2006 Working Papers

Papers are listed alphabetically by UCLA Anderson faculty. To search by keyword, use the Find feature on your browser.

Are Executive Stock Option Exercises Driven by Private Information?
David Aboody, John Hughes, Jing Liu & Wei Su

We examine the extent to which executive stock option exercises may be driven by private information. Contrary to the maintained assumption in prior literature that all shares acquired though exercises are immediately sold, we found that no shares are sold within thirty days following approximately half of the exercises. Generally speaking, we find strong evidence that executives are exploiting positive private information when they exercise the options but hold the shares beyond thirty days, and weaker evidence that they are exploiting negative private information when they exercise the options and sell the shares within thirty days. To increase the power of tests, especially on the negative side, we consider several factors that may be important to executives when making exercise decisions. Along with the exploitation of private information, these include dividend and tax incentives to exercise early, opportunity costs of early exercise due to the loss of time value in options, and reduction of diversifiable risk and concomitant disguise in potential law suits offered by claims of diversification when options are deeply in the money. We find strong evidence that executive's trading gains are positively correlated with time value and depth. Further findings support the conclusion that executives exploit positive private information by holding options as well as by exercising options and holding the shares.

Cognitive Dissonance in Negotiation: Free Choice or Counter-Attitudinal Justification?
Corinne Bendersky & Jared R. Curhan

Previous research suggests that negotiators inflate their valuation for offers they make and devalue offers they choose not to make due to the psychological process of cognitive dissonance reduction. Research outside of the negotiation context suggests that cognitive dissonance is induced either by being forced to choose among relatively equal options or by having to justify a counter-attitudinal position. A negotiation involves both choice and justification, so it is unclear which process is responsible for inducing cognitive dissonance or preference inflation. We present two studies in which the effect of choosing an opening offer is disentangled from the effects of justifying that choice. Findings indicate that choice and justification have an additive effect on negotiator preference change. We discuss implications of these results for cognitive dissonance theory and the practice of negotiation.

Growth Options, Beta and the Cost of Capital
Antonio Bernardo, Bhagwan Chowdhry and Amit Goyal

We show how to decompose a firm's beta into its beta of assets-in-place and its beta of growth opportunities. Our empirical results demonstrate that the beta of growth opportunities is greater than the beta of assets-in-place for virtually all industries over all periods of time dating back to 1977. The difference has important implications for determining the cost of capital. For example, when choosing comparables to determine project beta one should match the growth opportunities of the project with those of the comparable firm. Assuming a 6% market equity risk premium, accounting for growth opportunities alters the project cost of capital by as much as 2 to 3%.

Motivating Entrepreneurial Activity in a Firm
Antonio E. Bernardo, Hongbin Cai & Jiang Luo

We consider the problem of motivating privately informed managers to engage in entrepreneurial activity to improve the quality of the firm's investment opportunities. The firm's investment and compensation policy must balance the manager's incentives to provide entrepreneurial effort and to report her private information truthfully. The optimal policy is to underinvest (compared to first-best) and provide weak incentive pay in low-quality projects and overinvest (compared to first-best) and provide strong incentive pay in high-quality projects. We also show that, unlike the standard agency model, uncertainty and incentives can be positively related.

The Impact of Feature Advertising on Customer Store Choice
V. Seenu Srinvasan & Anand V. Bodapati

A heavily used competitive tactic in the grocery business is the weekly advertising of price reductions in newspaper inserts and store fliers. Store managers commonly believe that advertisements of price reductions and loss leaders help to build store traffic by diverting customers from competing stores, thereby increasing store volume and profitability. It is therefore not surprising that grocery retail planners across competing stores expend considerable thought on what items to advertise each week and at what levels of prominence. What is surprising, however, is that we marketing scientists do not know much about the manner and extent to which feature advertising in a competitive environment influences where and how customers shop. The marketing science literature has not even been able to establish that feature advertising has a substantial impact on store choice, let alone the more operational question of which categories are better at drawing consumers away from one store and into a competing store. In this paper we employ a stochastic choice modeling framework to propose and empirically estimate a disaggregate, consumer-level model of the effects of feature advertising on store choice. We use this model to understand which categories are more influential drivers of store traffic and better at diverting consumers from competing stores.

Dollar Cost Averaging
Michael J. Brennan, Feifei Li & Walter Torous

Dollar Cost Averaging is a strategy for purchasing equity securities that is widely recommended by professional investment advisors and commentators, but which has been virtually ignored by academic theorists and textbook writers. In this paper we explore whether the strategy is but another instance of irrational behavior by individual investors, or whether it is an investment heuristic that has survival value in an environment in which security prices exhibit mean reversion behavior that has only belatedly been recognized by academic theorists. Our evidence supports the view that the individual investors who follow this strategy in purchasing individual stocks to add to an existing portfolio are better off than if they followed the 'rational' strategies traditionally recommended by academics."

International Capital Markets and Foreign Exchange Risk
Michael J. Brennan and Yihong Xia

Relations between foreign exchange risk premia, exchange rate volatility, and the volatilities of the pricing kernels for the underlying currencies, are derived under the assumption of integrated capital markets. As predicted, the volatility of exchange rates is significantly associated with the estimated volatility of the relevant pricing kernels, and foreign exchange risk premia are significantly related to the estimated volatility if the pricing kernels and the volatility of exchange rates. The estimated foreign exchange risk premia mostly satisfy Fama's (1984) necessary conditions for explaining the forward premium puzzle, but the puzzle remains in several cases even after taking account of the pricing kernel volatilities.

Option Pricing Kernels and the ICAPM
Michael J. Brennan, Xiaoquan Liuy & Yihong Xia

We estimate the parameters of pricing kernels that depend on both aggregate wealth and state variables that describe the investment opportunity set, using FTSE 100 and S&P 500 index option returns as the returns to be priced. The coefficients of the state variables are highly significant and remarkably consistent across specifications of the pricing kernel, and across the two markets. The results provide further evidence that, consistent with Merton's (1973) Intertemporal Capital Asset Pricing Model, state variables in addition to market risk are priced.

Brand Competition in CPG Industries: Sustaining Large Local Advantages with Little Product Differentiation
Bart J. Bronnenberg

In direct competition between national brands of consumer packaged goods (CPG), one brand often has a large local share advantage over the other despite that the products are similar. I present an explanation for these large and persistent advantages in the context of local competition on perceived quality or brand image. The main result of the analysis is a relation between varying degrees of horizontal product differentiation and local share advantages. Namely, I find that local share advantages can be sustained especially if competing brands are objectively similar. Conversely, local share advantages can not be sustained if brands are dissimilar. This paper provides two independent intuitions for this result. First, if brands are objectively similar, different levels of investments in local quality perceptions can co-exist in the same market. Specifically, if it pays to do so, early movers will invest in high perceived quality. Late movers have reduced incentives to invest because of subsequent demand sharing and price competition. Second, if the perceived quality advantages are geographically distributed across competitors, the above argument is reinforced by multimarket contact. Even if local "brand building" is free, firms have an incentive to sustain asymmetric market shares because, holding total demand constant, multimarket profits are increasing in share variation, i.e., monopoly power, across regions. This increase is steeper when the products are similar, because price competition looms large.

Market Structure and the Geographic Distribution of Brand Shares in Consumer Package Goods Industries
Bart J. Bronnenberg, Sanjay K. Dhar & Jean-Pierre Dube

We describe industrial market structure using a unique database spanning 31 consumer package goods (CPG) industries, 39 months, and the 50 largest US metropolitan markets. We organize our description of market structure around the notion that firms can improve brand perceptions through advertising investments, as in Sutton's endogenous sunk cost theory. In the data, observed advertising levels escalate (i.e. larger brands) in larger markets while the number of advertised brands within an industry remains stable. Correspondingly, observed concentration levels in advertising-intensive industries are bounded away from zero irrespective of market size. For two industries, we collect historic order-of-entry data. The geographic distribution of entry is found to account for the levels, rank-orders and covariation in the geographic distribution of brand shares, perceived brand qualities and advertising effort. Interestingly, alternative potential sources of geographic asymmetry on both the supply and demand sides do not mimic the geographic patterns of shares. In general, our findings highlight several striking persistent geographic patterns in the industrial market structures of CPG industries.

