Review of Financial Studies - recent issues

Editorial Board

2009-06-17

Forthcoming Articles

2009-06-17

Is the Market for Mortgage-Backed Securities a Market for Lemons?

Downing, C., Jaffee, D., Wallace, N. — 2009-06-17

This paper models and provides empirical evidence for the quality of assets that are securitized through bankruptcy remote special purpose vehicles (SPVs). The model predicts that assets sold to SPVs will be of lower quality ("lemons") compared to assets that are not sold to SPVs. We find strong empirical support for this prediction using a comprehensive data set of sales of mortgage-backed securities (Freddie Mac Participation Certificates, or PCs) to SPVs over the period 1991 through 2002. Valuation estimates based on a structural two-factor model indicate that PCs sold to SPVs are on average valued $0.39 lower per $100 of face value relative to PCs not so sold. For the four largest coupon groups in our full sample of Freddie Mac PCs, we find a "lemons spread" of 4–6 basis points in terms of yield-to-maturity, and this spread accounts for 13–45% of the overall prepayment spread of these securities.

Are "Market Neutral" Hedge Funds Really Market Neutral?

Patton, A. J. — 2009-06-17

Using a variety of different definitions of "neutrality," this study presents significant evidence against the neutrality to market risk of hedge funds in a range of style categories. I generalize standard definitions of "market neutrality," and propose five different neutrality concepts. I suggest statistical tests for each neutrality concept, and apply these tests to a database of monthly returns on 1423 hedge funds from five style categories. For the "market neutral" style, approximately one-quarter of the funds exhibit significant exposure to market risk; this proportion is statistically significantly different from zero, but less than the proportion of significant exposures for other hedge fund styles.

How Smart Are the Smart Guys? A Unique View from Hedge Fund Stock Holdings

Griffin, J. M., Xu, J. — 2009-06-17

Compared to mutual funds, hedge funds prefer smaller, opaque value securities, and have higher turnover and more active share bets. Decomposing returns into three components, we find that hedge funds are better than mutual funds at stock picking by only 1.32% per year on a value-weighted basis, and this result is insignificant on an equal-weighted basis or with price-to-sales benchmarks. Hedge funds exhibit no ability to time sectors or pick better stock styles. Surprisingly, we find only weak evidence of differential ability between hedge funds. Overall, our study raises serious questions about the perceived superior skill of hedge fund managers.

New Measures for Performance Evaluation

Cherny, A., Madan, D. — 2009-06-17

This paper characterizes performance measures satisfying a set of proposed axioms. We develop four new measures consistent with the axioms and show that they improve on the economic properties of the Sharpe Ratio and the Gain-Loss Ratio. In our treatment, the performance measures, or the indexes of acceptability, are linked to positive expectations resulting from a stressed sampling of the cash-flow distribution. Theoretically, it is shown that the level of acceptability varies directly with the amount of stress tolerated. In an empirical application, the performance measures are applied to cash flows generated by writing options on the SPX and the FTSE. This exercise reveals that acceptability levels are U-shaped in the strike direction.

Liquidity and Market Crashes

Huang, J., Wang, J. — 2009-06-17

In this paper, we develop an equilibrium model for stock market liquidity and its impact on asset prices when constant market presence is costly. We show that even when agents' trading needs are perfectly matched, costly market presence prevents them from synchronizing their trades and hence gives rise to endogenous order imbalances and the need for liquidity. Moreover, the endogenous liquidity need, when it occurs, is characterized by excessive selling of significant magnitudes. Such liquidity-driven selling leads to market crashes in the absence of any aggregate shocks. Finally, we show that illiquidity in the market leads to high expected returns, negative and asymmetric return serial correlation, and a positive relation between trading volume and future returns. We also propose new measures of liquidity based on its asymmetric impact on prices and demonstrate a negative relation between these measures and expected stock returns.

The "Wall Street Walk" and Shareholder Activism: Exit as a Form of Voice

Admati, A. R., Pfleiderer, P. — 2009-06-17

We examine whether a large shareholder can alleviate conflicts of interest between managers and shareholders through the credible threat of exit on the basis of private information. In our model, the threat of exit often reduces agency costs, but additional private information need not enhance the effectiveness of the mechanism. Moreover, the threat of exit can produce quite different effects depending on whether the agency problem involves desirable or undesirable actions from shareholders' perspective. Our results are consistent with empirical findings on the interaction between managers and minority large shareholders and have further empirical implications.

