determinants of business groups’ownership structure using a unique dataset of Korean chaebols, and a setof new metrics of group ownership structure. We find that chaebols growvertically (that is, pyramidally) as the family uses well-establishedgroup firms (“central firms”) to set up and acquire firmsthat have low profitability and high capital requirements. Chaebols growhorizontally (that is, using direct family ownership) when the familyacquires firms that are highly profitable and require less capital. Wealso provide direct evidence that the low profitability of firms ownedthrough pyramids is partly due to a selection effect: the profitabilityof new group firms in the year before they are added to the grouppredicts whether they are added to pyramids or controlled directly bythe family. The relationships between pyramids, profitability, andcapital intensity that we uncover do not appear to be due to theseparation between ownership and control induced by pyramids. Finally,we find that the selection of low-profitability firms into pyramidscauses the group’s central firms to trade at a discount relativeto other public group firms. Taken together, these results suggest thatcontrolling families optimally design the ownership structure of thegroup in a manner that is consistent with theory.

Limited arbitrage and liquidity in the market for credit risk

Mon, 02 Feb 2009 16:09:18 GMT

Title: Limited arbitrage and liquidity in the market for credit risk

Subrahmanyam, Marti; Nashikkar, Amrut; Mahanti, Sriketan

Abstract: Recent research has shown that default risk accounts for only a part ofthe total yield spread on risky corporate bonds relative to theirrisk-less benchmarks. One candidate for the unexplained portion of thespread is a premium for liquidity. We investigate this possibility byrelating the liquidity of corporate bonds to the basis between thecredit default swap (CDS) price of the issuer and the parequivalentcorporate bond yield spread. The liquidity of a bond is measured using arecently developed measure called latent liquidity, which is defined asthe weighted average turnover of funds holding the bond, where theweights are their fractional holdings of the bond. We find that bondswith higher latent liquidity are more expensive relative to their CDScontracts, after controlling for other realized measures of liquidity.However highly illiquid bonds with high default risk are also expensive,consistent with limits to arbitrage between CDS and bond markets, due tothe higher costs of “shorting” illiquid bonds. Additionally,we document the positive effects of liquidity in the CDS market on theCDS-bond basis. We also find that several firm-level variables relatedto credit risk affect the basis, indicating that the CDS price does notfully capture the credit risk of the bond.

Group Affiliation and the Performance of Initial Public Offerings in the Indian Stock Market

Mon, 02 Feb 2009 16:07:42 GMT

Title: Group Affiliation and the Performance of Initial Public Offerings in theIndian Stock Market

Subrahmanyam, Marti; Marisetty, Vijaya

Abstract: We document the effects of group affiliation on the initial performanceof 2,713 Initial Public Offerings (IPOs) in India under three regulatoryregimes during the period 1990-2004. We distinguish between twocompeting hypotheses regarding group affiliation: the“certification” and the “tunneling” hypotheses.We lend support to the latter by showing that the underpricing ofbusiness group companies is higher than that of stand-alone companies.Furthermore, we find that the long run performance of IPOs, in general,is negative. We also find that Indian investors over-react to IPOs andtheir over-reaction (proxied by the oversubscription rate) explains theextent of underpricing.

Fitting vast dimensional time-varying covariance models

Mon, 02 Feb 2009 16:06:03 GMT

Title: Fitting vast dimensional time-varying covariance models

Engle, Robert; Shephard, Neil; Sheppard, Kevin

Abstract: Building models for high dimensional portfolios is important in riskmanagement and asset allocation. Here we propose a novel and fast way ofestimating models of time-varying covariances that overcome anundiagnosed incidental parameter problem which has troubled existingmethods when applied to hundreds or even thousands of assets. Indeed wecan handle the case where the cross-sectional dimension is larger thanthe time series one. The theory of this new strategy is developed insome detail, allowing formal hypothesis testing to be carried out onthese models. Simulations are used to explore the performance of thisinference strategy while empirical examples are reported which show thestrength of this method. The out of sample hedging performance ofvarious models estimated using this method are compared.

Financial Globalization and the Transmission of Credit Supply Shocks: Evidence from an Emerging Market

Mon, 02 Feb 2009 16:03:51 GMT

Title: Financial Globalization and the Transmission of Credit Supply Shocks:Evidence from an Emerging Market

Schnabl, Philipp

Abstract: This paper analyzes whether equity holdings of international lendersaffect the transmission of credit supply shocks from developed countriesto emerging markets. I exploit the 1998 Russian debt default as anexogenous credit supply shock to international lenders and trace out theimpact on bank lending in Peru. I find that after the shockinternational lenders with equity holdings in Peruvian banks increasedfinancing to banks in Peru, while international lenders without equityholdings reduced financing to banks in Peru. This effect could be driveneither by differential credit supply from international lenders or byheterogeneity in credit demand across banks. I control for credit demandby examining firms that have loans from both banks with internationalequity holders and banks without international equity holders and findevidence for the credit supply explanation. The change in credit supplyhas real effects: I find a lower bankruptcy rate among firms borrowingfrom banks with international equity holders than among firms borrowingfrom banks without international equity holders. These results suggestthat equity holdings of international lenders mitigate the transmissionof credit supply shocks to emerging markets.