Measuring Consumer Switching to a New Brand across Local Markets
Paulo Albuquerque & Bart J. Bronnenberg

We estimate local demand for new brands of consumer packaged goods (CPG), identify its underlying sources, and explore cross-market patterns in substitution to the new product using aggregate level data. We show that the standard choice-based demand model overestimates the degree of consumer switching to a new brand and underestimates consumer heterogeneity in a market. We introduce a model and an estimation procedure to avoid these problems. The approach augments the market-level time series with widely available summaries of household switching behavior. This data also has the benefit that it is informative about the size of the outside good. The latter allows us to estimate the size of the total market rather than assume it. Empirically, we use data from the Frozen Pizza Category to estimate our model. The data cover the launch of a new national brand, DiGiorno. We find that this new brand was very successful at targeting consumers from outside of the category and that cannibalization of existing brand share was largely avoided. We also find that substitution patterns and perceptions of brand similarity are different across markets. We explore the cross-market variation in switching patterns and find that local pre-entry share, and local branding explain a large part of how much an incumbent looses to the new entrant. In contrast, we find only very small national brand effects on switching to the new brand. Therefore, the origins of demand for the new brand are not common to markets.

Retrieving Unobserved Consideration Sets from Household Panel Data
Erjen van Nierop, Richard Paap, Bart J. Bronnenberg, Philip Hans Franses & Michel Wedel

We propose, operationalize and estimate a new model to capture unobserved consideration from discrete choice data. This model consists of a multivariate binary choice model component for consideration and a multinomial probit model component for choice, given consideration. The approach allows one to analyze stated consideration set data, revealed consideration set (choice) data or both, while at the same time it allows for unobserved dependence in consideration among brands. In addition, the model can easily cope with many brands, and accommodates different effects of the marketing mix on consideration and choice, and unobserved consumer heterogeneity in both processes. We attempt to establish the validity of existing practice to infer consideration sets from observed choices in panel data. To this end, we collect data in an on-line choice experiment involving interactive supermarket shelves and post-choice questionnaires to measure the choice protocol and stated consideration levels. We show with these experimental data that underlying consideration sets can be reliably retrieved from choice data alone and that consideration is positively affected by display and shelf space. We also find that consideration does not covary greatly across brands once we account for observed effects and unobserved heterogeneity.

Pricing and Market Segmentation for Software Upgrades
Ram Bala & Scott Carr

Upgrades are endemic in the software industry and create the possibility that customers might either postpone purchase or buy early on and never upgrade: When will a customer upgrade? Is it better to upgrade now or to wait for an improved version? When should we release an improved product? How much should we charge for each version? Should we give discounts on upgrades to existing customers? Will today's sales be cannibalized by the anticipated improved version? We focus on pricing and how it is affected by the degree to which a product is improved between versions. In particular, we are interested how the firm should price different versions of its product and whether it should offer "upgrade discounts" to existing customers. To address these issues, we analyze a two-period model in which a firm sells an initial version of its product in the first period and an improved version the second. In each period, the firm (i.e., the software supplier) selects the selling prices, and customers decide whether to purchase. Customers may purchase the product in either or both periods and, at the firm's discretion, are given a discounted price if they repurchase/upgrade in the second period. We solve this model for subgame perfect equilibrium prices and purchasing decisions and investigate how equilibrium prices, profits, and cash flows are influenced by the degree of product improvement. We also uncover a number of managerial insights; for example, equilibrium pricing induces all of the first period purchasers to upgrade to the improved product in the second period.

Pricing of Software Services
Ram Bala & Scott Carr

We analyze and compare fixed-fee and usage-fee software pricing schemes - in fixed-fee pricing, all users pay the same price; in usage-fee pricing, the users' fees depend on the amount that they use the software (e.g., the user of an online-database service might be charged for each data query). We employ a two-dimensional model of customer heterogeneity - specifically, we assume that customers vary in the amount that they will use the software (usage heterogeneity) and also in their per-use valuation of the software. To understand the performance of these pricing schemes and their sensitivity to the competitive environment in which they are used, we look at a number of different scenarios: a monopolist offering just one of these schemes, a monopolist offering a choice of pricing schemes, and several duopoly scenarios. We characterize and compare the equilibria that arise in these scenarios and provide insights into optimal pricing strategies.

Information in Equity Markets with Ambiguity Averse Investors
Judson A. Caskey

Investors in equity markets tend to use highly aggregated financial information. For example, share prices react strongly to summary measures of performance such as reported earnings while financial analysts issue fairly coarse information in the form of buy-sell recommendations, price targets and earnings forecasts. The aggregation of signals increases equity premiums in an economy with subjective expected utility maximizers because it reduces information content in the sense of Blackwell. I show that information aggregation reduces the equity premium when the market includes ambiguity averse investors who face uncertainty about the joint distribution of payoffs and signals. The benefit to aggregation arises because a reduction in ambiguity compensates for the loss of information.

Franchising Microfinance
Bhagwan Chowdhry & Amit Bubna

Financial intermediaries worldwide are seeking mechanisms for participating in micro lending. We consider a simple model where a bank may use informed local capitalists as agents for on-lending. But the availability of multiple credit sources provides borrowers with an incentive to default voluntarily, making the bank's on-lending mechanism a non-starter. We argue that a franchising model of on-lending that offers a commitment technology for lenders to not lend to a borrower who has defaulted on a loan from another franchisee, may be effective. Under this mechanism, the borrower is better off having both the moneylender and franchisee lenders to borrow from. Interestingly, the borrower is induced to borrow from the moneylender first even though some franchisee would have charged a lower interest rate. But if the success of such a mechanism were to attract a large number of competing banks to offer separate franchises, the market for on-lending would once again fail. These results have important policy implications.

Organization Capital and Intrafirm Communication
Bhagwan Chowdhry & Mark J. Garmaise

We present a dynamic model of production in which a firm's output increases when its managers share ideas. Communication of ideas depends on the quality of the firm's internal language. We prove that firms with richer languages, i.e., more organizational capital, will have higher market values. Organizational capital generates static complementarities among incumbents which implies that firms with larger organization capital will experience greater employee retention, insider managerial succession and higher wages. Dynamic complementarities between inter-temporal investments in organization capital generate long-run persistence in firm market-to-book and turnover ratios. We demonstrate that the optimal compensation of incumbents includes an earnings-insensitive component that is larger in firms with larger organization capital. In a simple model of mergers, we show that the most value-creating mergers are those between firms with very different levels of organization capital.

Possibility of dying as a unified explanation of why we discount the future, get weaker with age and display risk-aversion
Bhagwan Chowdhry

A number of evolutionary theories have been proposed to explain the phenomenon of aging or senescence or why we get weak as we get older (see the review article by Gavrilov and Gavrilova, 2002). Economists have also begun to explore the biological basis of preferences, such as discounting of future consumption (Rogers, 1994), that are usually taken as primitive (see a comprehensive article by Robson, 2002). In this paper, I formulate a simple and parsimonious evolutionary model that shows that because most species face a possibility of dying because of external factors, called extrinsic mortality in the biology literature, it can simultaneously explain (i) why we discount the future, ii) get weaker with age and (iii) display risk-aversion.

