Margin of Error
Ambiguity Shifts and the 2007-2008 Financial Crisis
Nina Boyarchenko
Journal of Monetary Economics, forthcoming
Abstract:
Faced with doubts about the quality of information and the quality of modeling techniques, ambiguity-averse agents assign higher probabilities to lower utility states, leading to higher CDS premia and lower equity prices. Using data on financial institutions, I find that the sudden increases in credit spreads during the recent crisis can be explained by changes in the amount of ambiguity faced by market participants and changes in how the total amount of ambiguity was distributed between ambiguity about information quality and ambiguity about model quality.
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The seeds of a crisis: A theory of bank liquidity and risk taking over the business cycle
Viral Acharya & Hassan Naqvi
Journal of Financial Economics, forthcoming
Abstract:
We examine how the banking sector could ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, to induce effort, loan officers are compensated based on the volume of loans. Volume-based compensation also induces greater risk taking; however, due to lack of commitment, loan officers are penalized ex post only if banks suffer a high enough liquidity shortfall. Outside banks, when there is heightened macroeconomic risk, investors reduce direct investment and hold more bank deposits. This ‘flight to quality' leaves banks flush with liquidity, lowering the sensitivity of bankers' payoffs to downside risks and inducing excessive credit volume and asset price bubbles. The seeds of a crisis are thus sown.
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Local Religious Beliefs and Mutual Fund Risk-Taking Behaviors
Tao Shu, Johan Sulaeman & Eric Yeung
Management Science, forthcoming
Abstract:
We study the effects of local religious beliefs on mutual fund risk-taking behaviors. Funds located in low-Protestant or high-Catholic areas exhibit significantly higher fund return volatilities. Similar differences persist when we use the religiosity ratios at fund managers' college locations. Risk-taking associated with local religious beliefs manifests in higher portfolio concentrations, higher portfolio turnover, more aggressive interim trading, and more "tournament" risk-shifting behaviors, but not over-weighting risky individual stocks. Overall, our results suggest that local religious beliefs have significant influences on mutual fund behaviors.
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On political connectedness and the arrest of Ivan Boesky
Charles Knoeber & Mark Walker
Public Choice, forthcoming
Abstract:
The bombshell arrest of Ivan Boesky on November 14, 1986 signaled the intention of then-US attorney for the southern district of New York, Rudy Giuliani, to increase enforcement of laws against insider trading. Looking at concurrent stock price changes, we find that New York companies were affected especially. More interestingly, New York firms with active political arms fared better than those without them; and New York firms connected to Mr. Giuliani's Republican Party fared better still. We find no such effects for non-New York firms. These findings suggest that political connectedness was valuable in the era of more rigorous legal enforcement associated with Mr. Giuliani's attack on insider trading.
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Chansog (Francis) Kim, Christos Pantzalis & Jung Chul Park
Journal of Financial Economics, forthcoming
Abstract:
We show that political geography has a pervasive effect on the cross-section of stock returns. We collect election results over a 40-year period and use a political alignment index (PAI) of each state's leading politicians with the ruling (presidential) party to proxy for local firms' proximity to political power. Firms whose headquarters are located in high PAI states outperform those located in low PAI states, both in terms of raw returns, and on a risk-adjusted basis. Overall, although we cannot rule out indirect political connectedness advantages as an explanation of the PAI effect, our results are consistent with the notion that proximity to political power has stock return implications because it reflects firms' exposure to policy risk.
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Does speculation drive the price of oil?
Rögnvaldur Hannesson
OPEC Energy Review, June 2012, Pages 125-137
Abstract:
An error correction model is estimated for the spot versus 12 months futures price of Brent Blend. Whether or not speculation in the futures market has been driving the spot price is examined by testing for Granger causality; if the futures price Ganger causes the spot price and not the other way around, it is an indication that speculation in the futures market is influencing the spot price. We find this to be the case for the recent changes in the oil price, both for the run-up to the price peak of July 2008, the subsequent abrupt fall, and the rise from early 2009 to May 2011.
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John Griffin, Tao Shu & Selim Topaloglu
Review of Financial Studies, forthcoming
Abstract:
Institutions often have access to corporate inside information through their connections, but relatively little is known about the extent to which they exploit their informational advantage through short-term trading. We employ broker-level trading data to systematically examine possible cases of connected trading. Despite examining the issue from multiple angles, we are unable to find much evidence to support that investment bank clients take advantage of connections through takeover advising, IPO and SEO underwriting, or lending relationships. In contrast to recent academic literature and popular press, our findings suggest that institutional investors are reluctant to use inside information in traceable manners.