Risk Shifting versus Risk Management: Investment Policy in Corporate Pension Plans

Rauh, J. D. — 2009-06-17

The asset allocation of defined benefit pension plans is a setting where both risk-shifting and risk-management incentives are likely be present. Empirically, firms with poorly funded pension plans and weak credit ratings allocate a greater share of pension fund assets to safer securities such as government debt and cash, whereas firms with well-funded pension plans and strong credit ratings invest more heavily in equity. These relations hold both in pooled regressions and within firms and plans over time. The incentive to limit costly financial distress plays a considerably larger role than risk shifting in explaining variation in pension fund investment policy among firms in the United States.

Testing Portfolio Efficiency with Conditioning Information

Ferson, W. E., Siegel, A. F. — 2009-06-17

We develop asset pricing models’ implications for portfolio efficiency with conditioning information in the form of lagged instruments. A model identifies a portfolio that should be minimum-variance efficient with respect to the conditioning information. Our framework refines tests of portfolio efficiency by using the given conditioning information optimally. The optimal use of the lagged variables is economically important; by using the instruments optimally, we reject several efficiency hypotheses that are not otherwise rejected. The Sharpe ratios of a sample of hedge fund indexes appear consistent with the optimal use of conditioning information.

Optimal Filtering of Jump Diffusions: Extracting Latent States from Asset Prices

Johannes, M. S., Polson, N. G., Stroud, J. R. — 2009-06-17

This paper provides an optimal filtering methodology in discretely observed continuous-time jump-diffusion models. Although the filtering problem has received little attention, it is useful for estimating latent states, forecasting volatility and returns, computing model diagnostics such as likelihood ratios, and parameter estimation. Our approach combines time-discretization schemes with Monte Carlo methods. It is quite general, applying in nonlinear and multivariate jump-diffusion models and models with nonanalytic observation equations. We provide a detailed analysis of the filter's performance, and analyze four applications: disentangling jumps from stochastic volatility, forecasting volatility, comparing models via likelihood ratios, and filtering using option prices and returns.

Time-Varying Risk Premiums and the Output Gap

Cooper, I., Priestley, R. — 2009-06-17

The output gap, a production-based macroeconomic variable, is a strong predictor of U.S. stock returns. It is a prime business cycle indicator that does not include the level of market prices, thus removing any suspicion that returns are forecastable due to a "fad" in prices being washed away. The output gap forecasts returns both in-sample and out-of-sample, and it is robust to a host of checks. We show that the output gap also has predictive power for excess stock returns in other G7 countries and U.S. excess bond returns.

On Loan Sales, Loan Contracting, and Lending Relationships

Drucker, S., Puri, M. — 2009-06-17

This paper examines the secondary market for loan sales and, in particular, loan contract design as a mechanism to resolve informational issues in loan sales and associated costs and benefits. Using loan-level data, we find that sold loans contain additional covenants and more restrictive net worth covenants, particularly when agency and informational problems are more severe. Why do borrowers agree to incur the additional costs associated with loan sales? Our evidence suggests that these borrowers benefit through increased private debt availability. Further, loan sales go hand in hand with more durable lending relationships, suggesting that risk management aids continued relationship lending.

Corruption, Political Connections, and Municipal Finance

Butler, A. W., Fauver, L., Mortal, S. — 2009-06-17

We show that state corruption and political connections have strong effects on municipal bond sales and underwriting. Higher state corruption is associated with greater credit risk and higher bond yields. Corrupt states can eliminate the corruption yield penalty by purchasing credit enhancements. Underwriting fees were significantly higher during an era when underwriters made political contributions to win underwriting business. This pay-to-play underwriting fee premium exists only for negotiated bid bonds where underwriting business can be allocated on the basis of political favoritism. Overall, our results show a strong impact of corruption and political connections on financial market outcomes.

Big Business Owners in Politics

Bunkanwanicha, P., Wiwattanakantang, Y. — 2009-05-14

This paper investigates a little studied but common mechanism that firms use to obtain state favors: business owners themselves seeking election to top office. Using Thailand as a research setting, we find that the more business owners rely on government concessions or the wealthier they are, the more likely they are to run for top office. Once in power, the market valuation of their firms increases dramatically. Surprisingly, the political power does not influence the financing strategies of their firms. Instead, business owners in top offices use their policy-decision powers to implement regulations and public policies favorable to their firms. Such policies hinder not only domestic competitors but also foreign investors. As a result, these politically connected firms are able to capture more market share.