Innovation, Competition and Welfare-Enhancing Monopoly
Michael R. Darby & Lynne G. Zucker

The basic competitive model with freely available technology is suited for static industries but misleading as applied to major innovative economies for which development of new technologies equals in magnitude around 10% of gross domestic investment. We distinguish free generic technology from proprietary technologies resulting from risky investment with uncertain outcome. The totality of possible outcomes drives the national innovation system and the returns to a particular successful technology cannot be compared to its own direct investment costs. Eureka moments are hardly ever self-enabling and incentives are required to motivate investment attempting to turn them into an innovation. The alternative to a valuable proprietary innovation is not the same innovation freely available but the unchanged generic technology. Growth is concentrated in any country at any time in a few firms in a few industries that are achieving metamorphic technological progress as a result of breakthrough innovations.

So long as the entry and exit of firms using the generic technology sets the price in an industry, one or more price-taking firms can coexist with proprietary technologies yielding more or less substantial quasi-rents to the sunk development costs. Consumer welfare is increased if an innovator creates a proprietary technology such that the market equilibrium price is reduced and output increased. If the technological breakthrough is sufficiently large for the innovator to drive all generic producers out of the industry and increase output as a wealth-maximizing monopolist, consumer welfare is surely increased. After some time, the innovative technology will diffuse into an imitative generic technology. The best innovators develop a stream of innovations so that technological leaders can maintain their status as dominant firm or monopolist for extended periods of time despite lagged diffusion, and consumers benefit from this stream as well. The economics of an innovative nation are different from those of the no-growth stationary state which we teach and fall back on. We propose an ambitious agenda to integrate major research streams treating innovation as an object of economic analysis into our standard models.

Movement of Star Scientists and Engineers and High-Tech Firm Entry
Lynne G. Zucker & Michael R. Darby

This paper extends the concept of star scientist to all areas of science and technology. We follow careers 1981-2004 for 5,401 stars as identified in ISIHighlyCited.comSM, using their publication history to locate them each year. The number of stars in a U.S. region or in one of the top-25 science and technology countries generally has a consistently significant and quantitatively large positive effect on the probability of firm entry in the same area of science and technology. Other measures of academic knowledge stocks have weaker and less consistent effects. Thus the stars themselves rather than their potentially disembodied discoveries play a key role in the formation or transformation of high-tech industries. We identify separate economic geography effects in poisson regressions for the 179 BEA-defined U.S. regions, but not for the 25 countries analysis. Stars become more concentrated over time, moving from areas with relatively few peers to those with many in their discipline. A special counter-flow operating on the U.S. versus the other 24 countries is the tendency of foreign-born American stars to return to their homeland when it develops sufficient strength in their area of science and technology. In contrast high impact articles and university articles and patents all tend to diffuse, becoming more equally distributed over time.

Churn, Baby, Churn: Strategic Dynamics Among Dominant and Fringe Firms in a Segmented Industry
John M.P. de Figueiredo & Brian S. Silverman

This paper integrates and extends the literatures on industry evolution and dominant firms to develop a dynamic theory of dominant and fringe competitive interaction in a segmented industry. It argues that a dominant firm, seeing contraction of growth in its current segment, enters new segments to exploit its technological strengths, but segments sufficiently distant to avoid cannibalization. The dominant firm acts as a low-cost Stackelberg leader, driving down prices and triggering a sales takeoff in the new segment. We identify a "churn" effect associated with dominant firm entry: fringe firms that precede the dominant firm into the segment tend to exit the segment, while new fringe firms enter, causing a net increase in the number of firms in the segment. As the segment matures and sales decline in the segment, the process repeats itself. We examine the predictions of the theory with a study of price, quantity, entry and exit across 24 product classes in the desktop laser printer industry from 1984 through 1996. Using descriptive statistics, hazard rate models, and panel data methods, we find empirical support for most of the theoretical predictions.

Congress and the Political Expansion of the U.S. District Courts
John M.P. de Figueiredo, Gerald S. Gryski , Emerson H. Tiller & Gary Zuk

Expanding the number of U.S. district judgeships is often justified as a response to expanding caseloads. Increasing judgeships during unified government, however, allows Congress and the President to engage in political (patronage and ideological) control of the federal district courts. This paper examines empirically the relative importance of caseload pressure and political motives for Congress to expand the number of federal district judgeships. We demonstrate that politics dominates the timing of judgeship expansion in the U.S. District Courts. We also show that both politics and caseload affect the actual size of those timed expansions. In particular, we find that before 1970, Congress seemed to have strong political motivations for the size of an expansion. After 1970, Congress became much more attentive to caseload considerations.

E-Rulemaking: Bringing Data to Theory at the Federal Communications Commission
John M.P. de Figueiredo

This paper examines the theoretical promise of e-rulemaking with an examination of data about all filings at the Federal Communications Commission (FCC) from 1999 to 2004. The paper first reviews the theoretical and empirical literature on e-rulemaking. It then analyzes a dataset of all filings at the FCC using descriptive statistics and regression analysis to determine what drives e-filings and whether the theoretical promise of e-rulemaking is being realized six years into the experiment. The paper finds that though there has indeed been a long-term trend away from paper filings and toward electronic filings, citizen participation seems not to have increased from earlier time periods. Rather, e-filing has become a marginal change to the rulemaking process and merely another avenue by which interested parties file comments.

External Imbalances In An Advanced, Commodity-Exporting Country: The Case Of New Zealand
Sebastian Edwards

During the last three years New Zealand has faced increasingly large external imbalances. The current account deficit has increased from 4.3% of GDP in 2003 to almost 9.0% of GDP in 2005. During the same period the country's net international investment position (NIIP) went from a negative level equivalent to 78.5% of GDP to negative 89% of GDP. In this paper I analyze the potential consequences of New Zealand's external imbalances. More specifically, I investigate what is the probability that New Zealand will undergo a costly adjustment characterized by an abrupt and large current account reversal. I find that to an important extent the (very) negative NIIP and (very) large current account deficit may be explained by New Zealand's very close economic relationship with Australia. The econometric results suggest that the rapid growth in the deficit during the last few years has (greatly) increased New Zealand's vulnerability to "contagion." It has also increased the advantage of the country's current floating exchange rate regime.

Monetary Unions, External Shocks and Economic Performance: A Latin American Perspective
Sebastian Edwards

During the last few years there has been a renewed analysis in currency unions as a form of monetary arrangement. This new interest has been largely triggered by the Euro experience. Scholars and policy makers have asked about the optimal number of currencies in the world economy. They have analyzed whether different countries satisfy the traditional "optimal currency area" criteria. These include, among other: (a) the synchronization of the business cycle; (b) the degree of factor mobility; and (c) the extent of trade and financial integration. In this paper I analyze the desirability of a monetary union from a Latin American perspective. First, I review the existing literature on the subject. Second, I use a large data set to analyze the evidence on economic performance in currency union countries. I investigate these countries' performance on four dimensions: (a) whether countries without a national currency have a lower occurrence of "sudden stop" episodes; (b) whether they have a lower occurrence of "current account reversal" episodes; (c) what is their ability to absorb international terms of trade shocks; and (d) what is their ability to absorb "sudden stops" and "current account reversals" shocks. I find that belonging to a currency union has not lowered the probability of facing a sudden stop or a current account reversal. I also find that external shocks have been amplified in currency union countries. The degree of amplification is particularly large when compared to flexible exchange rate countries.

Temporary Import Tariffs, the Real Exchange Rate and the Current Account
Sebastian Edwards

In this paper a general equilibrium intertemporal model with optimizing consumers and producers is developed to analyze how the imposition of a temporary import tariff affects the path of real exchange rates and the current account. The model is completely real, and considers a small open economy that produces and consumes three goods each period. It is shown that, without imposing rigidities or adjustment costs, interesting paths for the equilibrium real exchange rate can be generated. In particular "equilibrium overshooting" can be observed. Precise conditions under which a temporary import tariff will worsen the current account in period 1 are derived. Several ways in which the model can be extended are discussed.

