Abstracts of Brattle Prize Winning Papers

Ilya A. Strebulaev

Do Tests of Capital Structure Theory Mean What They Say?

Abstract

In the presence of frictions, firms adjust their capital structure infrequently. As a consequence, in a dynamic economy the leverage of most firms is likely to differ from the "optimum" leverage at the time of readjustment. This paper explores the empirical implications of this observation. I use a calibrated dynamic trade-off model to simulate firms' capital structure paths. The results of standard cross-sectional tests on these data are consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results leads to the rejection of the underlying model. Taken together, the results suggest a rethinking of the way capital structure tests are conducted.

Christopher A. Hennessy and Toni M. Whited

How Costly Is External Financing? Evidence from a Structural Estimation

Abstract

We apply simulated method of moments to a dynamic model to infer the magnitude of financing costs. The model features endogenous investment, distributions, leverage, and default. The corporation faces taxation, costly bankruptcy, and linear-quadratic equity flotation costs. For large (small) firms, estimated marginal equity flotation costs start at 5.0% (10.7%) and bankruptcy costs equal to 8.4% (15.1%) of capital. Estimated financing frictions are higher for low-dividend firms and those identified as constrained by the Cleary and Whited-Wu indexes. In simulated data, many common proxies for financing constraints actually decrease when we increase financing cost parameters.

Amir Sufi

Information Asymmetry and Financing Arrangements: Evidence from Syndicated Loans

Abstract

I empirically explore the syndicated loan market, with an emphasis on how information asymmetry between lenders and borrowers influences syndicate structure and on which lenders become syndicate members. Consistent with moral hazard in monitoring, the lead bank retains a larger share of the loan and forms a more concentrated syndicate when the borrower requires more intense monitoring and due diligence. When information asymmetry between the borrower and lenders is potentially severe, participant lenders are closer to the borrower, both geographically and in terms of previous lending relationships. Lead bank and borrower reputation mitigates, but does not eliminate information asymmetry problems.

Joshua D. Rauh

Investment and Financing Constraints: Evidence from the Funding of Corporate Pension Plans

Abstract

I exploit sharply nonlinear funding rules for defined benefit pension plans in order to identify the dependence of corporate investment on internal financial resources in a large sample. Capital expenditures decline with mandatory contributions to DB pension plans, even when controlling for correlations between the pension funding status itself and the firm's unobserved investment opportunities. The effect is particularly evident among firms that face financing constraints based on observable variables such as credit ratings. Investment also displays strong negative correlations with the part of mandatory contributions resulting solely from unexpected asset market movements.

Mark T. Leary and Michael R. Roberts

Do Firms Rebalance Their Capital Structures?

Abstract

We empirically examine whether firms engage in a dynamic rebalancing of their capital structures while allowing for costly adjustment. We begin by showing that the presence of adjustment costs has significant implications for corporate financial policy and the interpretation of previous empirical results. After confirming that financing behavior is consistent with the presence of adjustment costs, we find that firms actively rebalance their leverage to stay within an optimal range. Our evidence suggests that the persistent effect of shocks on leverage observed in previous studies is more likely due to adjustment costs than indifference toward capital structure.

Aydogan Alti

How Persistent Is the Impact of Market Timing on Capital Structure?

Abstract

This paper examines the capital structure implications of market timing. I isolate timing attempts in a single major financing event, the initial public offering, by identifying market timers as firms that go public in hot issue markets. I find that hot-market IPO firms issue substantially more equity, and lower their leverage ratios by more, than cold-market firms do. However, immediately after going public, hot-market firms increase their leverage ratios by issuing more debt and less equity relative to cold-market firms. At the end of the second year following the IPO, the impact of market timing on leverage completely vanishes.

Christopher A. Hennessy and Toni M. Whited

Debt Dynamics

Abstract

We develop a dynamic trade-off model with endogenous choice of leverage, distributions, and real investment in the presence of a graduated corporate income tax, individual taxes on interest and corporate distributions, financial distress costs, and equity flotation costs. We explain several empirical findings inconsistent with the static trade-off theory. We show there is no target leverage ratio, firms can be savers or heavily levered, leverage is path dependent, leverage is decreasing in lagged liquidity, and leverage varies negatively with an external finance weighted average Q. Using estimates of structural parameters, we find that simulated model moments match data moments.

Marianne P. Bitler, Tobias J. Moskowitz, and Annette Vissing-Jørgensen

Testing Agency Theory with Entrepreneur Effort and Wealth

Abstract

We develop a principal-agent model in an entrepreneurial setting and test the model's predictions using unique data on entrepreneurial effort and wealth in privately held firms. Accounting for unobserved firm heterogeneity using instrumental-variables techniques, we find that entrepreneurial ownership shares increase with outside wealth and decrease with firm risk; effort increases with ownership; and effort increases firm performance. The magnitude of the effects in the cross-section of firms suggests that agency costs may help explain why entrepreneurs concentrate large fractions of their wealth in firm equity.

Belen Villalonga

Diversification Discount or Premium? New Evidence from the Business Information Tracking Series

Abstract

I use the Business Information Tracking Series (BITS), a new census database that covers the whole U.S. economy at the establishment level, to examine whether the finding of a diversification discount is an artifact of segment data. BITS data allow me to construct business units that are more consistently and objectively defined than segments, and thus more comparable across firms. Using these data on a sample that yields a discount according to segment data, I find a diversification premium. The premium is robust to variations in the sample, business unit definition, and measures of excess value and diversification.

Christopher A. Hennessy

Tobin's Q, Debt Overhang, and Investment

Abstract

Incorporating debt in a dynamic real options framework, we show that underinvestment stems from truncation of equity's horizon at default. Debt overhang distorts both the level and composition of investment, with underinvestment being more severe for long-lived assets. An empirical proxy for the shadow price of capital to equity is derived. Use of this proxy yields a structural test for debt overhang and its mitigation through issuance of additional secured debt. Using measurement error-consistent GMM estimators, we find a statistically significant debt overhang effect regardless of firms' ability to issue additional secured debt.

