(PDF | 368 KB) (PDF | 414 KB) (PDF | 484 KB) (PDF | 243 KB) (PDF | 255 KB) (PDF | 411 KB) (PDF | 135 KB) (PDF | 252 KB) (PDF | 280 KB)Over the crisis-rich 1997 to 2005 period, we document new time-series and cross-sectional evidence which suggests a sizable flight-to-quality- and liquidity-related variation in the correlations and mean returns across stocks and T-Bonds. Our collective results support the premise of a "searching" in the relative valuation of stocks and bonds during times of market stress. First, higher levels of stock implied volatility (IV) and stock illiquidity and higher time-series variability in stock IV are associated with both: (1) a much lower correlation in the subsequent returns of stock and T-bond returns, and (2) much greater time-series variability in the subsequent stock IV and illiquidity values. Second, daily stock returns are negatively and appreciably related to the contemporaneous stock IV change, and more-liquid stocks exhibit both: (1) greater responsiveness to the IV change, and (2) a more negative stock-bond correlation in stressful times. Third, stock IV changes are positively related to the T-bond returns. Finally, when stock IV is relatively high, the subsequent mean returns and turnover are relatively greater for portfolios of more-liquid stocks, as compared to portfolios of less-liquid stocks.
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We document a striking new regularity in the dynamics of winner-minus-loser (WML) stock return spreads, based on past relative return strength; and high-minus-low (HML) stock return spreads, based on book-to-market equity ratios. Specifically, we find that time-variation in the stock market's cross-sectional return dispersion (RD) is negatively related to the subsequent change in WML spreads and positively related to the subsequent change in HML spreads, where `change' is defined relative to recent realized spreads. These patterns are reliably evident and economically sizable at the 6, 18, and 36-month spread horizon. We present additional evidence to assist in interpretation, including findings that RD is informative about the likelihood of state changes in a regime-switching estimation on stock returns. Collectively, our results suggest that the stock market's RD is a leading indicator of market-state changes and that market cyclicality is important in understanding WML.
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We study the stock exchange rivalry between the New York Stock Exchange (NYSE) and the Consolidated Stock Exchange (Consolidated) from 1885 to 1926 using a new database of bid-ask spreads and stock data collected from The New York Times and other primary sources. The magnitude of this important, but largely forgotten rivalry was substantial. From 1885 to 1895, the ratio of Consolidated to NYSE volume averaged 40 percent and reached as high as 60 percent. The market share of the Consolidated averaged 23 percent for approximately 40 years. The Consolidated focused on the relatively liquid securities on the NYSE as measured by bid-ask spreads and trading volume. Our results suggest that NYSE bid-ask spreads fell by more than 10 percent when the Consolidated began to trade NYSE stocks while bid-ask spreads for our quasicontrol group of stocks trading on the Boston Stock Exchange remain unchanged. The effect persisted over the entire history of the stock market rivalry until a series of scandals and investigations of the Consolidated by state regulators led to the demise of the exchange in the 1920s. The analysis suggests three conclusions: (1) the NYSE has faced significant long-run competition (2) the NYSE may be susceptible to a similar level of competition in the future and (3) that the Consolidated may have improved the efficiency of stock prices by contributing to the price discovery process.
Stock prices may provide valuable information for a public firm's managers. In this paper, we examine whether managers listen to the market in making major corporate investments, and whether agency costs and corporate governance mechanisms help explain managers' propensity to listen. We find that, on average, managers listen to the market: they are more likely to cancel investments when the market reacts unfavorably to the related announcement. Further, while we have some difficulty identifying precisely which governance mechanisms are most important, we find some evidence consistent with the notion that managers' propensity to listen is related to agency costs. We find that firms tend to listen to the market more when more of their shares are held by large blockholders, and when their CEOs have higher pay-performance sensitivities.
We develop a new proxy for divergence of opinion to use in examining how this phenomenon affect cross-sectional asset returns for different stocks with different arbitrage costs. We generalize Tauchen and Pitts' (1983) well-known Mixture of Distribution Hypothesis (MDH), which links asset volume and volatility in a way that derives a proxy for divergence of opinion among all individual investors. This new measure can more directly capture the information of divergence of opinion among all individual investors than other proxies, such as the dispersion in analyst's earnings forecasts and turnover. In our empirical asset pricing analysis, we incorporate the crucial role of divergence of opinion in determining cross-sectional asset returns and establish that when divergence of opinion is high, stock prices tend to be biased upward, resulting in lower future returns. These effects are especially pronounced for stocks with higher arbitrage costs, such as idiosyncratic risks, short sale costs, and other transaction costs, which are more difficult and costly to short sell. Our results support Miller's (1977) view that, given short-sale constraints, observed prices overweight optimistic valuations. The predictions of recent theoretical work, such as Hong and Stein (2003), are valid only for stocks with lower arbitrage costs. Also, our results suggest that idiosyncratic risk, relative to other arbitrage cost measures, incrementally explains the effect of the divergence of opinion on stock returns.