The Relationship Between Exchange Rates and Inflation Targeting Revisited
Sebastian Edwards

This paper deals with the relationship between inflation targeting and exchange rates. I address three specific issues: first, I analyze the effectiveness of nominal exchange rates as shock absorbers in countries with inflation targeting. This issue is closely related to the magnitude of the "pass-through" coefficient. Second, I investigate whether exchange rate volatility is different in countries with an inflation targeting regime than in countries with alternative monetary policy arrangements. And third, I discuss whether the exchange rate should play a role in determining the monetary policy stance under inflation targeting. An alternative way of posing this question is whether the exchange rate should have an independent role in an open economy Taylor rule.

The U.S. Current Account Deficit: Gradual Correction or Abrupt Adjustment?
Sebastian Edwards

In this paper I use a large multi-country data set to analyze the determinants of abrupt and large "current account reversals." The results from a variance-component probit model indicate that the probability of experiencing a major current account reversal is positively affected by larger current account deficits, lower prices of exports relative to imports, and expansive monetary policies. On the other hand, this probability is lower for more advanced countries, and for countries with flexible exchange rates. An analysis of the marginal effects of current account deficits and of the predicted probability of reversal indicates that both have increased significantly for the U.S. since 1999. However, the level of this probability is still on the low side. I estimate that the predicted probability of a current account reversal in the U.S. has increased from 1.7% in 1999, to 14.9% in 2006.

Losses Loom Larger than Gains in the Brain: Neural loss aversion predicts behavioral loss aversion
Sabrina M. Tom, Craig R. Fox, Christopher Trepel, & Russell A. Poldrack

One of the most robust phenomena in behavioral studies of decision making is loss aversion, the tendency for people to exhibit greater sensitivity to losses than to equivalent sized gains. We measured brain activity while individuals decided whether to accept or reject gambles without feedback. This design isolated activity reflecting decisions without contamination by the anticipation or experience of impending monetary gains or losses. A broad neural network (including midbrain dopaminergic regions and their limbic and cortical targets) showed increasing activity as the potential gain increased, whereas an overlapping set of regions showed decreasing activity as the potential loss increased. Thus, potential losses did not engage a separate set of emotional brain systems, but were instead represented by decreasing activity in several gainsensitive areas. Moreover, these regions exhibited neural loss aversion as shown by their greater sensitivity to losses than gains. Finally, individual differences in behavioral loss aversion were predicted by a measure of neural loss aversion in several regions including ventral striatum and prefrontal cortex. These results provide the first neuroscientific evidence that risk aversion is driven by the brain's greater sensitivity to losses than gains.

Informed Investors and the Financing of Entrepreneurial Projects
Mark J. Garmaise

We consider a model of the financing of a small-business venture in which it is presumed that outside investors have greater expertise in project evaluation than the entrepreneur. We show that entrepreneurs and investors may restrict themselves to debt and junior equity (call option) contracts without loss of efficiency. A "pecking order" for new ventures is demonstrated, in which entrepreneurs prefer to be financed by junior equity rather than by debt. In addition, the model correctly predicts that large and successful venture-capital firms are likelier to hold debt stakes and makes untested predictions about the lending patterns of specialist banks.

Ties that Truly Bind: Non-competition Agreements, Executive Compensation and Firm Investment
Mark J. Garmaise

We study the effects of non-competition agreements by analyzing time series and cross-sectional variation in the enforceability of these contracts across U.S. states. We find that increased enforceability reduces executive compensation and shifts its form towards greater use of salary. We also show that tougher non-competition enforcement reduces research and development spending and capital expenditures per employee. Non-competition agreements promote executive stability and board participation, but higher quality managers apparently shun firms in high-enforcement jurisdictions. Our results have implications for theories of executive compensation and firm organization.

Sensation Seeking, Overconfidence, and Trading Adversity
Mark Grinblatt & Matti Keloharju

This study analyzes the role that two psychological attributes - sensation seeking and overconfidence - play in the tendency of investors to trade stocks. Equity trading data are combined with data from an investor's tax filings, driving record, and psychological profile. We use the data to construct measures of overconfidence and sensation seeking tendencies. Controlling for a host of variables, including wealth, income, age, number of stocks owned, marital status, and occupation, we find that overconfident investors and those investors most prone to sensation seeking trade more frequently.

Advertising Spending and Stock Return
Amit Joshi & Dominique M. Hanssens

The paper investigates one important aspect of long-term investor response to marketing actions, namely, the relationship between advertising spending and stock return. We hypothesize that advertising can have a direct effect on valuation, i.e. an effect over and above its known impact on revenue and profit response. The empirical results in two industries support our hypothesis and quantify the investor-response impact of advertising spending.

The Impact of Marketing-Induced vs. Word-of-Mouth Customer Acquisition on Customer Equity
Julian Villanueva, Shijin Yoo & Dominique M. Hanssens

Companies can acquire customers through costly but fast-acting marketing investments, or through slower but cheaper word-of-mouth processes. Their long-term success depends critically on the contribution that each acquired customer makes to overall customer equity. We propose and test an empirical model that captures these long-term effects. An application to a web hosting company reveals that marketing-induced customers add more short-term value, but word-of-mouth customers add nearly twice as much long-term value to the firm. We illustrate our findings with some dynamic simulations of the long-term impact of different resource allocations for acquisition marketing.

Marketing Spending and the Volatility of Revenues and Cash Flows
Marc Fischer, Hyun Shin & Dominique M. Hanssens

While effective marketing spending is known to improve a brand's financial performance, it can also increase the volatility of performance, which is not a desirable outcome. This paper analyzes how revenue and cash-flow volatility are influenced by own and competitive marketing spending volatility, by the level of marketing spending, by the effectiveness of own and competitive marketing spending, and by competitive reactivity. We develop hypotheses about the influence of these variables on revenue and cash-flow volatility that are rooted in market response theory. Based on a broad sample of 99 pharmaceutical brands in four clinical categories and four European countries, we test these hypotheses and assess the magnitude of the different sources of marketing-induced performance volatility. The results show that marketing spending policies have an impact on the level as well as the volatility of revenues and cash flows. Such performance volatility may incur negative financial side effects such as greater financing costs or higher opportunity costs of cash holdings. Our results offer new and surprising insights, as we demonstrate that common volatilityincreasing marketing practices such as advertising pulsing are effective at the top-line, but may turn out to be ineffective at the bottom-line.

Movie Advertising and the Stock Market Valuation of Studios
Amit M. Joshi & Dominique M. Hanssens

Major studios typically launch fewer than twenty motion pictures per year, so the financial performance of a single movie release can have a major effect on the studio's profitability. The Efficient Capital Markets hypothesis posits that the stock market would recognize such an impact. In this paper we study how single movie releases impact the investor valuation of the distributor. We analyze the change in post-launch stock price of a movie, and predict the direction and magnitude of excess returns based on the expectation built up for that movie. That expectation is set, in part, by media support, i.e. highly advertised movies are expected to draw larger audiences than others. By using an event study methodology, we isolate the impact of a movie launch on studio stock price, and track the determinants of that change. We examine a comprehensive dataset from 1995-1998 comprising over 300 movies released by the largest studios, including variables such as their media expenditures, production budget, MPAA ratings, opening and total gross revenues, critical ratings, number of screens at opening and beta excess stock return. Our results indicate that there exists a clear interaction between the marketing support received by a movie and the direction and magnitude of its excess stock return post launch. Movies with above-average advertising have lower post-launch stock returns than films with below-average advertising. Our findings also suggest that movies that are hits at the box office may result in a lowering of stock price if they had high media support, on account of high expectations build-up prior to launch. Thus pre-launch advertising plays a dual role of informing consumers about a movie's arrival as well as helping investors form expectations about the studio's profit performance.