Predictability and ‘Good Deals’ in Currency Markets

Mon, 02 Feb 2009 16:01:28 GMT

Title: Predictability and ‘Good Deals’ in Currency Markets

Levich, Richard; Poti, Valerio

Abstract: This paper studies predictability of currency returns over the period1971-2006. To assess the economic significance of predictability, weconstruct an upper bound on the explanatory power of predictiveregressions. The upper bound is motivated by “no good-deal”restrictions that rule out unduly attractive investment opportunities.We find evidence that predictability often exceeds this bound.Excess-predictability is highest in the 1970s and tends to decrease overtime, but it is still present in the final part of the sample period.Moreover, periods of high and low predictability tend to alternate.These stylized facts pose a serious challenge to Fama’s (1970)Efficient Market Hypothesis but are consistent with Lo’s (2004)Adaptive Market Hypothesis, coupled with slow convergence towardsefficient markets. Strategies that attempt to exploitexcess-predictability are very sensitive to transaction costs but thosethat exploit monthly predictability remain attractive even afterrealistic levels of transaction costs are taken into account and are notspanned either by the Fama and French (1993) equity-based factors or bythe AFX Currency Management Index.

Corporate Governance Objectives of Labor Union Shareholders: Evidence from Proxy Voting

Mon, 02 Feb 2009 16:00:03 GMT

Title: Corporate Governance Objectives of Labor Union Shareholders: Evidencefrom Proxy Voting

Agrawal, Ashwini

Abstract: Labor union shareholders have become increasingly vocal in matters ofcorporate governance, however, their motives have been subject to muchdebate in the academic literature and business press. I examine theproxy votes of AFL-CIO pension funds in director elections of 504companies from 2003 to 2006. Using the 2005 AFL-CIO breakup as a sourceof exogenous variation in the union affiliations of workers acrossfirms, I find that AFL-CIO affiliated shareholders are significantlymore supportive of director nominees once the AFL-CIO no longerrepresents workers or represents significantly fewer workers at a givenfirm. Other institutional investors do not exhibit the same changes invoting behavior. This difference suggests that labor relations affectthe voting patterns of some union shareholders. I also find that AFL-CIOfunds are more likely to vote against directors of firms in which thereis greater frequency of plant-level conflict between labor unions andmanagement during collective bargaining and union member recruiting. Thesensitivity of director votes to union conflict, however, decreases atfirms in which the AFL-CIO no longer represents workers or representssignificantly fewer workers. The evidence suggests that AFL-CIOaffiliated shareholders vote against directors partly to support unionworker interests rather than increase shareholder value alone.

Trades of the Living Dead: Style Differences, Style Persistence and Performance of Currency Fund Managers

Mon, 02 Feb 2009 15:58:24 GMT

Title: Trades of the Living Dead: Style Differences, Style Persistence andPerformance of Currency Fund Managers

Levich, Richard; Pojarliev, Momtchil

Abstract: We make use of a new database on daily currency fund manager returnsover a three-year period, 2005-08. This higher frequency data allows usto estimate both alpha measures of performance and beta style factors ona yearly basis, which in turn allows us to test for persistence. We findno evidence to support alpha persistence; a manager’s alpha in oneyear is not significantly related to his alpha in the prior year. On theother hand, there is substantial evidence for style persistence; fundsthat rely on carry, trend or value trading or with a long/short biastoward currency volatility are likely to maintain that style in thefollowing year. In addition, we are able to examine the performance ofmanagers that survive through the entire sample period, versus thosethat drop out. We find significant differences in both the investmentstyles of living versus deceased funds, as well as their realized alphaperformance measures. We conjecture that both style differences andineffective market timing, rather than market conditions, have impactedperformance outcomes and induced some managers to close their funds.

Estimating the Implied Risk Neutral Density

Mon, 02 Feb 2009 15:54:03 GMT

Title: Estimating the Implied Risk Neutral Density

Figlewski, Stephen

Abstract: The market's risk neutral probability distribution for the value of anasset on a future date can be extracted from the prices of a set ofoptions that mature on that date, but two key technical problems arise.In order to obtain a full well-behaved density, the option market pricesmust be smoothed and interpolated, and some way must be found tocomplete the tails beyond the range spanned by the available options.This paper develops an approach that solves both problems, with acombination of smoothing techniques from the literature modified to takeaccount of the market's bid-ask spread, and a new method of completingthe density with tails drawn from a Generalized Extreme Valuedistribution. We extract twelve years of daily risk neutral densitiesfrom S&P 500 index options and find that they are quite differentfrom the lognormal densities assumed in the Black-Scholes framework, andthat their shapes change in a regular way as the underlying index moves.Our approach is quite general and has the potential to reveal valuableinsights about how information and risk preferences are incorporatedinto prices in many financial markets.

Estimating Operational Risk for Hedge Funds: The ω-Score

Sat, 29 Dec 2007 22:58:59 GMT

Title: Estimating Operational Risk for Hedge Funds: The ω-Score

Brown, Stephen; Goetzmann, William; Liang, Bing

Abstract: Using a complete set of the SEC filing information on hedge funds (FormADV) and the TASS data, we develop a quantitative model called theω-Score to measure hedge fund operational risk. The ω-Scoreis related to conflict of interest issues, concentrated ownership, andreduced leverage in the ADV data. With a statistical methodology, wefurther relate the ω-Score to readily available information suchas fund performance, volatility, size, age, and fee structures. Finally,we demonstrate that this risk score can be used to effectively predictfund failures in the future.

