Papers are listed alphabetically by UCLA Anderson faculty. To search by keyword, use the Find feature on your browser.
In this paper, we apply basic principles from the domain of design and architecture to choices made by employees saving for retirement. Three of the basic principles of design we apply are: (1) there is no neutral design, (2) design does matter, and (3) many of the seemingly minor design elements could matter as well. Applying these principles to the domain of retirement savings, we show that the design of retirement saving vehicles has a large effect on saving rates and investment elections, and that some of the minor details involved in the architecture of retirement plans could have dramatic effects on savings behavior. We conclude our paper by discussing how lessons learned from the design of objects could be applied to help people make better decisions, which we refer to as “choice architecture.”
Heuristics and Biases in Retirement Savings Behavior
Shlomo Benartzi and Richard Thaler
All around the world, in both the public and private sectors, retirement plans are shifting away from "defined benefit" plans and toward "defined contribution" plans. Poterba et al., for example, followed the cohort of Americans who were 45 years old in 1984 and report a decrease in defined benefit plan coverage from about 40 percent to 20 percent and a corresponding increase in defined contribution plan coverage from about 5 percent to more than 30 percent. Defined contribution plans have many attractive features for participants, such as portability and flexibility, but these attractions come with an increased responsibility to choose wisely. The plans also provide economists with an attractive domain in which to study savings behavior.
Nominal prices of common stocks have remained constant at around $30 per share since the Great Depression as a result of firms splitting their stocks. It is somewhat intriguing that share prices remained constant while general prices in the economy went up more than ten-fold. This is especially puzzling given that commissions paid by investors on trading ten $30 shares are ten times those paid on a single $300 share. We estimate, for example, that had share prices of General Electric kept up with inflation, investors in that stock would have saved $100 million last year in commissions. We explore potential explanations for this phenomenon, including signaling, preferred trading range, marketability, and optimal bid-ask spreads, and conclude that existing theories are unable to explain the observed constant nominal prices.
This article analyzes how legal presumptions can mediate between costly litigation and ex ante incentives. We augment a moral hazard model with a redistributional litigation game in which a presumption parameterizes how a court 'weighs' evidence offered by the opposing sides. Strong prodefendant presumptions foreclose lawsuits altogether, but also engender shirking. Strong proplaintiff presumptions have the opposite effects. Moderate presumptions give rise to equilibria in which both shirking and suit occur probabilistically. The socially optimal presumption trades off agency costs against litigation costs, and could be either strong or moderate, depending on the social importance of effort, the costs of filing suit, and the comparative advantage that diligent agents have over their shirking counterparts in mounting a defense. We posit three applications of our model: the litigation rate effects of the 1995 Private Securities Litigation Reform Act, the business judgment rule in corporations law, and fiduciary duties in financially distressed firms.
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.
Managing Customer Relationships: Should managers really focus on the long term?
Julian Villanueva, Pradeep Bhardwaj, Yuxin Chen & Sridhar Balasubramanian
Researchers and business thought leaders have emphasized that, towards maximizing the lifetime value of customers, firms must manage customer relationships for the long term. In contrast to this recommendation, we demonstrate that firm profits in competitive environments are maximized when managers focus on the short term with respect to their customers. Intuitively, while a long term focus yields more loyal customers, it sharpens short term competition to gain and keep customers to such an extent that overall firm profits are lower than when managers focus on the short term. Further, a short term focus continues to deliver higher profits even when customer loyalty yields a higher share-of-wallet or reduced costs of service from the perspective of the firm. Intuitively, while such revenue enhancement or cost reduction effects enhance the proverbial pot of gold at the end of the rainbow, they lead to even more intense competition to gain and keep customers in the short term. These findings suggest that the competitive implications of a switch to a long term customer focus must be carefully examined before such a switch is advocated or implemented. Paradoxically, customer lifetime value may be maximized when managers focus on the short term.
In this paper we develop models for stock returns when stock prices are subject to stochastic mispricing errors. We show that expected rates of return depend not only on the fundamental risk that is captured by a standard asset pricing model, but also on the type and degree of asset mispricing, even when the mispricing is zero on average. Empirically, the mispricing induced return bias, proxied either by Kalman filter estimates or by volatility and variance ratio of residual returns, are shown to be significantly associated with realized risk adjusted returns.