Leading Indicators of Goodwill Impairment
Carla Hayn & Patricia J. Hughes

This paper examines whether currently available financial disclosures on acquired entities allow investors to effectively predict goodwill impairment, a task that has become more important following the recent abolishment of goodwill amortization. We track the performance of acquired companies through time from the year of the acquisition, using performance measures of the operating segment to which the acquired company's assets are allocated as well as characteristics of the acquisition. We find that available disclosures do not provide financial statement users with information to adequately predict future write-offs of goodwill. Further, the characteristics of the original acquisitions are more powerful predictors of eventual goodwill write-offs than those based on segment disclosures of the acquired entities' performance. On average, goodwill write-offs lag behind the economic impairment of goodwill by an average of three to four years. For a third of the companies examined, the delay can extend up to ten years.

Information Assymetry, Diversification and Cost of Capital
John Hughes, Jing Liu and Jun Liu

Recently, there has been considerable interest among accounting researchers in the relation between asymmetric information and cost of capital. A number of empirical studies document associations between proxies for asymmetric information such as earnings quality and risk premiums. However, the theoretical foundation for these studies has yet to be fully established. In this study, we consider the effects of private signals that are informative of both systematic factors and idiosyncratic shocks affecting asset payoffs in a competitive noisy rational expectations setting. Taking a large economy limit, we show that i) risk premiums equal products of betas and factor risk premiums, irrespective of information asymmetries; ii) holding total information constant, greater information asymmetry leads to higher factor risk premiums and thus higher costs of capital; and iv) controlling for betas, there is no cross-sectional effect of information asymmetries on cost of capital. These results provide guidance in interpreting the findings of existing empirical work and suggest specifications helpful for future research.

Convergence by Design: The Case of CalPERS in Japan
Sanford M. Jacoby

U.S. institutional investors are a key actor helping to diffuse shareholder-primacy precepts overseas, including to Japan. This study focuses on CalPERS, the public pension fund that is one of Japan's largest foreign equity investors. Using original sources, the article shows how CalPERS transferred to Japan the activist tactics and governance principles it developed in the United States. CalPERS had modest success in changing corporate governance law and practice in Japan. It faced opposition from big business and other groups skeptical that the CalPERS principles would improve corporate performance. Given this resistance as well as barriers to institutional and legal change, CalPERS turned to relational investing as a way of extracting greater value from its Japan investments. Although CalPERS seeks to create long-term value, it is also concerned with the distribution of value among corporate stakeholders. The article considers the distributional effects of governance change and urges continuing attention to this issue.

The Impact of Similar-Gender and Standard-Setting Career Referents on Expected Career Achievement
Donald E. Gibson & Barbara S. Lawrence

This study examines two questions concerning the impact of women's and men's career referents, the people they see as having similar careers, on expected career achievement. First, what is the relative effect of similar-gender and standard-setting career referents on individuals' expected career achievement? Second, what happens to expected career achievement when women and men select standard-setters at the same hierarchical level? Current research suggests that women have lower expected career achievement than men because they compare themselves with women who hold lower-level positions than the standard-setters selected by men. Thus, if women and men compared themselves with similar level standard-setters, their expected career achievement would be equal. However, this chain of reasoning has not been tested. Using data collected from a large organization, we employ a social network measure of career referents that identifies the specific individuals women and men perceive as having similar careers. The organization's personnel data are then used to assess these referents' hierarchical level. The results show that the hierarchical level of standard-setters is more important than the gender composition of career referents in explaining expected career achievement. In contrast to extant explanations, the results show that even when women select career referents at the same levels as men, they still exhibit significantly lower expected career achievement. Drawing on social comparison theory, we speculate this occurs because men's expectations are bolstered by extreme upward comparisons, whereas women's expectations are dampened, perhaps because they see high achieving others as representing a less probable goal.

Structure, Norms and Outcomes: Organizational Demography and Individual Careers
Barbara S. Lawrence & Pamela S. Tolbert

Careers, the evolving sequences of individuals' work experiences over time, and the factors that shape them, have long fascinated both popular and academic audiences (1989). Individuals want to know how their personal attributes, perhaps their intelligence, gender, or experience, propel them along the pathways they desire. They are curious about what sorts of organizational conditions facilitate mobility or produce barriers along the way. Organizations want to discern the conditions that allow them to attract and retain the best employees, and comprehend how internal and external labor markets affect the desirability of the career inducements they offer. Understanding the impact of organizational demography on individuals' career choices and on the opportunity structure that confronts them is relevant to both of these perspectives.

Cash Flow is King? Comparing Valuations Based on Cash Flow Versus Earnings Multiples
Jing Liu, Jacob K. Thomas & Doron Nissim

Contrary to the common perception that operating cash flows are better than accounting earnings at explaining equity valuations, recent studies suggest that valuations derived from industry multiples based on reported earnings are closer to traded prices than those based on reported operating cash flows. We extend those analyses to determine if the balance tilts in favor of cash flows when we consider a) forecasts rather than reported numbers, b) dividends rather than operating cash flows, c) individual industries rather than all industries combined, and d) firms in other markets beyond the U.S. Our main finding is that in all venues cash flows (both operating and dividends) are dominated by earnings. Our results imply that those seeking quick valuations should use multiples based on forecasted earnings, since they are remarkably close to traded prices.

On International Accounting Valuation
Jing Liu

This paper develops an accounting based equity valuation model for multinational firms, and uses the model to examine the forecasting and valuation properties of foreign currency gains and losses (TGL). It shows that TGL can be systematically decomposed into a core component and a transitory component; and because the two components are negatively correlated, the combined effect is that TGL is "more transitory" than transitory earnings, mapping into value with a weight between zero and one. The analysis helps to resolve the classical debate on the value relevance of TGL by showing that the opposing views are special cases of a more general framework.

On the Relation between Market and Analyst Forecast Inefficiencies
Jing Liu & Wei Su

We examine the relation between market and analyst forecast inefficiencies. Using a common set of public information variables, we find 1) both abnormal stock returns and analyst earnings forecast errors are predictable; 2) while future analyst forecast errors are positively correlated with the predictable component of abnormal returns, future abnormal returns are not significantly correlated with the predictable component of forecast errors; 3) in contemporaneous regressions of stock returns on analyst forecast errors, removing the predictable component of analyst forecast errors results in higher coefficient estimates and R2 values; but in the reverse regressions, removing the predictable component of stock returns does not generate a similar effect. Our results suggest an asymmetric relation between market and analyst forecast inefficiencies, and that analyst forecasts embed more inefficiency than market pricing. This conclusion has important implications for capital markets research and portfolio management.

Focusing on Desirability: The Effect of Decision Interruption and Suspension on Preferences
Wendy Liu

This research examines the phenomenon of interruptions and suspensions in decision making. It is proposed that an interruption may lead to a more top-down goal-directed mode of information processing, resulting in greater attention to the desirability rather than feasibility of options. Four studies found that when a decision is interrupted and later resumed, people are more likely to favor a highly desirable but less feasible product (study 1) and to choose a high-risk high-winning option in financial decisions (study 2). Further, in price-quality tradeoffs, interruption increases the choice of high-desirability high-price options and decreases price sensitivity (studies 3 and 4).

Risk and Return in Fixed Income Arbitrage: Nickels in Front of a Steamroller?
Jefferson Duarte, Francis A. Longstaff & Fan Yu

We conduct an analysis of the risk and return characteristics of a number of widely used fixed income arbitrage strategies. We find that the strategies requiring more "intellectual capital" to implement tend to produce significant alphas after controlling for bond and equity market risk factors. These positive alphas remain significant even after taking into account typical hedge fund fees. In contrast with other hedge fund strategies, many of the fixed income arbitrage strategies produce positively skewed returns. These results suggest that there may be more economic substance to fixed income arbitrage than simply "picking up nickels in front of a steamroller."