Estimation of Employee Stock Option Exercise Rates

Wed, 28 Jan 2009 19:40:33 GMT

Title: Estimation of Employee Stock Option Exercise Rates

Carpenter, Jennifer; Stanton, Richard; Wallace, Nancy

Abstract: This paper is the first to perform a comprehensive estimation ofemployee stock option exercise behavior and option cost to firms. Wedevelop a GMM-based methodology, robust to heteroskedasticity andcorrelation across exercises, for estimating the rate of voluntaryoption exercise as a function of the stock price path and of variousfirm and option holder characteristics. We use it to estimate anexercise function from a sample of 870,624 employee-option grants at 47publicly-traded firms between 1980-2005, finding that volatility has acounterintuitive effect, and that men exercise faster than women. Wealso estimate the rate of employment termination, which determinesforfeitures, cancellations, and forced exercises. We use the estimatedexercise and termination functions in a simulation based valuation modelto analyze the effect of different firm and option holdercharacteristics on option value, and show that the true value of theseoptions can differ substantially from values calculated using the usualFASB approximation.

Do Markets React to Bank Examination Ratings? Evidence of Indirect Disclosure of Management Quality Through BHCs' Applications to Convert to FHCs

Thu, 28 Sep 2000 22:58:59 GMT

Title: Do Markets React to Bank Examination Ratings? Evidence of IndirectDisclosure of Management Quality Through BHCs' Applications to Convertto FHCs

Allen, Linda; Jagtiani, Julapa; Moser, James

Abstract: Certain nonrecurring circumstances associated with the passage of theFinancial Services Modernization Act of 1999 have created a uniqueopportunity for the market to obtain bank examination ratings ofmanagement quality. We utilize this natural experiment in order todetermine how the market views this heretofore private information. Wefind that the stock market utilizes bank examination ratings in order toreveal regulatory intent, rather than simply as information aboutmanagement quality. Revelation of unsatisfactory M ratings (denoted“bad news”) causes BHC stock returns and market risk betasto increase, whereas revelation of acceptable M ratings (“goodnews”) causes BHC stock returns and market risk betas to decrease.The market thrives on “bad news” because unsatisfactory Mratings indicate that regulatory intervention is likely to occur,possibly benefiting both shareholders and creditors. On the other hand,revelation of acceptable M ratings (“good news”) indicatesthat bank regulators are unprepared to intervene in the near future.Moreover, we find lower bond spreads for a subsample of FHCs withsatisfactory M ratings revealed upon conversion.

Optimal Mortgage Design

Sun, 19 Nov 2006 22:58:59 GMT

Title: Optimal Mortgage Design

Piskorski, Tomasz; Tchistyi, Alexei

Abstract: This paper studies optimal mortgage design. A borrower (a household)with limited liability needs financial support from a lender (a bigfinancial institution) to purchase a home. We characterize the optimalallocation in a continuous time setting in which (i) the borrower sincome is volatile and its realization is unobservable to the lender,(ii) the lender has a right to costly foreclose the loan and seize thehouse, (iii) the borrower s intertemporal consumption preferences arerepresented by a constant discount factor, (iv) the lender discountscash ows using a stochastic discount factor that depends on the marketinterest rate. We show that the optimal allocation can be implementedusing either a combination of an interest only mortgage with a homeequity line of credit or an option adjustable rate mortgage. Under theoptimal contracts, mortgage payments and default rates are higher whenthe market interest rate is high. However, borrowers benefit from lowmortgage payments and low default rates when the market interest rate islow. Thus, our analysis provides theoretical evidence that thesealternative mortgages, which have recently generated great controversy,can benefit both lenders and borrowers.

Do Financial Conglomerates Create or Destroy Economic Value?

Sun, 02 Dec 2007 22:58:59 GMT

Title: Do Financial Conglomerates Create or Destroy Economic Value?

Schmid, Markus M.; Walter, Ingo

Abstract: This paper investigates whether functional diversification isvalue-enhancing or value-destroying in the financial services sector,broadly defined. Based on a U.S. dataset comprising approximately 4,060observations covering the period 1985-2004, we report a substantial andpersistent conglomerate discount among financial intermediaries. Thestudy differs materially from earlier work on scope dimensions offinancial institution structures. Our results suggest that it isdiversification that causes the discount, and not that troubled firmsdiversify into other more promising areas. In addition, the discountapplies to all financial services industries with the exception ofinvestment banking and is stable over different combinations offinancial activ-ity-areas with the exception of commercial banking unitscombined with insurance companies and/or investment banking activities.Finally, our results reveal that geographic diversification per se isnot associated with a significant discount. Although geographicdiversity is value de-stroying in all financial services activity-areaswhen there are more geographic segments and the activities aredistributed relatively evenly over these segments.

Can Microfinance Reduce Portfolio Volatility?

Sun, 17 Feb 2008 22:58:59 GMT

Title: Can Microfinance Reduce Portfolio Volatility?