Antoinette Schoar

Effects of Corporate Diversification on Productivity

Abstract

Using plant-level observations from the Longitudinal Research Database I show that conglomerates are more productive than stand-alone firms at a given point in time. Dynamically, however, firms that diversify experience a net reduction in productivity. While the acquired plants increase productivity, incumbent plants suffer. Moreover, stock prices track firm productivity and this tracking is equally strong for diversified and stand-alone firms. Therefore, lower transparency of conglomerates is unlikely to explain the discrepancy between productivity and stock prices on average. Finally, I offer some evidence that this discrepancy may arise because conglomerates dissipate rents in the form of higher wages.

Aydoğan Altı

How Sensitive is Investment to Cash Flow When Financing is Frictionless?

Abstract

I analyze the sensitivity of a firm's investment to its own cash flow in the benchmark case where financing is frictionless. This sensitivity has been proposed as a measure of financing constraints in earlier studies. I find that the investment–cash flow sensitivities that obtain in the frictionless benchmark are very similar, both in magnitude and in patterns they exhibit, to those observed in the data. In particular, the sensitivity is higher for firms with high growth rates and low dividend payout ratios. Tobin's q is shown to be a more noisy measure of near-term investment plans for these firms.

Malcolm Baker and Jeffrey Wurgler

Market Timing and Capital Structure

Abstract

It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market.

Anil K. Kashyap, Raghuram Rajan, and Jeremy C. Stein

Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit-Taking

Abstract

What ties together the traditional commercial banking activities of deposit-taking and lending? We argue that since banks often lend via commitments, their lending and deposit-taking may be two manifestations of one primitive function: the provision of liquidity on demand. There will be synergies between the two activities to the extent that both require banks to hold large balances of liquid assets: If deposit withdrawals and commitment takedowns are imperfectly correlated, the two activities can share the costs of the liquid-asset stockpile. We develop this idea with a simple model, and use a variety of data to test the model empirically.

Per Strömberg

Conflicts of Interest and Market Illiquidity in Bankruptcy Auctions: Theory and Tests

Abstract

I develop and estimate a model of cash auction bankruptcy using data on 205 Swedish firms. The results challenge arguments that cash auctions, as compared to reorganizations, are immune to conflicts of interest between claimholders but lead to inefficient liquidations. I show that a sale of the assets back to incumbent management is a common bankruptcy outcome. Sale-backs are more likely when they favor the bank at the expense of other creditors. On the other hand, inefficient liquidations are frequently avoided through sale-backs when markets are illiquid, that is, when industry indebtedness is high and the firm has few nonspecific assets.

Douglas Diamond and Raghuram Rajan

A Theory of Bank Capital

Abstract

Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance.

John R. Graham

How Big Are the Tax Benefits of Debt?

Abstract

I integrate under firm-specific benefit functions to estimate that the capitalized tax benefit of debt equals 9.7 percent of firm value (or as low as 4.3 percent, net of personal taxes). The typical firm could double tax benefits by issuing debt until the marginal tax benefit begins to decline. I infer how aggressively a firm uses debt by observing the shape of its tax benefit function. Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively. Product market factors, growth options, low asset collateral, and planning for future expenditures lead to conservative debt usage. Conservative debt policy is persistent.

Fuqua School of Business, Duke University

Raghuram Rajan, Henri Servaes and Luigi Zingales

The Cost of Diversity: The Diversification Discount and Inefficient Investment

Abstract

We model the distortions that internal power struggles can generate in the allocation of resources between divisions of a diversified firm. The model predicts that if divisions are similar in the level of their resources and opportunities, funds will be transferred from divisions with poor opportunities to divisions with good opportunities. When diversity in resources and opportunities increases, however, resources can flow toward the most inefficient division, leading to more inefficient investment and less valuable firms. We test these predictions on a panel of diversified U.S. firms during the period from 1980 to 1993 and find evidence consistent with them.

University of Chicago, London Business School and University of North Carolina at Chapel Hill

Clifford G. Holderness, Randall S. Kroszner, and Dennis P. Sheehan

Were the Good Old Days That Good? Changes in Managerial Stock Ownership Since the Great Depression

Abstract

We document that ownership by officers and directors of publicly-traded firms is on average higher today than earlier in the century. Managerial ownership rises from 13 percent for the universe of exchange-listed corporations in 1935, the earliest year for which such data exist, to 21 percent in 1995. We examine in detail the robustness of the increase and explore hypotheses to explain it. Higher managerial ownership has not substituted for alternative corporate governance mechanisms. Lower volatility and greater hedging opportunities associated with the development of financial markets appear to be important factors explaining the increase in managerial ownership.

Boston College, University of Chicago, and Penn State University

Distinguished Paper 1999

Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer

Corporate Ownership Around the World

Abstract

We use data on ownership structures of large corporations in 27 wealthy economies to identify the ultimate controlling shareholders of these firms. We find that, except in economies with very good shareholder protection, relatively few of these firms are widely held, in contrast to the Berle and Means image of ownership of the modern corporation. Rather, these firms are typically controlled by families or the State. Equity control by financial institutions is far less common. The controlling shareholders typically have power over firms significantly in excess of their cash flow rights, primarily through the use of pyramids and participation in management.

Harvard University

Abstracts of Smith Breeden Prize Winning Papers

Paul C. Tetlock

Giving Content to Investor Sentiment: The Role of Media in the Stock Market

Abstract

I quantitatively measure the interactions between the media and the stock market using daily content from a popular Wall Street Journal column. I find that high media pessimism predicts downward pressure on market prices followed by a reversion to fundamentals, and unusually high or low pessimism predicts high market trading volume. These and similar results are consistent with theoretical models of noise and liquidity traders, and are inconsistent with theories of media content as a proxy for new information about fundamental asset values, as a proxy for market volatility, or as a sideshow with no relationship to asset markets.