An Empirical Analysis of the Pricing of Collateralized Debt Obligations
Francis Longstaff and Arvind Rajan

We study the pricing of collateralized debt obligations (CDOs) using an extensive new data set for the actively-traded CDX credit index and its tranches. We find that a three-factor portfolio credit model allowing for firm-specific, industry, and economywide default events explains virtually all of the time-series and crosssectional variation in CDX index tranche prices. These tranches are priced as if losses of 0.4, 6, and 35 percent of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65 percent of the CDX spread is due to firm-specific default risk, 27 percent to clustered industry or sector default risk, and 8 percent to catastrophic or systemic default risk. Recently, however, firm-specific default risk has begun to play a larger role.

California's Lessons for Trade and Monetary Integration: Gains from Trade and Investment versus Fiscal Sovereignty
Daniel J.B. Mitchell

If one were looking for an attribute that characterized most countries for much of the 20th century, having a unique currency would be a good choice. Most countries issued their own currencies and determined their currency exchange rate regimes. But creation of the euro-zone within the E.U. represented a change in the concept of a country. Member nations in the euro-zone became akin to regions within traditional countries. Students in international economics courses are immediately introduced to David Ricardo's model of "comparative advantage." This model involves island economies whose only contact is through trade. The implication is that all countries have relative advantages, regardless of their absolute efficiencies. Given that starting point, economists tend to look askance at business types who speak instead of "competitive advantage," which suggests absolute efficiency and cost are important in the international context. Competitive advantage, in the economists' view, is a concept valid only within a country for competition between regions or firms. However, a major deviation from the Ricardian model has long been present: factor mobility. Capital is mobile, whether thought of in the financial sense or as trade in capital equipment. And labor mobility exists between countries, although labor is less mobile than capital. Once we add monetary integration to factor mobility, the concept of competitive (absolute) advantage becomes more and more relevant to international commerce.

Hubris, Learning, and M&A Decisions: Empirical Evidence
Nihat Aktas, Eric de Bodt, and Richard Roll

Recent empirical results have found a declining trend in the cumulative abnormal return (CAR) of acquiring firms during an M&A program. Should one conclude that CEOs undertaking M&As are infected by hubris and unable to learn? We first confirm the existence of this declining trend. However, we find a positive CAR trend for CEOs most likely to be infected by hubris and a negative (and significantly different) trend for likely rational CEOs. This supports the learning hypothesis and conforms to the theoretical analysis of Aktas et al. (2005). Moreover, the empirical evidence is broadly consistent with theoretical predictions about the implications of learning for the time between successive M&A deals. We conclude that CEO behavior reveals substantial learning during acquisition programs.

Is European M&A Regulation Protectionist?
Nihat Aktas, Eric de Bodt & Richard Roll

Why do regulatory authorities scrutinize mergers and acquisitions? The authorities themselves claim to be combating monopoly power and protecting consumers. But the last two decades of empirical research has found little supporting evidence for such motives. An alternative is that M&A regulation is actually designed to protect privileged firms. We provide a test of protectionism by studying whether European regulatory intervention is more likely when European firms are harmed by increased competition. Our findings raise a suspicion of protectionist motivations by the European regulator during the nineties. The results are robust to many statistical difficulties, including endogeneity between investor valuations and regulatory actions.

Earnings Announcements are Full of Surprises
Michael W. Brandt, Runeet Kishore, Pedro Santa-Clara & Mohan Venkatachalam

We introduce a new measure of the surprise in a company' earnings announcement: the stock's return around the announcement date. This Earnings Announcement Return (EAR) is driven by the unexpected information contained in the company's earnings release. Besides the actual earnings, this includes information about sales, margins, investment, and other less tangible information communicated around the earnings announcement. A strategy that buys and sells companies sorted on EAR produces an average abnormal return of 6.3% per year, 0.6% more than a strategy based on the traditional measure of earnings surprise. More important, the EAR strategy returns are concentrated in the earnings announcements in the four quarters after the surprise, which contrasts with the gradual return drift observed for strategies based on traditional measure of earnings surprise. In particular, around subsequent earnings announcement dates the EAR strategy earns a three-day abnormal return of about 3.3%, more than five times higher than that obtained for the SUE strategy. Moreover, the EAR and SUE strategies appear to be independent of each other. Consequently, a strategy that exploits both pieces of information generates abnormal returns of about 11% on an annual basis.

Accountability and Control in Buyer-Supplier Relationships
Richard Saouma

A recent trend in supply chain management is to purchase fully assembled systems from suppliers rather than ordering components. When purchasing assembled systems, a manufacturer can test the assembled unit and hold the supplier accountable for system failures; however she cannot control the assembly effort. On the other hand, when a manufacturer purchases components, she controls the assembly process, yet she may find it difficult to hold the suppliers accountable for the performance of the finished product. In this paper, I explore the manufacturer's delegation decision when her supplier has a liability constraint. My results are specific to the type of effort used to assemble systems. When systems can be assembled with only binary effort, the manufacturer prefers to assemble the system herself whenever feasible. However, if assembly effort is continuous, then delegation is optimal when the supplier's cost of producing high quality components is large and his liability constraint is lax. Surprisingly, I find that if the manufacturer cannot penalize the supplier for systems which pass testing but fail in the field, then delegation becomes even more attractive. Finally, I demonstrate that a manufacturer will always perform more testing when the supplier builds the system relative to when the manufacturer assembles the system.

A General Stochastic Volatility Model for the Pricing and Forecasting of Interest Rate Derivatives
Anders B. Trolle & Eduardo S. Schwartz

We develop a tractable and flexible stochastic volatility multi-factor model of the term structure of interest rates. It features correlations between innovations to forward rates and volatilities, quasi-analytical prices of zero-coupon bond options and dynamics of the forward rate curve, under both the actual and risk-neutral measure, in terms of a finite-dimensional affine state vector. The model has a very good fit to an extensive panel data set of interest rates, swaptions and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities. The model also performs well in forecasting interest rates and derivatives.

Illiquid Assets and Optimal Portfolio Choice
Eduardo S. Schwartz & Claudio Tebaldi

The presence of illiquid assets, such as human wealth, housing and a proprietorship substantially complicates the problem of portfolio choice. This paper is concerned with the problem of optimal asset allocation and consumption in a continuous time model when one asset cannot be traded. This illiquid asset, which depends on an uninsurable source of risk, provides a liquid dividend. In the case of human capital we can think about this dividend as labor income. The agent is endowed with a given amount of the illiquid asset and with some liquid wealth which can be allocated in a market where there is a risky and a riskless asset. The main point of the paper is that the optimal allocations to the two liquid assets and consumption will critically depend on the endowment and characteristics of the illiquid asset, in addition to the preferences and to the liquid holdings held by the agent. We provide what we believe to be the first analytical solution to this problem when the agent has power utility of consumption and terminal wealth. We also derive the value that the agent assigns to the illiquid asset. The risk adjusted valuation procedure we develop can be used to value both liquid and illiquid assets, as well as contingent claims on those assets.

Unspanned Stochastic Volatility and the Pricing of Commodity Derivatives
Anders B. Trolle & Eduardo S. Schwartz

We conduct a comprehensive analysis of unspanned stochastic volatility in commodity markets in general and the crude-oil market in particular. We present model-free results that strongly suggest the presence of unspanned stochastic volatility in the crude-oil market. We then develop a tractable model for pricing commodity derivatives in the presence of unspanned stochastic volatility. The model features correlations between innovations to futures prices and volatility, quasi-analytical prices of options on futures and futures curve dynamics in terms of a low-dimensional affine state vector. The model performs well when estimated on an extensive panel data set of crude-oil futures and options.