We test two hypotheses about the determinants of closed-end fund premia and discounts using a comprehensive sample of non-taxable and taxable funds for the period 1988 to 2002. We test whether fund premia reflect agency costs, and the potential tax liability associated with unrealized capital gains by examining changes in fund premia around the declaration day of large dividend and capital gain distributions. We provide further evidence on the effect of the tax liability from unrealized capital gains by examining changes in the premium around the ex-day of capital gain distributions. Our results lend support to both agency cost and the capital gains tax explanations for fund premia and discounts. We also find that the market prices of municipal bond funds (which pay tax-free dividends) are more sensitive to capital gains tax liabilities than are the prices of taxable funds, which is consistent with the existence of tax clienteles among closed-end fund investors.
We show that, when stock prices are subject to stochastic mispricing errors, expected rates of return may depend not only on the fundamental risk that is captured by a standard asset pricing model, but also on the type and degree of asset mispricing, even when the mispricing is zero on average. Empirically, the mispricing induced return premium, either estimated using a Kalman filter or proxied by the volatility and variance ratio of residual returns, is shown to be significantly associated with realized risk adjusted returns.
We provide statistical estimates of individual security mispricing which is defined as the departure of the market price from the prediction of a fundamental asset pricing model. We show that there is a return premium associated with systematic mispricing risk which is the dependence of the individual security mispricing on a market wide mispricing factor. The risk or characteristic-adjusted return spread between high and low mispricing risk decile portfolios is 50-70 bp per month depending on the specification of the market mispricing factor. When portfolios are formed on estimates of both systematic mispricing risk and the liquidity betas of Amihud (2002), Pastor-Stambaugh (2003) or Liu (2006) there is evidence of a significant risk-adjusted return spread associated with systematic mispricing risk, but no longer any evidence of a systematic liquidity risk premium. When portfolios are formed using estimates of the mispricing return bias of Brennan and Wang (2007) and systematic mispricing risk, both characteristics are shown to contribute to the return premium.
In paid search advertising on Internet search engines, advertisers bid for specific keywords, e.g. “Rental Cars LAX,” to display a text ad in the sponsored section of the search results page. The advertiser is charged when a user clicks on the ad. Many of the keywords in paid search campaigns generate few, if any, sales conversions -- even over several months. This sparseness makes it difficult to assess the profit performance of individual keywords and has led to the practice of managing large groups of keywords together or relying on easy-to-calculate heuristics such as click-through rate (CTR). The authors develop a model of individual keyword conversion that addresses the sparseness problem. Conversion rates are estimated using a hierarchical Bayes binary choice model. This enables conversion to be based on both word-level covariates and shrinkage across keywords. The model is applied to keyword-level paid search data containing daily information on impressions, clicks and reservations for a major lodging chain. The results show that including keyword-level covariates and heterogeneity significantly improves conversion estimates. A holdout comparison suggests that campaign management based on the model, i.e., estimated cost-per-sale on a keyword level, would outperform existing managerial strategies.
Modeling Co-Existing Business Scenarios with Time Series Panel Data
Catarina Sismeiro, Natalie Mizik & Randolph E. Bucklin
Due to customer segmentation, multiple types of dynamic business scenarios (business-as-usual, escalation, hysteresis, and evolving business practice; Dekimpe and Hanssens 1999) may coexist within a single product market. The authors develop an approach to model this phenomenon with time series panel data. Unit-root tests are used to group panelists by whether or not outcome (e.g., sales) and marketing activity (e.g., advertising, promotion) variables are stationary or evolving. This produces four clusters corresponding to each business scenario. Next, panel-data vector autoregressive models appropriate for each panelist cluster are estimated to assess the dynamics and the magnitude of the response to marketing effort. The approach is applied to physician panel data on drug prescriptions and direct-to-physician promotions. Estimation results show markedly different response dynamics (as captured by impulse response functions) and elasticities across the physician groups. The approach also produces better insample and holdout fits than pooled data models. For firms that track customer-level marketing activity and response over time, a segmentation based on dynamic business scenarios provides a new tool for targeting and efficient marketing resource allocation.
This paper investigates whether dividends provide information about earnings quality. Specifically, we examine whether firms that have lower earnings quality, as measured by an accusation of fraud in a Securities and Exchange Commission Accounting and Auditing Enforcement Release, pay dividends less often (and/or increase dividends less often) than similar firms not accused of accounting fraud. Our results are consistent with the alleged fraud firms being less likely to pay dividends prior to the fraud years. This relation is robust to the inclusion of controls for factors thought to be associated with fraud and dividend policy (e.g., growth, leverage, volatility, age of the firm, and others). We obtain similar, although somewhat weaker, results when we examine the dividends paid during the fraud years and the frequency of dividend increases. Thus, overall the evidence is consistent with dividends indicating earnings quality. However, the data also reveal that the alleged fraud firms pay out a total of over $10.5 billion in dividends, or nearly 3% of their pre-fraud market value, while perpetrating the financial accounting fraud. Thus, while dividends do convey information about earnings quality on average, they do not constitute a preventative measure against financial accounting fraud.