Kraussa, Nicolas; Walter, Ingo

Abstract: Microfinance is arguably one of the most effective techniques forpoverty alleviation in developing countries. Although traditionallysupported by nongovernmental organizations and socially-orientedinvestors, microfinance institutions (MFIs) have increasinglydemonstrated their value on a stand-alone basis, typically exhibitinglow default rates combined with attractive returns and growth,encouraging greater commercial involvement. This paper addresses arelated issue whether microfinance shows low correlation withinternational and domestic market performance measures. If so, it couldform the empirical basis for MFI access to capital markets andperformance-driven investors in their search for efficient portfolios.Our empirical tests do not show any exposure of microfinanceinstitutions to global capital markets, but significant exposureregarding domestic GDP, suggesting that microfinance investments mayhave useful portfolio diversification value for international investors,not for domestic investors lacking significant country riskdiversification options.

Investigating ICAPM with Dynamic Conditional Correlations

Sun, 29 Oct 2006 22:58:59 GMT

Title: Investigating ICAPM with Dynamic Conditional Correlations

Bali, Turan G.; Engle, Robert F.

Abstract: This paper examines the intertemporal relation between expected returnand risk for 30 stocks in the Dow Jones Industrial Average. Themean-reverting dynamic conditional correlation model of Engle (2002) isused to estimate a stock’s conditional covariance with the marketand test whether the conditional covariance predicts time-variation inthe stock’s expected return. The risk-aversion coefficient,restricted to be the same across stocks in panel regression, isestimated to be between two and four and highly significant. This resultis robust across different market portfolios, different sample periods,alternative specifications of the conditional mean and covarianceprocesses, and including a wide variety of state variables that proxyfor the intertemporal hedging demand component of the ICAPM. Riskpremium induced by the conditional covariation of individual stocks withthe market portfolio remains economically and statistically significantafter controlling for risk premiums induced by conditional covariationwith macroeconomic variables (federal funds rate, default spread, andterm spread), financial factors (size, book-to-market, and momentum),and volatility measures (implied, GARCH, and range volatility).

Negative Hedging: Performance Sensitive Debt and CEOs’ Equity Incentives

Fri, 07 Dec 2007 22:58:59 GMT

Title: Negative Hedging: Performance Sensitive Debt and CEOs’ Equity Incentives

Tchistyi, Alexei; Yermack, David; Yun, Hayong

Abstract: We examine the relation between CEOs’ equity incentives and theiruse of performance-sensitive debt contracts. These contracts requirehigher or lower interest payments when the borrower's performancedeteriorates or improves, thereby increasing expected costs of financialdistress while also making a firm riskier to the benefit of optionholders. We find that managers whose compensation is more sensitive tostock price volatility choose steeper and more convex performancepricing schedules, while those with high delta incentives chooseflatter, less convex pricing schedules. Performance pricing contractstherefore seem to provide a channel for managers to increasefirms’ financial risk to gain private benefits.

Where are the shareholders’ mansions? CEOs’ home purchases, stock sales, and subsequent company performance

Tue, 16 Oct 2007 22:58:59 GMT

Title: Where are the shareholders’ mansions? CEOs’ home purchases,stock sales, and subsequent company performance

Liu, Crocker; Yermack, David

Abstract: We study real estate purchases by major company CEOs, compiling adatabase of the principal residences of nearly every top executive inthe Standard & Poor’s 500 index. When a CEO buys real estate,future company performance is inversely related to the CEO’sliquidation of company shares and options for financing the transaction.We also find that, regardless of the source of finance, future companyperformance deteriorates when CEOs acquire extremely large or costlymansions and estates. We therefore interpret large home acquisitions assignals of CEO entrenchment. Our research also provides useful insightsfor calibrating utility based models of executive compensation and forunderstanding patterns of Veblenian conspicuous consumption.

Risk Premia in International Equity Markets Revisited

Tue, 13 Feb 2007 22:58:59 GMT

Title: Risk Premia in International Equity Markets Revisited

Brown, Stephen J.; Hiraki, Takato; Arakawa, Kiyoshi; Ohno, Saburo

Abstract: Recent evidence suggests that global equity markets are becoming morerisky. We find that much of the apparent increase in internationalvariance and covariance of returns can be attributed to systematicvariations in global risk premia correlated across markets, rather thanto any fundamental change in the risk attributes of these markets. Thisresult has interest both for practitioners and for those interested inmodeling global asset prices.

HEDGE FUND DUE DILIGENCE: A SOURCE OF ALPHA IN A HEDGE FUND PORTFOLIO STRATEGY

Sun, 20 Jan 2008 22:58:59 GMT

Title: HEDGE FUND DUE DILIGENCE: A SOURCE OF ALPHA IN A HEDGE FUND PORTFOLIO STRATEGY

Brown, Stephen J.; Fraser, Thomas L.; Liang, Bing

Abstract: Due diligence is an important source of alpha in a well designed hedgefund portfolio strategy. It is generally understood that the highreturns possible in investing in hedge funds are somewhat offset by therelative lack of transparency on operational issues. The performance ofa diversified hedge fund portfolio can be enhanced by excluding thosefunds likely to do poorly – or fail – due to operationalrisk concerns. However, effective due diligence is an expensive concern.This implies that there is a strong competitive advantage to those fundsof funds sufficiently large to absorb this fixed and necessary cost. Theconsequent economies of scale that we document in funds of funds arequite substantial and support the proposition that due diligence is asource of alpha in hedge fund investment.

Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration

Sun, 29 Oct 2006 22:58:59 GMT

Title: Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration

Brown, Stephen; Goetzmann, William; Liang, Bing; Schwarz, Christopher

Abstract: Mandatory disclosure is a regulatory tool intended to allow marketparticipants to assess operational risk. We examine the value ofdisclosure through the controversial SEC requirement, since overturned,which required major hedge funds to register as investment advisors andfile Form ADV disclosures. Leverage and ownership structures suggestthat lenders and equity investors were already aware of operationalrisk. However, operational risk does not mediate flow-performancerelationships. Investors either lack this information or regard it asimmaterial. These findings suggest that regulators should account forthe endogenous production of information and the marginal benefit ofdisclosure to different investment clienteles.

Competition and the Structure of Vertical Relationships in Capital Markets

Mon, 31 Mar 2008 22:58:59 GMT

Title: Competition and the Structure of Vertical Relationships in Capital Markets

Asker, John; Ljungqvist, Alexander

Abstract: We document that firms appear disinclined to share underwriters withother firms in the same industry. We show that this disinclination isevident only when firms engage in product-market competition. This leadsus to suggest that concerns about information leakage may motivate thepatterns we see in the data. We discuss how these effects help usunderstand how the investment banking industry is structured, how bankscompete, and how prices are set. At each step we exploit sources ofexogenous variation that correspond to specific margins on which theeffects of interest directly influence incentives and choices.

Scaling the Hierarchy: How and Why Investment Banks Compete for Syndicate Co-Management Appointments

Mon, 09 Apr 2007 22:58:59 GMT

Title: Scaling the Hierarchy: How and Why Investment Banks Compete forSyndicate Co-Management Appointments

Ljungqvist, Alexander; Marston, Felicia; Wilhelm Jr., William J.

Abstract: We investigate why banks pressured research analysts to provideaggressive assessments of issuing firms during the 1990s. Thiscompetitive strategy did little to directly increase a bank’schances of winning lead-management mandates and ultimately led toregulatory penalties and costly structural reform. We show thataggressively optimistic research and even the mere provision of researchcoverage for the issuer (regardless of its direction) attractco-management appointments. Co-management appointments are valuablebecause they help banks establish relationships with issuers. Theserelationships, in turn, substantially increase their chances of winningmore lucrative lead-management mandates in the future. This is true evenin the presence of historically exclusive banking relationships. Ifrecent regulatory reforms compromise this entry mechanism, they may havethe unintended consequence of diminishing competition among securities underwriters.

Networking as a Barrier to Entry and the Competitive Supply of Venture Capital

Sat, 05 May 2007 22:58:59 GMT

Title: Networking as a Barrier to Entry and the Competitive Supply of Venture Capital

Hochberg, Yael; Ljungqvist, Alexander; Lu, Yang

Abstract: We examine whether networks among incumbent venture capital firms helprestrict entry into local VC markets in the U.S., thus improvingVCs’ bargaining power over entrepreneurs. We show that VC marketswith more extensive networking among the incumbent players experienceless entry. The effect is sizeable economically and appears robust toplausible endogeneity concerns. Entry is accommodated if the entrant hasestablished relationships with a target-market incumbent in its own homemarket. In turn, incumbents react strategically to an increased threatof entry, in the sense that they freeze out any incumbent that builds arelationship with a potential entrant. Finally, companies seekingventure capital raise money on worse terms in more densely networkedmarkets while increased entry is associated with higher valuations.

Innovation in International Law and Global Finance: Estimating the Financial Impact of the Cape Town Convention

Sat, 29 Oct 2005 22:58:59 GMT

Title: Innovation in International Law and Global Finance: Estimating theFinancial Impact of the Cape Town Convention

Saunders, Anthony; Srinivasan, Anand; Walter, Ingo

Abstract: This paper examines the financial impact of a transfer of legalsovereignty covering the rights to collateral to an international regimein the case of the Cape Town Convention and Protocol coveringinternational mobile assets, specifically commercial aircraft andrelated equipment, which came into force in 2004. We estimate the impacton financing costs facing airlines based in signatory countries in termsof access to financial markets and interest differentials, debt ratingmigration and stock prices using rating-sensitivity analysis, OLSregressions and event studies. We find that the present value of theresulting financing cost reductions are very significant and are biasedin favor of developing countries, the sources of much of the growth indemand for commercial aircraft going forward. The results suggest thepower of changes in the legal framework of financial markets toinfluence the costs and pricing of global financial flows.