An Empirical Analysis of Stock and Bond Market Liquidity
Tarun Chordia, Asani Sarkar & Avanidhar Subrahmanyam

We study the joint time-series of daily liquidity in government bond and stock markets over the period 1991 to 1998. Innovations in liquidity are positively and significantly correlated across stock and bond markets. Further, order imbalances in the stock market impact bond and stock liquidity, even after controlling for order imbalances in the bond market. Both results suggest the existence of a common liquidity factor in stock and bond markets. We consider monetary conditions and mutual fund flows as sources of order flow and as primitive determinants of liquidity. Monetary expansion enhances stock market liquidity during crises. U.S. government bond funds see higher inflows and equity funds see higher outflows during financial crises, and these flows are associated with decreased liquidity in stock and bond markets. Our results establish a link between "macro" liquidity, or money flows, and "micro" or transactions liquidity.

Common Liquidity Risk and Market Collapse: Lessons from the Market for Perps
Chitru S. Fernando, Richard J. Herring & Avanidhar Subrahmanyam

We study the collapse of the market for perpetual floating rate notes (perps). The perp market was launched in 1984, and its first two years were characterized by explosive growth in which issues by high quality borrowers were placed with institutional investors and traded in liquid secondary markets. However, the perp market began collapsing precipitously in December 1986, due to the withdrawal of market intermediaries prompted by large order imbalances. Although most of the original perps remain outstanding, prices and liquidity have not recovered. We develop a model to explain the events observed in the perp market and to draw lessons on how commonality in liquidity can affect market performance and intermediary incentives. We provide new insights into how markets can collapse even in the absence of information asymmetry or bubbles. We also contribute to the corporate governance literature by providing a new rationale for placing securities with a broad investor base -- to minimize the possibility that common liquidity shocks will cause a market to fail.

Dual-Class Premium, Corporate Governance, and the Mandatory Bid Rule: Evidence from the Brazilian Stock Market
Andre Carvalhal da Silva and Avanidhar Subrahmanyam

This paper conducts a systematic analysis of the determinants of the relative price difference between voting and non-voting shares ("dual-class premium") within the context of a mandatory bid rule. This rule implies that the acquirer of a control block is also obliged to offer minority shareholders the same (or partially the same) price for their shares. In the presence of the rule, the dual-class premium represents a premium for the likelihood for corporate takeovers. Our paper innovates in the sense that we focus not only on bid rules imposed by Brazilian legislation on all domestic firms, but also on such rules that are voluntarily granted by companies for their minority shareholders in conditions beyond what is legally required. We also use a broad corporate governance index in order to capture, on a firm-level basis, the effect of investor protection on the dual-class premium. The dual-class premium is positively related to the mandatory bid rule, suggesting a positive takeover premium. Further, the premium increases (decreases) in response to enhancement (lowering) of investor protection via regulatory alterations in the rule. The premium also is inversely related to the firm's corporate governance practices suggesting that poor corporate governance makes it more likely that the firm will be taken over. The results suggest that takeovers are more likely at firms with poor corporate governance provisions and weak takeover rules on mandatory bids.

Information and Intermediary: Are Market Intermediaries Informed Traders in Electronic Markets?
Amber Anand and Avanidhar Subrahmanyam

Given the lack of any clear evidence on the informational contributions of market intermediaries vis-a-vis their clients in the extant literature, we compare the contribution of intermediaries to price discovery relative to that of outside investors. Further, we analyze whether intermediaries trade ahead of their clients to buttress their profits. Using confidential trades data from the Toronto Stock Exchange, we find that intermediaries account for greater price discovery than other institutional and individual investors, in spite of initiating fewer trades and volume. Our estimates of price discovery attributable to market intermediaries range between 55% and 62%, although these traders are responsible for only 37% of trades, representing 40% of total volume. Our analysis indicates that the informational advantage of intermediaries is greater in stocks with low analyst following (and hence less competition for information). This advantage does not appear to stem from inappropriate handling of customer orders by intermediaries, such as frontrunning or stepping ahead of their clients.

Liquidity, Return, and Order Flow Linkages Between REITs and the Stock Market
Avanidhar Subrahmanyam

This paper explores liquidity and order flow spillovers across NYSE stocks and real estate investment trusts (REITs). Impulse response functions and Granger causality tests indicate the existence of persistent liquidity spillovers running from REITs to non-REITs. Specifically, REIT liquidity indicators are forecastable from non-REIT ones, at both daily and monthly horizons. While REIT prices appear to be set efficiently in that neither REIT nor non-REIT order flows forecast REIT returns, we find that order flows and returns in the stock market negatively forecast REIT order flows. This result is consistent with the notion that real estate markets are viewed as substitute investments for the stock market, which causes down-moves in the stock market to increase money flows to the REIT market.

Executive Compensation and Investor Clientele
Laura Frieder and Avanidhar Subrahmanyam

Executive compensation has increased dramatically in recent times, but so has trading volume and individual investor access to financial markets. We provide a model where some managers may understate asset values through misleading statements in order to have enough of a cushion to compensate themselves. Owing to a lack of sophistication or naivete, possibly arising from high opportunity costs of learning about accounting conventions and financial markets, small investors are unable to ascertain the extent of this behavior. Expected compensation is therefore higher when small investors form a more significant clientele in the market for a firm's stock. Increased precision of private information deters the entry of small investors and may keep executive compensation in check. Technologies that lower the cost of trading facilitate entry of small investors and raise expected compensation. Such compensation can in general be reduced through appropriate regulation and transparent disclosures. Empirical tests provide support to the key implication of the model that indirect executive compensation is higher in stocks with more retail investor participation.

Lagged Order Flows and Returns: A Longer-Term Perspective
Avanidhar Subrahmanyam

In this paper, we consider the large-sample relation between returns and lagged order flows over horizons of up to two months. The analysis is motivated by work in market microstructure which suggests that the effects of inventory control on stock returns should be discernible over horizons longer than those considered in the literature. We begin our analysis by developing a simple model of inventory effects in the presence of public information. Using mid-quote return data, we then find some evidence of return predictability using order flows, even after controlling for lagged returns, which is consistent with our theoretical setting. The relation is present only for negative imbalances and is stronger in large firms rather than small ones. Overall, the analysis is consistent with the notion that inventory control effects span several weeks.

Theory-Based Illiquidity and Asset Pricing
Tarun Chordia, Sahn-Wook Huh and Avanidhar Subrahmanyam

Many proxies of illiquidity have been used in the literature that relates illiquidity to asset prices. These proxies generally are motivated from an empirical standpoint. However, theory-based formulae for an illiquidity measure, namely, the Kyle lambda, are available in closed-form and empirical proxies can be used to estimate such lambdas. We estimate such lambdas for a comprehensive sample of NYSE and Nasdaq stocks. There is convincing evidence that these theory-based estimates of illiquidity are priced in the cross-section of expected stock returns.

The Anatomy of Fluctuations in Book/Market Ratios
Avanidhar Subrahmanyam

We analyze trading activity accompanying equities' switches from "growth" (low bookto-market ratios) to "value" (high book-to-market ratios), and vice versa. Specifically, we consider the behavior of order flows for stocks experiencing extreme changes in book/market ratios over an year. We find that the switch appears to be accompanied by a dramatically positive large-trade order imbalance for switches from value to growth and vice versa. Small trade imbalance exhibits weaker patterns around these shifts. Institutional holdings also experience an increase for shifts from value to growth. The evidence indicates that large value-growth shifts are more strongly related to large traders (such as institutions). The interaction of book/market ratios with order flows plays a crucial role in return predictability.

Assessing the CIO's Application Focus
E. Burton Swanson & Arnaud Gorgeon

On what Information Technology (IT) business applications are Chief Information Officers (CIOs) of major companies presently focused and what motivates this focus? In the fall 2005 we undertook a small "snapshot study" to answer this question.