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David Tuckett
Journal of Economic Dynamics and Control, August 2012, Pages 1077-1087
Abstract:
Fifty-two research interviews were conducted with money managers controlling over $500 billion. This paper presents detailed material from one interview to argue interviews usefully describe their shared reality and provide information about the conditions of action facing financial decision-makers with implications for aggregate behaviour. Their shared reality was dominated by "radical" uncertainty and information ambiguity which severely limited the scope for "fully rational" decision-making. How they managed to commit to decisions was by creating narratives. The study suggests it may be useful to reconsider prejudices against the usefulness of talking to individual economic agents about what they actually do.
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Marc Oliver Rieger
Journal of Behavioral Finance, Spring 2012, Pages 108-118
Abstract:
We study the influence of systematic probability misestimation on complex financial investment decisions on the context of structured financial products. Structured products have become more and more complex. We study the question whether this complexity might be a sophisticated method to exploit systematic biases in probability estimation of investors in order to make products look safer and more attractive than they actually are. We present results of an experiment that focused on probability estimates in the context of certain classes of structured products, in particular barrier reverse convertibles, bonus certificates, and worst-of basket certificates. We find that behavioral biases, for example, the conjunction fallacy, increase the subjective attractiveness of these product types. We also investigate potential ways to de-bias investors by providing additional information.
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Curbing the Dangers of High-Frequency Trading
Matthew Clements
The Economists' Voice, April 2012
Abstract:
High-frequency trading, as distinct from other forms of algorithmic trading, is of little or no social value. Implementation of resting rules would retain the benefits of algorithmic trading while eliminating the potential harm of high-frequency trading.
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Does Going Public Affect Innovation?
Shai Bernstein
Harvard Working Paper, January 2012
Abstract:
This paper investigates the effects of going public on innovation. Using a novel data set consisting of innovative firms that filed for an initial public offering (IPO), I compare the long-run innovation of firms that completed their filing and went public with that of firms that withdrew their filing and remained private. I use NASDAQ fluctuations during the book-building period as a source of exogenous variation that affects IPO completion but is unlikely to affect long-run innovation. Using this instrumental variables approach, I find that going public affects firms' strategies in pursuing innovation. The quality of internal innovation declines by 50 percent relative to firms that remained private, measured by standard patent-based metrics. The decline in innovation is driven by both an exodus of skilled inventors and a decline in productivity among remaining inventors. However, access to public equity markets allows firms to partially offset the decline in internally generated innovation by attracting new human capital and purchasing externally generated innovations through mergers and acquisitions. Managerial incentives seem to play an important role in explaining the results.
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The sources of value destruction in acquisitions by entrenched managers
Jarrad Harford, Mark Humphery-Jenner & Ronan Powell
Journal of Financial Economics, forthcoming
Abstract:
Prior work has established that entrenched managers make value-decreasing acquisitions. In this study, we determine how they destroy that value. Overall, we find that value destruction by entrenched managers comes from a combination of factors. First, they disproportionately avoid private targets, which have been shown to be generally associated with value creation. Second, when they do buy private targets or public targets with blockholders, they tend not to use all-equity offers, which has the effect of avoiding the transfer of a valuable blockholder to the bidder. We further test whether entrenched managers simply overpay for good targets or choose targets with lower synergies. We find that while they overpay, they also choose low synergy targets in the first place, as shown by combined announcement returns and post-merger operating performance.
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Product Market Efficiency: The Bright Side of Myopic, Uninformed, and Passive External Finance
Thomas Noe, Michael Rebello & Thomas Rietz
Management Science, forthcoming
Abstract:
We model the effect of external financing on a firm's ability to maintain a reputation for high quality production. Producing high quality is first best. Defecting to low quality is tempting because it lowers current costs while revenue remains unchanged because consumers and outside investors cannot immediately observe the defection. However, defection to low quality impairs the firm's reputation, which lowers cash flows and inhibits production over the long term. Financing via short-term claims discourages defection to low quality because the gains from defection are mostly captured by outside investors through an increase in the value of their claims. Therefore, if the firm relies on short-term external financing, it is more likely to produce over the long run, produce high-quality goods, and enjoy high profitability. The aggregate results from a laboratory experiment generally accord with these predictions.
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Nina Rosenbusch, Jan Brinckmann & Verena Müller
Journal of Business Venturing, forthcoming
Abstract:
Researchers and practitioners frequently propose that venture capital (VC) is an important resource to increase the performance of funded firms, especially in environments of uncertainty. In this paper we scrutinize these theoretical propositions, following an evidence-based research approach. We synthesize 76 empirical samples on 36,567 firms. We find a small positive performance effect of VC investment on funded firm performance; however, the effect vanishes if researchers control for industry selection effects. Furthermore, we find that the performance effect mainly relates to firm growth while profitability is unaffected. We also uncover that performance effects are reduced when the funded firms are very young or very mature. In addition, studies focusing on IPO events, which constitute the majority of studies, determine a substantially smaller performance effect. We discuss theoretical implications and offer suggestions for future research on VC.