Lauren Cohen, Karl B. Diether, and Christopher J. Malloy

Supply and Demand Shifts in the Shorting Market

Abstract

Using proprietary data on stock loan fees and quantities from a large institutional investor, we examine the link between the shorting market and stock prices. Employing a unique identification strategy, we isolate shifts in the supply and demand for shorting. We find that shorting demand is an important predictor of future stock returns: An increase in shorting demand leads to negative abnormal returns of 2.98% in the following month. Second, we show that our results are stronger in environments with less public information flow, suggesting that the shorting market is an important mechanism for private information revelation.

Andrew W. Lo and Jiang Wang

Trading Volume: Implications of an Intertemporal Capital Asset Pricing Model

Abstract

We derive an intertemporal asset pricing model and explore its implications for trading volume and asset returns. We show that investors trade in only two portfolios: the market portfolio, and a hedging portfolio that is used to hedge the risk of changing market conditions. We empirically identify the hedging portfolio using weekly volume and returns data for U.S. stocks, and then test two of its properties implied by the theory: Its return should be an additional risk factor in explaining the cross section of asset returns, and should also be the best predictor of future market returns.

Leonid Kogan, Stephen A. Ross, Jiang Wang, and Mark M. Westerfield

The Price Impact and Survival of Irrational Traders

Abstract

Milton Friedman argued that irrational traders will consistently lose money, will not survive, and, therefore, cannot influence long-run asset prices. Since his work, survival and price impact have been assumed to be the same. In this paper, we demonstrate that survival and price impact are two independent concepts. The price impact of irrational traders does not rely on their long-run survival, and they can have a significant impact on asset prices even when their wealth becomes negligible. We also show that irrational traders' portfolio policies can deviate from their limits long after the price process approaches its long-run limit.

Mark Loewenstein and Gregory A. Willard

The Limits of Investor Behavior

Abstract

Many models use noise trader risk and corresponding violations of the Law of One Price to explain pricing anomalies, but include a storage technology in perfectly elastic supply or unlimited asset liability. Storage allows aggregate consumption risk to differ from exogenous fundamental risk, but using aggregate consumption as a factor for asset returns can make noise trader risk superfluous. Using (i) limited asset liability and limited storage withdrawals, or (ii) an endogenous locally riskless interest rate eliminates violations of the Law of One Price. Our main results use only budget equations and market clearing, and require virtually no assumptions about behavior.

Gur Huberman and Wei Jiang

Offering versus Choice in 401(k) Plans: Equity Exposure and Number of Funds

Abstract

Records of over half a million participants in more than 600 401(k) plans indicate that participants tend to allocate their contributions evenly across the funds they use, with the tendency weakening with the number of funds used. The number of funds used, typically between three and four, is not sensitive to the number of funds offered by the plans, which ranges from 4 to 59. A participant's propensity to allocate contributions to equity funds is not very sensitive to the fraction of equity funds among offered funds. The paper also comments on limitations on inferences from experiments and aggregate-level data analysis.

Joshua D. Coval and Tyler Shumway

Do Behavioral Biases Affect Prices?

Abstract

This paper documents strong evidence for behavioral biases among Chicago Board of Trade proprietary traders and investigates the effect these biases have on prices. Our traders appear highly loss-averse, regularly assuming above-average afternoon risk to recover from morning losses. This behavior has important short-term consequences for afternoon prices, as losing traders actively purchase contracts at higher prices and sell contracts at lower prices than those that prevailed previously. However, the market appears to distinguish these risk-seeking trades from informed trading. Prices set by loss-averse traders are reversed significantly more quickly than those set by unbiased traders.

Lu Zhang

The Value Premium

Abstract

The value anomaly arises naturally in the neoclassical framework with rational expectations. Costly reversibility and countercyclical price of risk cause assets in place to be harder to reduce, and hence are riskier than growth options especially in bad times when the price of risk is high. By linking risk and expected returns to economic primitives, such as tastes and technology, my model generates many empirical regularities in the cross-section of returns; it also yields an array of new refutable hypotheses providing fresh directions for future empirical research.

Murray Carlson, Adlai Fisher, and Ron Giammarino

Corporate Investment and Asset Price Dynamics: Implications for the Cross-Section of Returns

Abstract

We show that corporate investment decisions can explain the conditional dynamics in expected asset returns. Our approach is similar in spirit to , but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and the current product market demand. Book-to-market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data.

Markus K. Brunnermeier and Stefan Nagel

Hedge Funds and the Technology Bubble

Abstract

This paper documents that hedge funds did not exert a correcting force on stock prices during the technology bubble. Instead, they were heavily invested in technology stocks. This does not seem to be the result of unawareness of the bubble: Hedge funds captured the upturn, but, by reducing their positions in stocks that were about to decline, avoided much of the downturn. Our findings question the efficient markets notion that rational speculators always stabilize prices. They are consistent with models in which rational investors may prefer to ride bubbles because of predictable investor sentiment and limits to arbitrage.

Andrea L. Eisfeldt

Endogenous Liquidity in Asset Markets

Abstract

This paper analyzes a model in which long-term risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets is determined endogenously by the amount of trade for reasons other than private information. I find that higher productivity leads to increased liquidity. Moreover, liquidity magnifies the effects of changes in productivity on investment and volume. High productivity implies that investors initiate larger scale risky projects which increases the riskiness of their incomes. Riskier incomes induce more sales of claims to high-quality projects, causing liquidity to increase.

Ravi Bansal and Amir Yaron

Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

Abstract

We model consumption and dividend growth rates as containing (1) a small long-run predictable component, and (2) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better long-run growth prospects raise equity prices. The model can justify the equity premium, the risk-free rate, and the volatility of the market return, risk-free rate, and the price–dividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time-varying.