The Asset Management Industry in Asia: Dynamics of Growth, Structure and Performance

Sat, 29 Oct 2005 22:58:59 GMT

Title: The Asset Management Industry in Asia: Dynamics of Growth, Structure and Performance

Walter, Ingo; Sisli, Elif

Abstract: We examine the industrial organization and institutional development ofthe asset management industry in Asian developing economies –specifically in China, Indonesia, Korea, Malaysia, Singapore,Philippines and Thailand. We focus on the size and growth of thebuy-side of the respective financial markets, asset allocation, theregulatory environment, and the state of internationalization of thefund management industry in its key components – mutual funds,pension funds and asset management for high net worth individuals. Welink these the evolution of professional asset management in theseenvironments to the development of the respective capital markets and tothe evolution of corporate governance. We find that the fund managementindustry occupies a very small niche in domestic financial systems thatare dominated by banks. At the same time, we find that its growth hasbeen very rapid in the early 2000s and we suggest that this is likely topersist as the demand for professional management of financial wealth inthe region develops and as the pension fund sectors of the respectiveeconomies are liberalized to allow larger portions of assets to beinvested in collective investment schemes.

Do Financial Conglomerates Create or Destroy Economic Value?

Sun, 02 Dec 2007 22:58:59 GMT

Can Microfinance Reduce Portfolio Volatility?

Sun, 17 Feb 2008 22:58:59 GMT

Title: Can Microfinance Reduce Portfolio Volatility?

Krauss, Nicolas; Walter, Ingo

Abstract: Microfinance is arguably one of the most effective techniques forpoverty alleviation in developing countries. Although traditionallysupported by nongovernmental organizations and socially-orientedinvestors, microfinance institutions (MFIs) have increasinglydemonstrated their value on a stand-alone basis, typically exhibitinglow default rates combined with attractive returns and growth,encouraging greater commercial involvement. This paper addresses arelated issue – whether microfinance shows low correlation withinternational and domestic market performance measures. If so, it couldform the empirical basis for MFI access to capital markets andperformance-driven investors in their search for efficient portfolios.Our empirical tests do not show any exposure of microfinanceinstitutions to global capital markets, but significant exposureregarding domestic GDP, suggesting that microfinance investments mayhave useful portfolio diversification value for international investors,not for domestic investors lacking significant country riskdiversification options.

Reputational Risk and Conflicts of Interest in Banking and Finance: The Evidence So Far

Tue, 19 Dec 2006 22:58:59 GMT

Title: Reputational Risk and Conflicts of Interest in Banking and Finance: TheEvidence So Far

Walter, Ingo

Abstract: This paper attempts define reputational risk in financial intermediationand to identify the proximate sources of reputational risk facingfinancial services firms. It then considers the key drivers ofreputational risk in the presence of transactions costs and imperfectinformation in financial markets, surveys empirical research in theliterature on the impact of reputational losses imposed on financialintermediaries, and presents some new empirical findings. The paper thendevelops the link between reputational risk and exploitation ofconflicts of interest in financial intermediation, arguably one of themost important threats to the reputational capital of financial firms.Finally, it considers some managerial requisites for dealing with bothreputational risk and conflicts of interest.

Portfolio Concentration and Investment Manager Performance

Sat, 29 Oct 2005 22:58:59 GMT

Title: Portfolio Concentration and Investment Manager Performance

Brands, Simone; Brown, Stephen J.; Gallagher, David R.

Abstract: active equity portfolios. Active management is dependent on the successof two important components in the investment process – stockselection skill and portfolio management. Our study documents a positiverelationship between fund performance and portfolio concentration. Therelationship is stronger for stocks in which active managers holdoverweight positions, as well as for stocks outside the largest 50stocks listed on the Australian Stock Exchange (ASX). We find moreconcentrated funds tend to be those implementing growth styles, havingsmaller aggregate assets under management, being institutions which arenot affiliated with a bank or life-office entity, whose funds experiencepast period outflows, and who are benchmarked to narrower indexes thanthe S&P/ASX 300.

Portfolio Concentration and Investment Manager Performance

Sat, 29 Oct 2005 22:58:59 GMT

Title: Portfolio Concentration and Investment Manager Performance

Brands, Simone; Brown, Stephen J.; Gallagher, David R.

Abstract: This study examines the relationship between investment performance andconcentration in active equity portfolios. Active management isdependent on the success of two important components in the investmentprocess – stock selection skill and portfolio management. Ourstudy documents a positive relationship between fund performance andportfolio concentration. The relationship is stronger for stocks inwhich active managers hold overweight positions, as well as for stocksoutside the largest 50 stocks listed on the Australian Stock Exchange(ASX). We find more concentrated funds tend to be those implementinggrowth styles, having smaller aggregate assets under management, beinginstitutions which are not affiliated with a bank or life-office entity,whose funds experience past period outflows, and who are benchmarked tonarrower indexes than the S&P/ASX 300.

The Financial Accelerator: Evidence from the International Housing Markets

Mon, 17 Oct 2005 22:58:59 GMT

Title: The Financial Accelerator: Evidence from the International Housing Markets

Almeida, Heitor; Campello, Murillo; Liu, Crocker

Abstract: This paper shows novel evidence on the mechanism through which financialconstraints amplify uctuations in asset prices and credit demand. Itdoes so using contractual features of housing finance. Among agentswhose housing demand is constrained by the availability of collateral,those who can borrow against a larger fraction of their housing value(achieve a higher loan-to-value, or LTV, ratio) have more procyclicaldebt capacity. This procyclicality underlies the nancial acceleratormechanism described by Stein (1995) and Bernanke et al. (1996). Ourstudy uses international variation in maximum LTV ratios over threedecades to test whether (a) housing prices and (b) demand for newmortgage borrowings are more sensitive to income shocks in countrieswhere households can achieve higher LTV ratios. The results we obtainare consistent with the dynamics of a collateral-based financialaccelerator in housing markets.