The Impact of Boards with Financial Expertise on Corporate Policies
A. Burak Guner, Ulrike Malmendier & Geoffrey Tate
We show that financial experts on boards significantly affect corporate decisions, but not necessarily in the interest of shareholders. Employing a novel director-level data set from 1988 to 2001, we find that, when commercial bankers enter a board, loan size increases and investment-cash flow sensitivity decreases. However, the increased financing benefits mostly financially unconstrained firms with good credit but poor investment opportunities. Investment bankers on boards are associated with larger public debt issues and worse acquisitions. Among financial experts without bank affiliation, finance professors increase the size of CEO option grants, reducing, however, the sensitivity of total compensation to performance.

Competition and Price Discrimination in the Market for Mailing Lists
Ron Borzekowski, Raphael Thomadsen & Charles Taragin

This paper examines the relationship between competition and price discrimination in the market for mailing lists. More specifically, we examine whether sellers are more likely to segregate consumers by offering a menu of quality choices (second-degree price discrimination) and/or offering different prices to readily identifiable groups of consumers (third-degree price discrimination) in more competitive markets. We also examine how the fineness with which consumers are divided corresponds to the level of competition in the market. The dataset includes information about all consumer response lists derived from mail order buyers (i.e. lists derived from catalogs) available for rental in 1997 and 2002. Using industry classifications, we create measures of competition for each list. We then use these measures to predict whether given lists utilize discriminatory pricing strategies. Our results indicate that lists facing more competition are more likely to implement seconddegree and third-degree price discrimination, and when implementing second-degree price discrimination, to offer menus with more choices.

Contagion in the Presence of Stochastic Interdependence
Clifford A. Ball & Walter Torous

Contagion represents a significant change in cross-market linkages precipitated by a crisis and is properly measured only after taking into account the interdependence or extant linkages prevailing between markets. Since it is well known that stock return volatilities and correlations are stochastic in the absence of a crisis, interdependence between markets should reflect the time varying nature of these covariances. We measure contagion in the presence of stochastic interdependence using data on stock indices from South East Asian countries around the July 1997 crisis. Since stock return covariances are observed with error, this suggests casting our model in a state space framework which is estimated using a multivariate Kalman filter. In the presence of stochastic interdependence, we find reliable evidence of contagion between Thailand and Indonesia, Malaysia, and the Philippines but not between Thailand and Hong Kong or Singapore.

Expected Returns and the Expected Growth in Rents of Commercial Real Estate
Alberto Plazzi, Walter Torous & Rossen Valkanov

We investigate whether the cap rate, that is, the rent-price ratio in commercial real estate incorporates information about future expected real estate returns and future growth in rents. Relying on transactions data spanning several years across fifty-three metropolitan areas in the U.S., we find that the cap rate captures fluctuations in expected returns for apartments, retail, as well as industrial properties. For offices, by contrast, the cap rate does not forecast returns even though additional evidence reveals that expected returns on offices are also time-varying. We link these differences in the ability of the cap rate to forecast commercial property returns to differences in the stochastic properties of their rental growth rates with the growth in office rents having a higher correlation with expected returns and being more volatile than for other property types. Taken together, our evidence suggests that variation in commercial real estate prices is largely due to movements in discount rates as opposed to cash flows.

Prophets and Losses: Reassessing the Return to Analysts' Stock Market Recommendations
B. Barber, R. Lehavy, M. McNichols and B. Trueman

After a string of years in which security analysts' top stock picks significantly outperformed their pans, the year 2000 was a disaster. During that year the stocks least favorably recommended by analysts earned an annualized market-adjusted return of 48.66 percent while the stocks most highly recommended fell 31.20 percent, a return difference of almost 80 percentage points. This pattern prevailed during most months of 2000, regardless of whether the market was rising or falling, and was observed for both tech and non-tech stocks. While we cannot conclude that the 2000 results are necessarily driven by an increased emphasis on investment banking by analysts, our findings should add to the debate over the usefulness of analysts' stock recommendations to investors. They should also serve to alert researchers to the possibility that excluding the year 2000 from their sample period could have a significant impact on any conclusions they draw concerning analysts' stock recommendations.

Comparing the Stock Recommendation Performance of Investment Banks and Independent Research Firms
B. Barber, R. Lehavy, and B. Trueman

This study compares the profitability of security recommendations issued by investment banks and independent research firms. During the 1996 through mid-2003 time period, the average daily abnormal return to independent research firm buy recommendations exceeds that of the investment banks by 3.1 basis points, or almost 8 percentage points annualized. In contrast, investment bank hold and sell recommendations outperform those of independent research firms by -1.8 basis points daily, or -4 1/2 percentage points annualized. Investment bank buy recommendation underperformance is concentrated in the subperiod subsequent to the NASDAQ market peak (March 10, 2000), where it averages 6.9 basis points per day, or slightly more than 17 percent annualized. More strikingly, during this period those investment bank buy recommendations outstanding subsequent to equity offerings underperform those of independent research firms by 8.7 basis points (almost 22 percent annualized). Taken as a whole, these results suggest that at least part of the underperformance of investment bank buy recommendations is due to a reluctance to downgrade stocks whose prospects dimmed during the early 2000's bear market, as claimed in the SEC's Global Research Analyst Settlement. Additional analyses find that the underperformance of investment bank buy recommendations extends not only to the ten investment banks sanctioned in the research settlement but to the nonsanctioned investment banks as well.

Buys, Holds, and Sells: The Distribution of Investment Banks' Stock Ratings and the Implications for the Profitability of Analysts' Recommendations
B. Barber, R. Lehavy, M. McNichols, and B. Trueman

This paper analyzes the distribution of stock ratings at investment banks and brokerage firms and examines whether these distributions can be used to predict the profitability of analysts' recommendations. Consistent with prior work, we find that the percentage of buy recommendations increased substantially from 1996-2000. Starting in mid-2000, however, the percentage of buys decreased steadily. Our analysis strongly suggests that this is due, at least in part, to the implementation of NASD Rule 2711, which requires brokers' ratings distributions to be made public. Notably, over our sample period the difference between the percentage of buy recommendations of the large investment banks singled out for sanction in the Global Research Analyst Settlement and that of the non-sanctioned brokers is economically quite small. Additionally, we find that a broker's stock ratings distribution can predict the profitability of its recommendations. Upgrades to buy issued by brokers with the smallest percentage of buy recommendations significantly outperformed those of brokers with the greatest percentage of buys, by an average of 50 basis points per month. Further, downgrades to hold or sell coming from brokers issuing the most buy recommendations significantly outperformed those of brokers issuing the fewest, by an average of 46 basis points per month.

The Real Determinants of Asset Sales
Liu Yang

In this paper, I develop a dynamic structural model in which a firm makes rational decisions to buy or sell assets in the presence of both idiosyncratic and aggregate productivity shocks. By identifying equilibrium asset prices, the model produces an industry with a well-defined panel of firms, and jointly analyzes firms' asset sales decisions and the aggregate asset sales activity in the business cycle. It suggests that changes of productivity, rather than levels, affect firms' decisions - firms with increasing productivity buy assets while firms with decreasing productivity choose to downsize. More assets are transacted in expansion years when aggregate productivity and price for existing assets are higher. The model is calibrated using the plant-level data from the U.S. Census Bureau's Longitudinal Research Database (LRD). Using the simulated panel, I show that most of the empirical evidence on asset sales is consistent with value-maximizing behavior: (1) firms which buy assets have higher valuation around the transaction, but lower long-run average - a result that was previously used to support the market-timing theory; (2) small acquirers have higher returns during the acquisition year than do large acquirers; and (3) dynamic properties of productivity shocks affect the asset sales activity in the industry: industries with less persistent and highly dispersed productivity shocks have greater asset sales.