Luboš Pástor and Pietro Veronesi

Stock Valuation and Learning about Profitability

Abstract

We develop a simple approach to valuing stocks in the presence of learning about average profitability. The market-to-book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firm's lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

Eli Ofek and Matthew Richardson

DotCom Mania: The Rise and Fall of Internet Stock Prices

Abstract

This paper explores a model based on agents with heterogenous beliefs facing short sales restrictions, and its explanation for the rise, persistence, and eventual fall of Internet stock prices. First, we document substantial short sale restrictions for Internet stocks. Second, using data on Internet holdings and block trades, we show a link between heterogeneity and price effects for Internet stocks. Third, arguing that lockup expirations are a loosening of the short sale constraint, we document average, long-run excess returns as low as −33 percent for Internet stocks postlockup. We link the Internet bubble burst to the unprecedented level of lockup expirations and insider selling.

Maureen O'Hara

Presidential Address: Liquidity and Price Discovery

Abstract

This paper examines the implications of market microstructure for asset pricing. I argue that asset pricing ignores the central fact that asset prices evolve in markets. Markets provide liquidity and price discovery, and I argue that asset pricing models need to be recast in broader terms to incorporate the transactions costs of liquidity and the risks of price discovery. I argue that symmetric information-based asset pricing models do not work because they assume that the underlying problems of liquidity and price discovery have been solved. I develop an asymmetric information asset pricing model that incorporates these effects.

Mark Mitchell, Todd Pulvino, and Erik Stafford

Limited Arbitrage in Equity Markets

Abstract

We examine 82 situations where the market value of a company is less than its subsidiary. These situations imply arbitrage opportunities, providing an ideal setting to study the risks and market frictions that prevent arbitrageurs from immediately forcing prices to fundamental values. For 30 percent of the sample, the link between the parent and its subsidiary is severed before the relative value discrepancy is corrected. Furthermore, returns to a specialized arbitrageur would be 50 percent larger if the path to convergence was smooth rather than as observed. Uncertainty about the distribution of returns and characteristics of the risks limits arbitrage.

Timothy C. Johnson

Rational Momentum Effects

Abstract

Momentum effects in stock returns need not imply investor irrationality, heterogeneous information, or market frictions. A simple, single-firm model with a standard pricing kernel can produce such effects when expected dividend growth rates vary over time. An enhanced model, under which persistent growth rate shocks occur episodically, can match many of the features documented by the empirical research. The same basic mechanism could potentially account for underreaction anomalies in general.

David Easley, Soeren Hvidkjaer, and Maureen O'Hara

Is Information Risk a Determinant of Asset Returns?

Abstract

We investigate the role of information–based trading in affecting asset returns. We show in a rational expectation example how private information affects equilibrium asset returns. Using a market microstructure model, we derive a measure of the probability of information–based trading, and we estimate this measure using data for individual NYSE–listed stocks for 1983 to 1998. We then incorporate our estimates into a Fama and French (1992) asset–pricing framework. Our main result is that information does affect asset prices. A difference of 10 percentage points in the probability of information–based trading between two stocks leads to a difference in their expected returns of 2.5 percent per year.

John Y. Campbell, Martin Lettau, Burton G. Malkiel and Yexiao Xu

Have Individual Stocks Become More Volatile: An Empirical Exploration of Idiosyncratic Risk?

Abstract

This paper uses a disaggregated approach to study the volatility of common stocks at the market, industry, and firm levels. Over the period from 1962 to 1997 there has been a noticeable increase in firm-level volatility relative to market volatility. Accordingly, correlations among individual stocks and the explanatory power of the market model for a typical stock have declined, whereas the number of stocks needed to achieve a given level of diversification has increased. All the volatility measures move together countercyclically and help to predict GDP growth. Market volatility tends to lead the other volatility series. Factors that may be responsible for these findings are suggested.

Mark Grinblatt and Matti Keloharju

What Makes Investors Trade?

Abstract

A unique data set allows us to monitor the buys, sells, and holds of individuals and institutions in the Finnish stock market on a daily basis. With this data set, we employ Logit regressions to identify the determinants of buying and selling activity over a two-year period. We find evidence that investors are reluctant to realize losses, that they engage in tax-loss selling activity, and that past returns and historical price patterns, such as being at a monthly high or low, affect trading. There also is modest evidence that life-cycle trading plays a role in the pattern of buys and sells.

Bengt Holmström and Jean Tirole

LAPM: A Liquidity-Based Asset Pricing Model

Abstract

This paper uses a disaggregated approach to study the volatility of common stocks at the market, industry, and firm levels. Over the period from 1962 to 1997 there has been a noticeable increase in firm-level volatility relative to market volatility. Accordingly, correlations among individual stocks and the explanatory power of the market model for a typical stock have declined, whereas the number of stocks needed to achieve a given level of diversification has increased. All the volatility measures move together countercyclically and help to predict GDP growth. Market volatility tends to lead the other volatility series. Factors that may be responsible for these findings are suggested.

Joshua D. Coval and Tobias J. Moskowitz

Home Bias at Home: Local Equity Preference in Domestic Portfolios

Abstract

The strong bias in favor of domestic securities is a well-documented characteristic of international investment portfolios, yet we show that the preference for investing close to home also applies to portfolios of domestic stocks. Specifically, U.S. investment managers exhibit a strong preference for locally headquartered firms, particularly small, highly levered firms that produce nontraded goods. These results suggest that asymmetric information between local and nonlocal investors may drive the preference for geographically proximate investments, and the relation between investment proximity and firm size and leverage may shed light on several well-documented asset pricing anomalies.

University of Michigan Business School and Graduate School of Business, University of Chicago

Qiang Dai and Kenneth J. Singleton

Specification Analysis of Affine Term Structure Models

Abstract

This paper explores the structural differences and relative goodness-of-fits of affine term structure models (ATSMs). Within the family of ATSMs there is a trade-off between flexibility in modeling the conditional correlations and volatilities of the risk factors. This trade-off is formalized by our classification of N-factor affine family into N + 1 non-nested subfamilies of models. Specializing to three-factor ATSMs, our analysis suggests, based on theoretical considerations and empirical evidence, that some subfamilies of ATSMs are better suited than others to explaining historical interest rate behavior.