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This paper considers the effect of private information on the returns to stocks with high levels of short interest. I use a measure from the market microstructure literature to proxy for levels of asymmetric information. Among highly shorted firms, portfolios with high levels of informed trading generally underperform, while those with low levels of informed trading do not. The results suggest that the underperformance of high short interest stocks is driven by firms that have high levels of informed trading. However, this negative relationship between informed trading and returns is reversed for stocks with low to moderate short interest levels.
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We provide the first comprehensive study on the impact of the Sarbanes-Oxley Act (SOX) on corporate boards using broad sample evidence from more than 7,000 public companies as well as detailed analysis of smaller subsamples. Post-SOX boards are larger and more independent. Director workload and risk increased: audit committees meet more than twice as often post SOX as they did pre SOX, and Director and Officer (D&O) insurance premiums more than doubled. SOX also had a dramatic affect on the makeup of the corporate director pool: more post-SOX directors are lawyers/consultants, financial experts and retired executives and fewer are current executives. These changes drove a large increase in the cost of the board, particularly for small firms. For example, small firms paid $3.19 in director fees per $1,000 of net sales in 2004, which is $0.84 more than they paid in 2001 and $1.21 more than in 1998. In contrast, large firms paid $0.32 in director fees per $1,000 of net sales in 2004, seven cents more than they paid in 2001 and ten cents more than in 1998. Overall, our evidence suggests that SOX had a dramatic impact on corporate boards and the cost thereof.
This paper shows that acquirer returns are significantly positively associated with target-specific factors that make the target more difficult to value and that increase the information asymmetry between the acquirer and target about the target's value. However, this is true only when the acquirer uses the optimal acquisition contract in the face of one-sided information asymmetry. We demonstrate that acquirer announcement returns in a sample of acquisitions of privately held targets, where information asymmetry is likely to be a considerable problem, are significantly higher when acquirers use stock as the method of payment and the target firm is in a development stage or has a balance sheet laden with intangible and difficult-to-value assets. While our sample only contains acquisitions of privately held target firms, our results have broader implications for the relation between the value of acquisitions for acquirers and the degree of opacity of the target's information environment.
We test for the winner's curse in the corporate takeover market by studying the effect of takeover competition on bidder returns. Our measure of takeover competition comes from a unique data set on the private auction process that occurs prior to the public announcement of a takeover. For a sample of 308 takeovers announced in the 1989 to 1999 period, we find that the returns to bidders are not significantly related to takeover competition. The results hold after controlling for size and deal characteristics that have been shown to affect bidder returns and are also robust to a variety of proxies for takeover competition. Our findings do not support the existence of a winner's curse in the corporate takeover market. Related analysis indicates that prestigious investment banks temper any tendency toward overbidding.
Using a comprehensive sample of nearly 7,000 firms from 1990 to 2004, this paper examines corporate board structure, its trends and its determinants. We study how board structure has evolved over time and, more importantly, we compare board structure across small and large firms in ways suggested by new theoretical work. Overall, our evidence suggests that firms structure their boards in response to the costs and benefits of board monitoring and advising. Our models explain as much as 45% of the observed variation in board structure. Further, small and large firms have dramatically different board structures. In addition, while board size was falling in the 1990s, this trend was reversed after the implementation of mandated reforms.
We study the movement of assets from private to public ownership through two alternative means: the acquisition of private companies by firms that are public (sellouts) or by initial public share offerings (IPOs). We consider firm-specific characteristics for 1,074 IPOs and 735 sellouts from 1995 through 2004 to identify differences in growth, capital constraints and asymmetric information between the two types of transactions. Our results suggest that firms move to public ownership through an IPO when they have greater growth opportunities, more capital constraints and are easier to value. Previous analyses of U.S. companies have focused on broad aggregate and industry-level trends while our work allows a better understanding of the firm-specific characteristics leading to firms choosing to go public through an IPO and the costs of accessing the public capital markets.
Firm management typically claims that voluntary accounting method changes (VACs) are made to enhance the informativeness of earnings by better matching accounting practices with economic reality. In contrast, skeptics argue that managers adopt new accounting procedures to opportunistically manage earnings and influence their firm's stock price. In this paper, we investigate whether VACs temporarily drive equity prices away from their fundamental values by examining the long-run stock price performance for a sample of firms that voluntarily change accounting methods. In contrast to prior research, we find little evidence that a strategy based solely on the earnings effect of a VAC can generate abnormal returns. While we do find some weak evidence of post-VAC abnormal returns for extreme VACs, our evidence suggests that this result is driven by the accruals anomaly as documented in Sloan (1996).