You Can't Take It With You: Sunset Provisions for Equity Compensation When Managers Retire, Resign, or Die

Wed, 28 Nov 2007 22:58:59 GMT

Title: You Can't Take It With You: Sunset Provisions for Equity CompensationWhen Managers Retire, Resign, or Die

Dahiya, Sandeep; Yermack, David

Abstract: Company stock option plans have diverse “sunset” policiesfor modifying terms of options held by managers who exit the firm. Inour S&P 500 sample, these forfeiture, vesting, and expirationprovisions are less generous in companies characterized by fast growth,dependence on skilled human capital, and high strategic interaction withcompetitors. While these results apply for workers who retire at the endof their careers, almost no variation exists in the treatment of workerswho resign with the possibility of working elsewhere. We show that thesefeatures of firms’ option plans directly impact managementturnover. For CEOs over age 60, companies’ sunset rules implylarge discounts to option award values and estimates of totalcompensation. The authors appreciate helpful comments from ManuelAmmann, Patrick Bolton, Jennifer Carpenter, Don Chance, Stephen Choi,John Core, Joan Heminway, Tracie Woidtke, and seminar participants atChinese University Hong Kong, Fordham University, Georgetown University,Mannheim University, University of St. Gallen, University of Tennessee,and the Gerzensee European Summer Symposium in Financial Markets.

Do Financial Conglomerates Create or Destroy Economic Value?

Sun, 02 Dec 2007 22:58:59 GMT

Title: Do Financial Conglomerates Create or Destroy Economic Value?

Schmid, Markus M.; Walter, Ingo

Abstract: This paper investigates whether functional diversification isvalue-enhancing or value-destroying in the financial services sector,broadly defined. Based on a U.S. dataset comprising approximately 4,060observations covering the period 1985-2004, we report a substantial andpersistent conglomerate discount among financial intermediaries. Thestudy differs materially from earlier work on scope dimensions offinancial institution structures. Our results suggest that it isdiversification that causes the discount, and not that troubled firmsdiversify into other more promising areas. In addition, the discountapplies to all financial services industries with the exception ofinvestment banking and is stable over different combinations offinancial activity areas with the exception of commercial banking unitscombined with insurance companies and/or investment banking activities.Finally, our results reveal that geographic diversification per se isnot associated with a significant discount. Although geographicdiversity is value destroying in all financial services activity-areaswhen there are more geographic segments and the activities aredistributed relatively evenly over these segments.

The Asset Management Industry in Asia: Dynamics of Growth, Structure and Performance

Sat, 29 Oct 2005 22:58:59 GMT

Title: The Asset Management Industry in Asia: Dynamics of Growth, Structure and Performance

Walter, Ingo; Sisli, Elif

Abstract: management industry in Asian developing economies – specificallyin China, Indonesia, Korea, Malaysia, Singapore, Philippines andThailand. We focus on the size and growth of the buy-side of therespective financial markets, asset allocation, the regulatoryenvironment, and the state of internationalization of the fundmanagement industry in its key components – mutual funds, pensionfunds and asset management for high net worth individuals. We link thesethe evolution of professional asset management in these environments tothe development of the respective capital markets and to the evolutionof corporate governance. We find that the fund management industryoccupies a very small niche in domestic financial systems that aredominated by banks. At the same time, we find that its growth has beenvery rapid in the early 2000s and we suggest that this is likely topersist as the demand for professional management of financial wealth inthe region develops and as the pension fund sectors of the respectiveeconomies are liberalized to allow larger portions of assets to beinvested in collective investment schemes.

Networking as a Barrier to Entry and the Competitive Supply of Venture Capital

Mon, 05 Mar 2007 22:58:59 GMT

Rewriting History

Tue, 15 Apr 2008 22:58:59 GMT

Title: Rewriting History

Ljungqvist, Alexander; Malloy, Christopher; Marston, Felicia

Abstract: We document widespread ex post changes to the historical contents of theI/B/E/S analyst stock recommendations database. Across a sequence ofseven downloads of the entire I/B/E/S recommendations database, obtainedbetween 2000 and 2007, we find that between 6,594 (1.6%) and 97,579(21.7%) of matched observations are different from one download to thenext. The changes, which include alterations of recommendation levels,additions and deletions of records, and removal of analyst names, arenon-random in nature: They cluster by analyst reputation, brokerage firmsize and status, and recommendation boldness. The changes have a largeand significant impact on the classification of trading signals andback-tests of three stylized facts: The profitability of tradingsignals, the profitability of changes in consensus recommendations, andpersistence in individual analyst stock-picking ability.