New York University and Stanford University

Katrina Ellis, Roni Michaely and Maureen O'Hara

When the Underwriter is the Market Maker: An Examination of Trading in the IPO Aftermarket

Abstract

This paper examines aftermarket trading of underwriters and unaffiliated market makers in the three-month period after an IPO. We find that the lead underwriter is always the dominant market maker; he takes substantial inventory positions in the aftermarket trading, and co-managers play a negligible role in aftermarket trading. The lead underwriter engages in stabilization activity for less successful IPOs, and uses the overallotment option to reduce his inventory risk. Compensation to the underwriter arises primarily from fees, but aftermarket trading does generate positive profits, which are positively related to the degree of underpricing.

Australian Graduate School of Management, Cornell University and Tel-Aviv University

Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam

Investor Psychology and Security Under - and Overreaction

Abstract

We propose a theory of securities market under- and overreactions based on two well- known psychological biases: investor overconfidence about the precision of private infor- mation; and biased self-attribution, which causes asymmetric shifts in investors' confidence as a function of their investment outcomes. We show that overconfidence implies nega- tive long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations (`momentum'), short-run earnings `drift,' but negative correlation between future returns and long-term past stock market and accounting perfor- mance. The theory also offers several untested implications and implications for corporate financial policy.

Northwestern University, University of Michigan, Ann Arbor, and University of California at Los Angeles

Jonathan B. Berk, Richard C. Green, Vasant Naik

Optimal Investment, Growth Options, and Security Returns

Abstract

As a consequence of optimal investment choices, firms' assets and growth options change in predictable ways. Using a dynamic model, we show that this imparts predictability to changes in a firm's systematic risk, and its expected return. Simulations show that the model simultaneously reproduces: (i) the time series relation between the book-to-market ratio and asset returns, (ii) the cross-sectional relation between book to market, market value and return, (iii) contrarian effects at short horizons, (iv) momentum effects at longer horizons and (v) the inverse relation between interest rates and the market risk premium.

University of California, Berkeley, Carnegie Mellon University, and University of British Columbia

Philippe Jorion and William N. Goetzmann

Global Stock Markets in the Twentieth Century

Abstract

Long-term estimates of expected return on equities are typically derived from U.S. data only. There are reasons to suspect, however, that these estimates are subject to survivorship, as the United States is arguably the most successful capitalist system in the world. We collect a database of capital appreciation indexes for 39 markets going back into the 1920s. Over 1921 to 1996, U.S. equities had the highest real return of all countries, at 4.3 percent, versus a median of 0.8 percent for other countries. The high equity premium obtained for U.S. equities therefore appears to be the exception rather than the rule.

University of California at Irvine and Yale School of Management

Gregor Andrade and Steven N. Kaplan

How Costly is Financial (not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed

Abstract

This paper studies thirty-one highly leveraged transactions (HLTs) that become financially, not economically distressed. The net effect of the HLT and financial distress (from pre-transaction to distress resolution, market- or industry-adjusted) is to increase value slightly. This finding strongly suggests that overall, the late 1980s HLTs created value. We present quantitative and qualitative estimates of the (direct and indirect) costs of financial distress and their determinants. We estimate financial distress costs to be ten to twenty percent of firm value. For a subset of firms that do not experience an adverse economic shock, financial distress costs are negligible.

University of Chicago

Todd C. Pulvino

Do Asset Fire-Sales Exist? An Empirical Investigation of Commercial Aircraft Transactions

Abstract

This paper uses commercial aircraft transactions to determine whether capital constraints cause firms to liquidate assets at discounts to fundamental values. Results indicate that financially constrained airlines receive lower prices than their unconstrained rivals when selling used narrow-body aircraft. Capital constrained airlines are also more likely to sell used aircraft to industry-outsiders, especially during market downturns. Further evidence that capital constraints affect liquidation prices is provided by airlines' asset acquisition activity. Unconstrained airlines significantly increase buying activity when aircraft prices are depressed; this pattern is not observed for financially constrained airlines.

Northwestern University

Alon Brav and Paul A. Gompers

Myth or Reality? The Long-Run Underperformance of Initial Public Offerings: Evidence from Venture and Nonventure Capital-Backed Companies

Abstract

We investigate the long-run underperformance of recent initial public offering (IPO) firms in a sample of 934 venture-backed IPOs from 1972-1992 and 3,407 nonventure-backed IPOs from 1975-1992. We find that venture-backed IPOs outperform nonventure-backed IPOs using equal- weighted returns. Value weighting significantly reduces performance differences and substantially reduces underperformance for nonventure-backed IPOs. In tests using several comparable benchmarks and the Fama-French (1993) three factor asset pricing model, venture-backed companies do not significantly underperform, while the smallest nonventure-backed firms do. Underperformance, however, is not an IPO effect. Similar size and book-to-market firms which have not issued equity perform as poorly as IPOs.

Duke University and Harvard University

Kent Daniel and Sheridan Titman

Evidence on the Characteristics of the Cross Sectional Variation in Stock Returns

Abstract

Firm sizes and book-to-market ratios are both highly correlated with the average returns of common stocks. Fama and French (1993) argue that the association between these characteristics and returns arise because the characteristics are proxies for nondiversifiable factor risk. In contrast, the evidence in this article indicates that the return premia on small capitalization and high book-to-market stocks does not arise because of the comovements of these stocks with pervasive factors. It is the characteristics rather than the covariance structure of returns that appear to explain the cross-sectional variation in stock returns.

Northwestern University and Boston College

Owen Lamont

Cash Flow and Investment: Evidence from Internal Capital Markets

Abstract

Using data from the 1986 oil price decrease, I examine the capital expenditures of nonoil subsidiaries of oil companies. I test the joint hypothesis that 1) a decrease in cash/collateral decreases investment, holding fixed the profitability of investment, and 2) the finance costs of different parts of the same corporation are interdependent. The results support this joint hypothesis: oil companies significantly reduced their nonoil investment compared to the median industry investment. The 1986 decline in investment was concentrated in nonoil units that were subsidized by the rest of the company in 1985.