The most important development in international corporate governance in the past 20 years has been the privatization of state-owned enterprises. There is evidence that privatization has resulted in improved firm performance but the source of this improvement is difficult to isolate. We argue that one of the most important results of privatization for corporate governance is the potential entry of those firms into the market for corporate control as targets and bidders, which can result in improved firm performance for numerous reasons. We document the magnitude and the wealth effects of the mergers of privatized firms, attempting to find every privatized firm that was either a target or a bidder in a merger. We find 52 privatized firms that subsequently become targets of takeovers and 90 privatized firms that became bidders in 341 mergers. In general, we find that privatized firms operate very much as non-privatized firms have in the market for corporate control. Target firms experience a 12 percent increase in equity value at the announcement of a merger. Bidding firms experience a positive but insignificant change in equity value at merger announcement. The results indicate that mergers result in net wealth creation for privatized firms and are indicative that one effect of privatization is wealth-creating mergers.
Agency theory implies that asset ownership and decision authority are complements. Using 1998 data from Texas commercial banks, we test whether the likelihood of local ownership of bank offices increases with the importance of granting local managers greater decision authority (for example, due to location or customer base). Our empirical evidence is consistent with this hypothesis. It suggests that complementarities between strategy and organizational structure can foster differentiation among firms in terms of location, customers, and products. It also supports the growing view that small locally-owned banks have a comparative advantage over large banks within specific environments.
Public firms that place equity privately experience positive announcements effects, with negative post-announcement stock-price performance. This finding is inconsistent with the underreaction hypothesis. Instead, it suggests that investors are overoptimistic about the prospects of firms issuing equity, regardless of the method of issuance. Further, in contrast to public offerings, private issues follow periods of relatively poor operating performance. Thus, investor overoptimism at the time of private issues is not due to the behavioral tendency to overweight recent experience at the expense of long-term averages.
In standard portfolio theory, an investor's only goal is to pursue a portfolio return maximization strategy. But in this paper, we consider another type of investor whose goal is to build, more broadly, a suitable portfolio taking additional factors into account. For instance, in addition to portfolio return, such an investor may wish to monitor his or her portfolio with regard to the proportion of portfolio return derived from dividends, the maximum amount invested in any security, short selling, the number of securities involved, social responsibility, and so forth. To accommodate such an investor, we develop a multiple criteria portfolio selection formulation, corroborate its appropriateness by examining the sensitivity of the nondominated frontier to various factors, and observe the conversion of the nondominated frontier to a nondominated surface. Furthermore, multiple criteria enable us to provide an explanation as to why the market portfolio," so often found deep below the nondominated frontier, is roughly where one would expect it to be with multiple criteria. After commenting on approaches for searching nondominated surfaces, the paper concludes with the idea that what is the modern portfolio theory"
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For researchers intending to investigate mid- to large-scale portfolio selection, good, inexpensive and understandable quadratic parametric programming software, capable of computing the efficient frontiers of problems with up to two thousand securities without simplifications to the covariance matrix, is hardly known to be available anywhere. As an alternative to Markowitz's critical line method, a full explication of a simplex-based quadratic parametric programming procedure, utilizing well-known components, is coded in Java for public domain use on modern desktops and laptops. The advantage of the different design is to provide an algorithm that can ultimately be extended (not a part of this paper) to portfolio problems with objectives beyond mean and variance. Using the code, aspects of portfolio selection problems are investigated and computational experience is reported.
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In portfolio selection, there is often the need for procedures to generate \realistic" covariance matrices for security returns, for example to test and benchmark optimization algorithms. For application in portfolio optimization, such a procedure should allow the entries in the matrices to have distributional characteristics which we would consider realistic" for security returns. Deriving motivation from the fact that a covariance matrix can be viewed as stemming from a matrix of factor loadings, a procedure is developed for the random generation of covariance matrices (a) whose o-diagonal (covariance) entries possess a pre-specified expected value and standard deviation and (b) whose main diagonal (variance) entries possess a likely different pre-specified expected value and standard deviation. The paper concludes with a discussion about the futility one would likely encounter if one simply tried to invent a valid covariance matrix in the absence of a procedure such as in this paper.
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Over the past decades, the complexity of financial decisions has increased rapidly, thus highlighting the importance of developing and implementing sophisticated and efficient quantitative analysis techniques for supporting and aiding financial decision making. Multicriteria decision aid (MCDA), an advanced branch of operations research, provides financial decision makers and analysts with a wide range of methodologies well suited for the complexity of modern financial decision making. The aim of this chapter is to provide an in-depth presentation of the contributions of MCDA in finance focusing on the methods used, applications, computation, and directions for future research.
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This paper provides a categorized bibliography on the application of the techniques of multiple criteria decision making (MCDM) to problems and issues in finance. A total of 265 references have been compiled and classified according to the methodological approaches of goal programming, multiple objective programming, the analytic hierarchy process (AHP), etc., and to the application areas of capital budgeting, working capital management, portfolio analysis, etc. The bibliography provides an overview of the literature on "MCDM combined with finance," shows how contributions to the area have come from all over the world, facilitates access to the entirety of this heretofore fragmented literature, and underscores the often multiple criterion nature of many problems in finance.
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