The Economics of Fraudulent Accounting

Kedia, S., Philippon, T. — 2009-05-14

We argue that earnings management and fraudulent accounting have important economic consequences. In a model where the costs of earnings management are endogenous, we show that in equilibrium, low-productivity firms hire and invest too much in order to pool with high productivity firms. This behavior distorts the allocation of economic resources in the economy. We test the predictions of the model using firm-level data. We show that during periods of suspicious accounting, firms hire and invest excessively, while managers exercise options. When the misreporting is detected, firms shed labor and capital and productivity improves. Our firm-level results hold both before and after the market crash of 2000. In the aggregate, our model provides a novel explanation for periods of jobless and investment-less growth.

Market Liquidity and Funding Liquidity

Brunnermeier, M. K., Pedersen, L. H. — 2009-05-14

We provide a model that links an asset's market liquidity (i.e., the ease with which it is traded) and traders' funding liquidity (i.e., the ease with which they can obtain funding). Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and margin requirements, depends on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to "flight to quality," and (v) co-moves with the market. The model provides new testable predictions, including that speculators' capital is a driver of market liquidity and risk premiums.

Asset Returns and the Listing Choice of Firms

Baruch, S., Saar, G. — 2009-05-14

We propose a mechanism that relates asset returns to the firm's optimal listing choice. We use a theoretical model to show that a stock will be more liquid when it is listed on a market where "similar" securities are traded. We empirically examine the implications of our model using New York Stock Exchange (NYSE) and Nasdaq securities. We find that the return patterns of stocks that switch markets become more similar to the return patterns of securities listed on the new market prior to the switch. Stocks that are eligible to switch but stay put are more similar to securities listed on their market than to securities listed on the other market. Our results suggest that managers make listing decisions that enhance the liquidity of their firms' stocks.

How Noise Trading Affects Markets: An Experimental Analysis

Bloomfield, R., O'Hara, M., Saar, G. — 2009-05-14

We use a laboratory market to investigate the behavior of traders who lack informational advantages and have no exogenous reason to trade. We find that these uninformed traders behave largely as irrational contrarian "noise traders," trading against recent price movements to their own detriment. The uninformed traders provide some benefits to the market: increasing market volume and depth, while reducing bid-ask spreads and the temporary price impact of trades. However, their noise trading also diminishes the ability of market prices to adjust to new information. A securities transaction tax reduces uninformed trader activity, but it reduces informed trader activity by approximately the same amount; as a result, the tax does not alter the impact of noise trading on the informational efficiency of the market.

The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns When Agents Differ in Risk Aversion

Bhamra, H. S., Uppal, R. — 2009-05-14

We study the effect of introducing a nonredundant derivative on the volatilities of the stock market return and the locally risk-free interest rate. Our analysis uses a standard, frictionless, full-information, dynamic, continuous-time, general-equilibrium, Lucas endowment economy in which there are two classes of agents who have time-additive power utility functions and differ only in their risk aversion. Our main result is to show analytically that if the intensity of the precautionary demand for savings is not too high, then the introduction of a nonredundant derivative increases the volatility of stock market returns. Furthermore, in the economy with the derivative, the volatility of stock market returns can be substantially greater than that of aggregate dividend growth (fundamental volatility). We also show that the volatility of the locally risk-free interest rate increases with the introduction of the derivative.

Do Politically Connected Boards Affect Firm Value?

Goldman, E., Rocholl, J., So, J. — 2009-05-14

This article explores whether political connections are important in the United States. The article uses an original hand-collected data set on the political connections of board members of S&P 500 companies to sort companies into those connected to the Republican Party and those connected to the Democratic Party. The analysis shows a positive abnormal stock return following the announcement of the nomination of a politically connected individual to the board. This article also analyzes the stock-price response to the Republican win of the 2000 presidential election and finds that companies connected to the Republican Party increase in value, and companies connected to the Democratic Party decrease in value.