University of Chicago

Darrell Duffie and Kenneth J. Singleton

An Econometric Model of the Term Structure of Interest-Rate Swap Yields

Abstract

This article develops a multi-factor econometric model of the term structure of interest- rate swap yields. The model accommodates the possibility of counterparty default, and any differences in the liquidities of the Treasury and Swap markets. By parameterizing a model of swap rates directly, we are able to compute model-based estimates of the defaultable zero-coupon bond rates implicit in the swap market without having to specify a priori the dependence of these rates on default hazard or recovery rates. The time series analysis of spreads between zero-coupon swap and treasury yields reveals that both credit and liquidity factors were important sources of variation in swap spreads over the past decade.

Stanford University

Shmuel Kandel and Robert F. Stambaugh

On the Predictability of Stock Returns: An Asset-Allocation Perspective

Abstract

Sample evidence about the predictability of monthly stock returns is considered from the perspective of a risk-adverse Bayesian investor who must allocate funds between stocks and cash. The investor uses the sample evidence to update prior beliefs about the parameters in a regression of stock returns on a set of predictive variables. The regression relation can seem weak when described by usual statistical measures, but the current values of the predictive variables can exert a substantial influence on the investor's portfolio decision, even when the investor's prior beliefs are weighted against predictability.

Recanati Graduate School of Business Administration, Tel-Aviv University and The Wharton School, University of Pennsylvania (Kandel) and The Wharton School, University of Pennsylvania and National Bureau of Economic Research (Stambaugh).

Peter Tufano

Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry

Abstract

The article examines a new database that details corporate risk management activity in the North American gold mining industry. I find little empirical support for the predictive power of theories that view risk management as a means to maximize shareholder value. However, firms whose managers hold more options manage less gold price risk, and firms whose managers hold more stock manage more gold price risk, suggesting that managerial risk aversion may affect corporate risk management policy. Further, risk management is negatively associated with the tenure of firms' CFOs, perhaps reflecting managerial interests, skills, or preferences.

Harvard Business School

Keith C. Brown, W.V. Harlow, and Laura Starks

Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry

Abstract

We test the hypothesis that when their compensation is linked to relative performance, managers of investment portfolios likely to end up as "losers" will manipulate fund risk differently than those managing portfolios likely to be "winners." An empirical investigation of the performance of 334 growth-oriented mutual funds during 1976 to 1991 demonstrates that mid-year losers tend to increase fund volatility in the latter part of an annual assessment period to a greater extent than mid-year winners. Furthermore, we show that this effect became stronger as industry growth and investor awareness of fund performance increased over time.

Brown and Starks are from the University of Texas at Austin, and Harlow is from Fidelity Management & Research.

William G. Christie and Paul Schultz

Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?

Abstract

The NASDAQ multiple dealer market is designed to produce narrow bid-ask spreads through the competition for order flow among individual dealers. However, we find that odd- eighth quotes are virtually nonexistent for 70 of 100 actively traded NASDAQ securities, including Apple Computer and Lotus Development. The lack of odd-eighth quotes cannot be explained by the negotiation hypothesis of Harris (1991), trading activity, or other variables thought to impact spreads. This result implies that the inside spread for a large number of NASDAQ stocks is at least $0.25 and raises the question of whether NASDAQ dealers implicitly collude to maintain wide spreads.

Christie is from the Owen Graduate School of Management, Vanderbilt University, and Schultz is from the Max Fisher College of Business, The Ohio State University.

Josef Lakonishok, Andrei Shleifer, and Robert W. Vishny

Contrarian Investment, Extrapolation, and Risk

Abstract

For many years, scholars and investment professionals have argued that value strategies outperform the market. These value strategies call for buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. While there is some agreement that value strategies produce higher returns, the interpretation of why they do so is more controversial. This article provides evidence that value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier.

Lakonishok is from the University of Illinois, Shleifer is from Harvard University, and Vishny is from the University of Chicago.

Judith A. Chevalier

Do LBO Supermarkets Charge more? An Empirical Analysis of the Effects of LBOs on Supermarket Pricing

Abstract

This article examines changes in supermarket prices in local markets following supermarket leveraged buyouts (LPOs). I find that prices rise following LBOs in local markets in which the LBO firm's rivals are also highly leveraged and that LBO firms have higher prices than their less leveraged rivals, suggesting that LBOs create incentives to raise prices. However, I also find that prices fall following LBOs in local markets in which rival firms have low leverage and are concentrated. These price drops are associated with LBO firms exiting the local market, suggesting that rivals attempt to "prey" on LBO chains.

Graduate School of Business, University of Chicago.

Mitchell A. Petersen and Raghuram G. Rajan

The Benefits of Lending Relationships: Evidence from Small Business Data

Abstract

This paper empirically examines how ties between a firm and its creditors affect the availability and cost of funds to the firm. We analyze data collected in a survey of small firms by the Small Business Administration. The primary benefit of building close ties with an institutional creditor is that the availability of financing increases. We find smaller effects on the price of credit. Attempts to widen the circle of relationships by borrowing from multiple lenders increases the price and reduces the availability of credit. In sum, relationships are valuable and appear to operate more through quantities rather than prices.

Graduate School of Business, University of Chicago.

Lawrence R. Glosten

Is the Electronic Open Limit Order Book Inevitable

Abstract

Under fairly general conditions, the article derives the equilibrium price schedule determined by the bids and offers in an open limit order book. The analysis shows: (1) the order book has a small-trade positive bid-ask spread, and limit orders profit from small traders; (2) the electronic exchange provides as much liquidity as possible in extreme situations; (3) the limit order book does not invite competition from third market dealers, while other trading institutions do; (4) If an entering exchange earns nonnegative trading profits, the consolidated price schedule matches the limit order book price schedule.