Competition and the Structure of Vertical Relationships in Capital Markets

Mon, 31 Mar 2008 22:58:59 GMT

Cost Inefficiency, Size of Firms, and Takeovers

Fri, 29 Oct 1999 22:58:59 GMT

Title: Cost Inefficiency, Size of Firms, and Takeovers

Frydman, Halina; Frydman, Roman; Trimbath, Susanne

Abstract: This study, using the Cox proportional hazards model, finds that therisk of takeover rises with cost inefficiency. It also finds that a firmfaces a significantly higher risk of takeover if its cost performancelags behind its industry benchmark. These findings, moreover, appear tobe remarkably stable over the nearly two decades spanned by the sample.The effect of the variables measuring the risk-size relationship,however, indicate temporal changes. Lastly, the study presents evidencefrom fixed-effects models of ex post cost efficiency improvements thatsupport the hypothesis that takeover targets are selected based on thepotential for improvement.

Credit Ratings and the Bis Reform Agenda

Fri, 29 Oct 1999 22:58:59 GMT

Title: Credit Ratings and the Bis Reform Agenda

Altman, Edward I.; Saunders, Anthony

Abstract: The authors are the Max L. Heine and John M. Schiff Professors ofFinance, Stern School of Business, NYU. This is an updated and revisedpaper from the authors’ report on "An Analysis and Critiqueof the BIS Proposal on Capital Adequacy and Ratings," (submitted tothe BIS and published in the Journal of Banking & Finance, Vol. 25,#1, January, 2001). The authors wish to thank Sreedar Bharath for hiscomputational assistance and Robyn Vanterpool of the NYU Salomon Centerfor her coordination. This paper was first prepared for the NYU SalomonCenter/University of Maryland research project on "The Role ofCredit Reporting Systems in the International Economy," sponsoredby the Center for International Political Economy. It was prepared forthe project’s conference in Washington D.C. on March 1-2, 2001 atthe headquarters of the World Bank.

Doubling: Nick Leeson's trading strategy

Fri, 29 Oct 1999 22:58:59 GMT

Title: Doubling: Nick Leeson's trading strategy

Brown, Stephen J.; Steenbeek, Onno W.

Abstract: This paper examines the trading strategy attributed to Mr. NicholasLeeson, who was the chief derivatives trader of Barings bank inSingapore. His activities were the main cause of the eventual collapseof Barings bank. Daily information is available for the full periodLeeson was active in Singapore, from January 1992 until 1995, for allrelevant products. The information includes daily volume, open interest,opening, closing, highest and lowest price. The empirical evidencesuggests that Leeson followed a doubling strategy: he continuouslydoubled his position as prices were falling.

Hedging Volatility Risk

Sun, 29 Oct 2000 22:58:59 GMT

Title: Hedging Volatility Risk

Brenner, Menachem; Ou, Ernest Y.; Zhang, Jin E.

Abstract: Volatility risk has played a major role in several financial debacles(for example, Barings Bank, Long Term Capital Management). This riskcould have been managed using options on volatility which were proposedin the past but were never offered for trading mainly due to the lack ofa tradable underlying asset. The objective of this paper is tointroduce a new volatility instrument, an option on a straddle, whichcan be used to hedge volatility risk. The design and valuation of suchan instrument are the basic ingredients of a successful financialproduct. Unlike the proposed volatility index option, the underlying ofthis proposed contract is a traded at-the-money-forward straddle, whichshould be more appealing to potential participants. In order to valuethese options, we combine the approaches of compound options andstochastic volatility. We use the lognormal process for the underlyingasset, the Orenstein-Uhlenbeck process for volatility, and assume thatthe two Brownian motions are independent. Our numerical results showthat the straddle option price is very sensitive to the changes involatility which means that the proposed contract is indeed a verypowerful instrument to hedge volatility risk.

Are Emerging-Market Equities a Separate Asset Class?

Fri, 07 Jul 2000 22:58:59 GMT

Title: Are Emerging-Market Equities a Separate Asset Class?

Saunders, Anthony; Walter, Ingo

Stalking the "Efficient Price" in Market Microstructure Specifications: An Overview

Tue, 20 Jun 2000 22:58:59 GMT

Title: Stalking the "Efficient Price" in Market MicrostructureSpecifications: An Overview

Hasbrouck, Joel

Abstract: The principle that revisions to the expectation of a security's valueshould be unforecastable identifies this expectation as a martingale.When price changes can plausibly be assumed covariance stationary, thisin turn motivates interest in the random walk. In the presence of themarket frictions featured in many microstructure models, however, thisexpectation does not invariably coincide with observed security pricessuch as trades and quotes. Accordingly, the random walk becomes animplicit, unobserved component. This paper is an overview of econometricapproaches to characterizing this important component in single- andmultiple-price applications.

Intraday Price Formation in US Equity Index Markets

Wed, 15 Nov 2000 22:58:59 GMT

Title: Intraday Price Formation in US Equity Index Markets

Hasbrouck, Joel

Abstract: The market for US equity indexes has traditionally comprisedfloor-traded index futures contracts and the individual markets for thecomponent stocks. This picture has been altered by the advent ofexchange-traded funds (ETFs) that mirror the indexes,electronically-traded, small-denomination (“E-mini”) futurescontracts, and (for the S&P 500) a family of sector ETFs that breakthe index into nine components. This paper empirically investigatesprice discovery (price leadership) in this new environment. Thespecifications are estimated at very fine (up to one second) timeresolution. The principal findings are as follows.