Investment, Financing Constraints, and Internal Capital Markets: Evidence from the Advertising Expenditures of Multinational Firms

Fee, C. E., Hadlock, C. J., Pierce, J. R. — 2009-05-14

We find a significant positive relation between a firm's advertising spending in the United States and its contemporaneous foreign cash flow. This relation holds even after controlling for factors that should be related to the optimal level of domestic advertising, and it is stronger for subsets of firms that we expect to be relatively more financially constrained. Our evidence supports the hypothesis that there is a causal and economically substantial link between cash flow and investment spending, even for intangible investments such as advertising. Our evidence also suggests that firms have active internal capital markets in which capital is moved across geographic regions.

The Long-Term Effects of Cross-Listing, Investor Recognition, and Ownership Structure on Valuation

King, M. R., Segal, D. — 2009-05-14

We show that investor recognition and bonding associated with a U.S. cross-listing are distinct effects using a sample of Canadian firms. In contrast to the post-listing decline documented in the literature, we find that cross-listed firms with a single class of shares enjoy a permanent increase in valuation if they attract and maintain investor recognition over time. Valuations of firms that fail to widen their U.S. shareholder base return to pre-listing levels within two years. Cross-listed firms with dual-class shares exhibit a permanent increase in valuation regardless of the level of U.S. investor holdings, consistent with firm-level bonding.

Dividends and Corporate Shareholders

Barclay, M. J., Holderness, C. G., Sheehan, D. P. — 2009-05-14

Corporations uniquely have a tax preference for cash dividends. Nevertheless, dividends do not increase following trades of large-percentage blocks of stock from individuals to corporations. Moreover, although one-third of firms have corporate blockholders, 68% of these firms pay no dividends, and ownership is not clustered at levels that increase the tax benefits of dividends. These findings are not driven by the investing firms’ tax rates or by agency problems. Instead, operating companies expand the target firms and pursue joint ventures. Dividends are lower with these investors. Financial investors are not attracted to dividend-paying firms and tend to be passive.

Incentives and Mutual Fund Performance: Higher Performance or Just Higher Risk Taking?

Massa, M., Patgiri, R. — 2009-04-07

We study the impact of contractual incentives on the performance of mutual funds. We find that high-incentive contracts induce managers to take more risk and reduce the funds’ probability of survival. Yet, funds with high-incentive contracts deliver higher risk-adjusted return, and the superior performance remains persistent. The top incentive quintile of funds outperforms the bottom quintile by 2.70% per year. Moreover, high-incentive winner funds from one year have a positive alpha of 0.41% per month in the following year. Focusing on funds’ holdings, we show that active portfolio rebalancing is the main channel through which incentives increase performance.

Ambiguity and Nonparticipation: The Role of Regulation

Easley, D., O'Hara, M. — 2009-04-07

We investigate the implications of ambiguity aversion for performance and regulation of markets. In our model, agents’ decision making may incorporate both risk and ambiguity, and we demonstrate that nonparticipation arises from the rational decision by some traders to avoid ambiguity. In equilibrium, these participation decisions affect the equilibrium risk premium, and distort market performance when viewed from the perspective of traditional asset pricing models. We demonstrate how regulation, particularly regulation of unlikely events, can moderate the effects of ambiguity, thereby increasing participation and generating welfare gains. Our analysis demonstrates how legal systems affect participation in financial markets through their influence on ambiguity.

Insider Trading Laws and Stock Price Informativeness

Fernandes, N., Ferreira, M. A. — 2009-04-07

We investigate the relation between a country’s first-time enforcement of insider trading laws and stock price informativeness using data from 48 countries over 1980–2003. Enforcement of insider trading laws improves price informativeness, as measured by firm-specific stock return variation, but this increase is concentrated in developed markets. In emerging market countries, price informativeness changes insignificantly after the enforcement, as the important contribution of insiders in impounding information into stock prices largely disappears. The enforcement does not achieve the goal of improving price informativeness in countries with poor legal institutions. It does turn some private information into public information, thereby reducing the cost of equity in emerging markets.

Distinguishing the Effect of Overconfidence from Rational Best-Response on Information Aggregation

Kogan, S. — 2009-04-07

This article studies the causal effect of individuals' overconfidence and bounded rationality on information aggregation by using a new multiperiod game in which agents are rewarded for submitting accurate estimates of an unknown asset's value based on (i) their private information and (ii) others' past estimates. By carrying out laboratory sessions of this game in which subjects' overconfidence is a treatment variable, I find that overconfidence affects the information aggregation process by increasing the dispersion of estimates and decreasing the rate of estimates' convergence. However, even when subjects are not overconfident, qualitatively similar deviations from the fully rational model predictions are observed. I show that this can be explained by subjects' strategic response to errors.

Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy?

DeMiguel, V., Garlappi, L., Uppal, R. — 2009-04-07

We evaluate the out-of-sample performance of the sample-based mean-variance model, and its extensions designed to reduce estimation error, relative to the naive 1/N portfolio. Of the 14 models we evaluate across seven empirical datasets, none is consistently better than the 1/N rule in terms of Sharpe ratio, certainty-equivalent return, or turnover, which indicates that, out of sample, the gain from optimal diversification is more than offset by estimation error. Based on parameters calibrated to the US equity market, our analytical results and simulations show that the estimation window needed for the sample-based mean-variance strategy and its extensions to outperform the 1/N benchmark is around 3000 months for a portfolio with 25 assets and about 6000 months for a portfolio with 50 assets. This suggests that there are still many "miles to go" before the gains promised by optimal portfolio choice can actually be realized out of sample.

Failure Is an Option: Impediments to Short Selling and Options Prices

Evans, R. B., Geczy, C. C., Musto, D. K., Reed, A. V. — 2009-04-07

Regulations allow market makers to short sell without borrowing stock, and the transactions of a major options market maker show that in most hard-to-borrow situations, it chooses not to borrow and instead fails to deliver stock to its buyers. A part of the value of failing passes through to options prices: when failing is cheaper than borrowing, the relation between borrowing costs and options prices is significantly weaker. The remaining value is profit to the market maker, and its ability to profit despite competition between market makers appears to result from the cost advantage of larger market makers.

Systematic Risk and the Price Structure of Individual Equity Options

Duan, J.-C., Wei, J. — 2009-04-07

This study demonstrates the impact of systematic risk on the prices of individual equity options. The option prices are characterized by the level and slope of implied volatility curves, and the systematic risk is measured as the proportion of systematic variance in the total variance. Using daily option quotes on the S, and P 100 index and its 30 largest component stocks, we show that after controlling for the underlying asset's total risk, a higher amount of systematic risk leads to a higher level of implied volatility and a steeper slope of the implied volatility curve. Thus, systematic risk proportion can help differentiate the price structure across individual equity options.

A General Stochastic Volatility Model for the Pricing of Interest Rate Derivatives

Trolle, A. B., Schwartz, E. S. — 2009-04-07

We develop a tractable and flexible stochastic volatility multifactor model of the term structure of interest rates. It features unspanned stochastic volatility factors, correlation between innovations to forward rates and their volatilities, quasi-analytical prices of zero-coupon bond options, and dynamics of the forward rate curve, under both the actual and risk-neutral measures, in terms of a finite-dimensional affine state vector. The model has a very good fit to an extensive panel dataset of interest rates, swaptions, and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities.

Margin Trading, Overpricing, and Synchronization Risk

Bhojraj, S., Bloomfield, R. J., Tayler, W. B. — 2009-04-07

We provide experimental evidence that relaxing margin restrictions to allow more short selling can exacerbate overpricing, even though it reduces equilibrium price levels. This is because smart-money traders initially profit more by front-running optimistic investor sentiment than by disciplining prices. When short selling is not possible, competitive pressures among arbitrageurs rapidly drive prices to the equilibrium. However, the risk of margin calls slows the convergence process, because arbitrageurs who sell short too early face substantial losses if they are unable to synchronize their trades with other arbitrageurs (as in Abreu and Brunnermeier. 2002. Journal of Financial Economics 66(2–3):341–60; 2003. Econometrica 71(1):173–204).

Financial Analysts' Performance: Sector Versus Country Specialization

Sonney, F. — 2009-04-07

Brokerage houses normally structure their research activities along either country or sector lines. I investigate whether organizational structure affects the quality of financial analysts' earnings forecasts. Specifically, I compare the performance of country-specialized financial analysts with that of sector-specialized financial analysts. The former issue forecasts considerably more accurately than the latter. Country specialists benefit from an informational advantage over sector specialists. A superior knowledge of country-specific factors, as well as geographical proximity between analysts and the firms they cover, are significant determinants of this advantage.