Columbia University

William L. Megginson, Robert C. Nash, and Matthias van Randenborgh

The Financial and Operating Performance of Newly Privatized Firms: An International Empirical Analysis

Abstract

This study compares the pre- and postprivatization financial and operating performance of 61 companies from 18 countries and 32 industries that experience full or partial privatization through public share offerings during the period 1961 to 1990. Our results document strong performance improvements, achieved surprisingly without sacrificing employment security. Specifically, after being privatized, firms increase real sales, become more profitable, increase their capital investment spending, improve their operating efficiency, and increase their work forces. Furthermore, these companies significantly lower their debt levels and increase dividend payout. Finally, we document significant changes in the size and composition of corporate boards of directors after privatization.

Megginson is from the University of Georgia, Nash is from the University of Baltimore, and van Randenborgh is from the University of Bielefeld, Bielefeld, Germany.

Lisa K. Meulbroek

An Empirical Analysis of Illegal Insider Trading

Abstract

Whether insider trading affects stock prices is central to both the current debate over whether insider trading is harmful or pervasive, and to the broader public policy issue of how best to regulate securities markets. Using previously unexplored data on illegal insider trading from the Securities and Exchange Commission, this paper finds that the stock market detects the possibility of informed trading and impounds this information into the stock price. Specifically, the abnormal return on an insider trading day averages 3%, and almost half of the pre-announcement stock price run-up observed before takeovers occurs on insider trading days. Both the amount traded by the insider and additional trade-specific characteristics lead to the market's recognition of the informed trading.

Harvard University

John Y. Campbell and John Ammer

What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns

Abstract

This paper uses a vector autoregressive model to decompose excess stock and 10-year bond returns into changes in expectations of future stock dividends, inflation, short-term real interest rates, and excess stock and bond returns. In monthly postwar U.S. data, stock and bond returns are driven largely by news about future excess stock returns and inflation, respectively. Real interest rates have little impact on returns, although they do affect the short-term nominal interest rate and the slope of the term structure. These findings help to explain the low correlation between excess stock and bond returns.

Woodrow Wilson School, Princeton University and International Finance Division, Board of Governors of the Federal Reserve System.

Lucy F. Ackert and Brian F. Smith

Stock Price Volatility, Ordinary Dividends, and Other Cash Flows to Shareholders

Abstract

This paper shows that the results of variance-bound tests depend on how cash distributions to shareholders are measured. As in prior studies, we find apparent evidence of excess volatility when a narrow definition of cash flow (dividends only) is applied. However, we are unable to reject the hypothesis of market efficiency when the cash flow measure also includes share repurchases and takeover distributions in addition to ordinary cash dividends.

School of Business and Economics, Wilfrid Laurier University.

Eugene F. Fama and Kenneth R. French

The Cross-Section of Expected Stock Returns

Abstract

Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market , size, leverage, book- to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in that is unrelated to size, the relation between market and average return is flat, even when is the only explanatory variable.

Graduate School of Business, University of Chicago

Laurie Simon Bagwell

Dutch Auction Repurchases: An Analysis of Shareholder Heterogeneity

Abstract

This paper documents that firms face upward-sloping supply curves when they repurchase shares in a Dutch auction, and it analyzes the market reaction to these offers. The announcement price increase is highly correlated with the ultimate repurchase premium. Prices decline at expiration only for pro-rated offers. The cumulative return is positive and highly correlated with the repurchase premium, excepting pro-rated offers. Much of this price increase is consistent with movement along an upward-sloping supply curve. Trading volume around the Dutch auction parallels fixed-price repurchases. Supply elasticity is larger for firms with large trading volume, firms included in the S&S 500 Index, and takeover targets.

Department of Finance, Northwestern University.

Raghuram G. Rajan

Insiders and Outsiders: The Choice Between Informed and Arm's Length Debt

Abstract

While the benefits of bank financing are relatively well understood, the costs are not. This paper argues that while informed banks make flexible financial decisions which prevent a firm's projects from going awry, the cost of this credit is the banks have bargaining power over the firm's profits, once projects have begun. The firm's portfolio choice of borrowing source and the choice of priority for its debt claims attempt to optimally circumscribe the powers of banks.

University of Chicago.

Ivo Welch

Sequential Sales, Learning, and Cascades

Abstract

When IPO share are sold sequentially, later potential investors can learn from the purchasing decisions of earlier investors. This can lead rapidly to "cascades" in which subsequent investors optimally ignore their private information and imitate earlier investors. Although rationing in this situation gives rise to a winner's curse, it is irrelevant. The model predicts that: (1) Offerings succeed or fail rapidly. (2) Demand can be so elastic that even risk- neutral issuers underprice to completely avoid failure. (3) Issuers with good inside information can price their shares so high that they sometimes fail. (4) An underwriter may want to reduce the communication among investors by spreading the selling effort over a more segmented market.

University of California, Los Angeles.

Jay R. Ritter

The Long-Run Performance of Initial Public Offerings

Abstract

The underpricing of initial public offerings (IPOs) that has been widely documented appears to be a short-run phenomenon. Issuing firms during 1975-84 substantially underperformed a sample of matching firms from the closing price on the first day of public trading to their three-year anniversaries. There is substantial variation in the underperformance year-to-year and across industries, with companies that went public in high-volume years faring the worst. The patterns are consistent with an IPO market in which (1) investors are periodically overoptimistic about the earnings potential of young growth companies, and (2) firms take advantage of these "windows of opportunity

University of Illinois at Urbana-Champaign

Robert Gertner and David Scharfstein

A Theory of Workouts and the Effects of Reorganization Law

Abstract

We present a model of a financially distressed firm with outstanding bank debt and public debt. Coordination problems among public debtholders introduce investment inefficiencies in the workout process. In most cases, these inefficiencies are not mitigated by the ability of firms to buy back their public debt with cash and other securities-the only feasible way that firms can restructure their public debt. We show that Chapter 11 reorganization law increases investment, and we characterize the types of corporate financial structure for which this increased investment enhances efficiency.