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Money Illusion and Nominal Inertia in Experimental Asset Markets
Charles Noussair, Gregers Richter & Jean-Robert Tyran
Journal of Behavioral Finance, Winter 2012, Pages 27-37
Abstract:
We test whether large but purely nominal shocks affect real asset market prices. We subject a laboratory asset market to an exogenous shock, which either inflates or deflates the nominal fundamental value of the asset while holding the real fundamental value constant. After an inflationary shock, nominal prices adjust upward rapidly, and we observe no real effects. However, after a deflationary shock, nominal prices display considerable inertia and real prices adjust only slowly and incompletely toward the levels that would prevail in the absence of a shock. Thus, an asymmetry is observed in the price response to inflationary and deflationary nominal shocks.
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Corporate Strategy, Analyst Coverage, and the Uniqueness Paradox
Lubomir Litov, Patrick Moreton & Todd Zenger
Management Science, forthcoming
Abstract:
In this paper, we argue that managers confront a paradox in selecting strategy. On one hand, capital markets systematically discount uniqueness in the strategy choices of firms. Uniqueness in strategy heightens the cost of collecting and analyzing information to evaluate a firm's future value. These greater costs in strategy evaluation discourage the collection and analysis of information regarding the firm, and result in a valuation discount. On the other hand, uniqueness in strategy is a necessary condition for creating economic rents and should, except for this information cost, be positively associated with firm value. We find empirical support for both propositions using a novel measure of strategy uniqueness in a firm panel data set between 1985 and 2007.
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Do Managers Always Know Better? The Relative Accuracy of Management and Analyst Forecasts
Amy Hutton, Lian Fen Leey & Susan Shuz
Journal of Accounting Research, forthcoming
Abstract:
We examine the relative accuracy of management and analyst forecasts of annual EPS. We predict and find that analysts' information advantage resides at the macroeconomic level. They provide more accurate earnings forecasts than management when a firm's fortunes move in concert with macroeconomic factors such as gross domestic product and energy costs. In contrast, we predict and find that management's information advantage resides at the firm level. Their forecasts are more accurate than analysts' when management's actions, which affect reported earnings, are difficult to anticipate by outsiders, such as when the firm's inventories are abnormally high, the firm has excess capacity, or is experiencing a loss. While analysts are commonly viewed as industry specialists, we fail to find evidence that analysts have an information advantage over managers at the industry level. The two have comparable abilities to forecast earnings for firms with revenues or earnings that are more synchronous with their industries.
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Corporate visibility and executive pay
Bruce Rayton, Stephen Brammer & Suwina Cheng
Economics Letters, forthcoming
Abstract:
This paper seeks evidence of implicit regulation of executive pay. The implicit regulation hypothesis suggests highly-visible companies will constrain their behavior to avoid potential reprisals from constituents, politicians and potential regulators. We extend this literature using a measure of corporate visibility based on the number of news stories about each firm in a balanced panel of 242 public companies.
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Gambling Preference and the New Year Effect of Assets with Lottery Features
James Doran, Danling Jiang & David Peterson
Review of Finance, July 2012, Pages 685-731
Abstract:
This paper shows that a New Year's gambling preference of individual investors impacts prices and returns of assets with lottery features. January call options, especially the out-of-the-money calls, have higher retail demand and are the most expensive and actively traded. Lottery-type stocks outperform their counterparts in January but tend to underperform in other months. Retail sentiment is more bullish in lottery-type stocks in January than in other months. Furthermore, lottery-type Chinese stocks outperform in the Chinese New Year's Month but not in January. This New Year effect provides new insights into the broad phenomena related to the January effect.
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Dirk Baur
Research in International Business and Finance, forthcoming
Abstract:
This paper studies recurring annual events potentially introducing seasonality into gold prices. We analyze gold returns for each month from 1980 to 2010 and find that September and November are the only months with positive and statistically significant gold price changes. This "autumn effect" holds unconditionally and conditional on several risk factors. We argue that the anomaly can be explained with hedging demand by investors in anticipation of the "Halloween effect" in the stock market, wedding season gold jewelery demand in India and negative investor sentiment due to shorter daylight time. The autumn effect can also be characterized by a higher unconditional and conditional volatility than in other seasons.
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Not paying dividends? A decomposition of the decline in dividend payers
Candra Chahyadi & Jesus Salas
Journal of Economics and Finance, April 2012, Pages 443-462
Abstract:
Current payout policy literature contends that firms' propensity to pay dividends declined between 1978 and 1998. Using the Oaxaca decomposition methodology, we measure changes in the propensity to pay dividends between 1978 and 1998. Results suggest that firms today have only a slightly lower propensity to pay dividends. Furthermore, when we also categorize firms that use stock repurchases as dividend payers, we find that 100% of the decline in the proportion of dividend payers can be explained by changes in firm characteristics only. The difference is that firms that firms are now repurchasing stock instead of paying dividends.