Gertner is with the Graduate School of Business and the Law School, University of Chicago; Scharfstein is with the Sloan School of Management, Massachusetts Institute of Technology, and with the National Bureau of Economic Research

Campbell R. Harvey

The World Price of Covariance Risk

Abstract

In a financially integrated global market, the conditionally expected return on a portfolio of securities from a particulary country is determined by the country's world wide exposure. This paper measures the conditional risk of 17 countries. The reward per unit of risk is the world price of covariance risk. Although the tests provide evidence on the conditional mean variance efficiency of the benchmark portfolio, the results show the countries' risk exposures help explain differences in performances. Evidence is also presented which indicates that these risk exposures change through time and that the world price of covariance risk is not constant

Duke University, Fuqua School of Business

David A. Hsieh and Merton H. Miller

Margin Regulation and Stock Market Volatility

Abstract

Using daily and monthly stock returns we find no convincing evidence that Federal Reserve margin requirements have served to dampen stock market volatility. The contrary conclusion, expressed in the recent papers by Hardouvelis (1988a,b), is traced to flaws in his test design. We do detect the expected negative relation between margin requirements and the amount of margin credit outstanding. We also confirm the recent finding by Schwert (1988) that changes in margin requirements by the Fed have tended to follow rather than lead changes in market volatility.

Fuqua School of Business, Duke University; Graduate School of Business, University of Chicago

Milton Harris and Artur Raviv

Capital Structure and the Informational Role of Debt

Abstract

This paper provides a theory of capital structure based on the effect of debt on investors' information about the firm and on their ability to oversee management. We postulate that managers are reluctant to relinquish control and unwilling to provide information that could result in such an outcome. Debt is a disciplining device because default allows creditors the option to force the firm into liquidation and generates information useful to investors. We characterize the time path of the debt level and obtain comparative statics results on the debt level, bond yield, probability of default, probability of reorganization, etc.

Harris is the Chicago Board of trade Professor of Finance and Business Economics, Graduate School of Business, University of Chicago. Raviv is the Alan E. Peterson Professor of Finance, Kellogg Graduate School of Management, Northwestern University, and Professor, Faculty of Management, Tel Aviv University

Deborah J. Lucas and Robert L. McDonald

Equity Issues and Stock Price Dynamics

Abstract

This paper presents an information-theoretic, infinite horizon model of the equity issue decision. The model predicts that (a) equity issues on average are preceded by an abnormal positive return on the stock, although for some firms the issue is preceded by a loss; (b) equity issues on average are reduced by an abnormal rise in the market; and (c) the stock price drops at the announcement of an issue. The model provides a measure of the welfare cost of asymmetric information; the welfare loss may be small even if the price drop at issue announcement is large.

D. J. Lucas is from the Finance Department, Kellogg School, Northwestern University. R. L. McDonald is from the Finance Department, Kellogg School, Northwestern University, and the National Bureau of Economic Research (NBER)

G. William Schwert

Why Does Stock Market Volatility Change Over Time?

Abstract

This paper analyzes the relation of stock volatility with the real and nominal macroeconomic volatility, economic activity, financial leverage, and stock trading activity using monthly data from 1857 to 1987. Am important fact, previously noted by Officer (1973), is that stock return variability was unusually high during the 1929-1939 Great Depression. While aggregate leverage is significantly correlated with volatility, it explains a relatively small part of the movements stock volatility. The amplitude of the fluctuations in aggregate stock volatility is difficult to explain using simple models of stock valuation, especially during the Great Depression.

William E. Simon Graduate School of Business Administration, University of Rochester, and National Bureau of Economic Research

Paul Asquith, David W. Mullins, Jr., and Eric D. Wolff

Original Issue High yield Bonds: Aging Analyses of Defaults, Exchanges, and Calls

Abstract

This paper presents an aging analysis of 741 high yield bonds and finds default, exchange, and call percentages substantially higher than reported in earlier studies. By December 31.1988, cumulative defaults are 34 percent for bonds issued in 1977 and 1978 and range from 19 to 27 percent for issue years 1979-1983 and from 3 to 9 percent for issue years 1984-1986. Exchanges are also a significant factor although they often are followed by default. Moreover, a significant percentage of high yield debt, 26-47 percent for 1977-1982, has been called. By December 31, 1988, approximately one third of the bonds issued in 1977-1982 has defaulted or been exchanged, and an additional one third has been called. On average, only 28 percent of these issues are still outstanding. There is no evidence that early results for more recent issue years differ markedly from issue years 1977 to 1982.

Asquith is at the Massachusetts Institute of Technology. Mullins is on leave from the Harvard Business School at the U.S. Department of the Treasury. This research was performed while Mullins was on the faculty of the Harvard Business School and represents his personal views and not those of the U.S. Department of the Treasury. Wolff is at the U.S. Department of Justice. This research was performed while Wolff was at the Harvard Business School and represents his personal views and not those of the U.S. Department of Justice.

Michael J. Fishman

Preemptive Bidding and the Role of the Medium of Exchange in Acquisitions

Abstract

The medium of exchange in acquisitions is studied in a model where (I) bidders' offers bring forth potential competition and (ii) targets and bidders are asymmetrically informed. In equilibrium, both securities and cash offers are observed. Securities have the advantage of inducing target management to make an efficient accept/reject decision. Cash has the advantage of serving, in equilibrium, to "preempt" competition by signaling a high valuation for the target. Implications concerning the medium of exchange of an offer, the probability of acceptance, the probability of competing bids, expected profits, and the costs of bidders are derived.

Kellogg Graduate School of Management, Northwestern University

Marshall E. Blume, A. Craig MacKinlay, and Bruce Terker

Order Imbalances and Stock Price Movements on October 19 and 20, 1987

Abstract

On October 19, 1987, NYSE stocks in the S&P index declined seven percentage points more than the NYSE stocks not in this index. In the first hour of trading on October 20, the S&P stocks virtually recovered to the level of the non-S&P stocks. There is a strong relation between order imbalances and stock price movements, both in the linkage between future prices and the spot index on these two days, there were also breakdowns in the linkage among NYSE stocks.

Blume and MacKinlay are at the Wharton School, University of Pennsylvania, Terker is at Geewax, Terker & Company.