In this paper, I show that persistent pricing anomalies are consistent with a market that includes ambiguity averse investors. In particular, I show that ambiguity averse investors may prefer to trade based on aggregate signals that reduce ambiguity at the cost of a loss in information. Because the aggregate signals preferred by ambiguity averse investors are not sufficient statistics for the components from which they are constructed, equilibrium prices may fail to impound publicly available information. This provides opportunities for investors whose preferences satisfy the Savage (1954) axioms to generate profitable trading strategies since they are neutral to ambiguity. Ambiguity averse investors perceive that the benefit of using aggregate signals outweighs the costs of trading against investors who have superior information. The model can explain both under-reaction such as that evident in post-earnings announcement drifts and momentum and over-reaction to accounting accruals.
While neoclassical asset pricing theory implies that leverage affects expected returns through its impact on factor loadings, recent findings by Penman, Richardson, and Tuna (2007) suggest that pricing implications of leverage may be more complex. In this study, we examine the relation between expected return and changes in leverage induced by distortions of leverage from an optimum. We conjecture that the market only reacts to predictable changes in leverage after the fact. Invoking a proxy for distortions from optimal leverage based on a measure defined by Graham (2000) and controlling for risk, we find an association between future returns and under-leverage consistent with this conjecture. This finding is robust in a qualitative sense to changes in sample composition to reduce noise in the proxy for distortions or explore an alternative explanation. Our results suggest that the addition of the proxy for distortions in a specification otherwise similar to Penman, et al. (2007) subsumes the anomalous effects of the leverage component of book-to-market on future returns documented in their study.
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 intermediaries 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 explore whether a coalition of local capitalists, effectively limiting borrower's opportunity for defaulting multiple times, might be sufficient to facilitate on-lending. Instead, we find that a monopoly moneylender with superior enforcement technology can out-compete the local capitalist coalition if the moneylender also enjoys the smallest transactions costs of lending. We show that a credible competitive threat to the monopoly moneylender can only arise if the local capitalist coalition can also be made cost-effective either by direct subsidies or by measures such as standardization, economies of scale and implementation of best practices. We argue that Franchising is one potential mechanism that could deliver both cost-efficiencies as well as ability for local capitalists to form a coalition.
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. Economists have also begun to explore the biological basis of preferences, such as discounting of future consumption, that are usually taken as primitive. 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,1 and (iii) display risk-aversion.
We examine the role of signaling and of intrinsic benefits in the adoption of the individual elements of the voluntary LEED (Leadership in Energy and Environmental Design) standards for green buildings. We use goodness-of-fit tests on data for all 442 LEED certified buildings and find that neither signaling nor pursuit of intrinsic benefits can independently explain the observed adoption pattern, but that a combination of the two factors can. We also find tentative evidence that the adoption decision is made sequentially: organizations first choose a level of certification (consistent with signaling), and then choose how many LEED elements to adopt given their chosen level of certification (consistent with pursuing intrinsic benefits). We relate our findings to some open questions in the literature on diffusion of technology and draw implications for the design and the future development of similar voluntary standards and eco-labels.
This work empirically assesses the degree to which inventory decisions made by entrepreneurs and small businesses are informed by the logic underlying the newsvendor or base stock model and are influenced by the decision-maker’s risk profile. We used a web- and email-based survey, combined with a telephone follow-up to elicit risk profiles, obtaining 51 usable responses. Our findings suggest that entrepreneurs do follow the newsvendor logic, but more so for high-margin than for best-selling products. We find that entrepreneurs’ risk profiles are consistent with a key prediction from prospect theory, displaying risk aversion for profits and risk-seeking behavior for losses. Furthermore, we find that risk aversion for profits is associated with higher safety stocks, in contradiction to existing theory, and discuss several possible explanations for this finding.
Modeling Long Memory in REITs
John Cotter & Simon Stevenson
One stylized feature of financial volatility impacting the modeling process is long memory. This paper examines long memory for alternative risk measures, observed absolute and squared returns for Daily Equity REITs and compares the findings for a market equity index. The paper utilizes a variety of tests for long memory finding evidence that REIT volatility does display persistence. Trading volume is found to be strongly associated with long memory. Results suggest differences in the findings with regard to REITs in comparison to the broader equity sector.
Greedoid languages provide a basis to infer best-fitting noncompensatory decision rules from full-rank conjoint data or partial-rank data such as consider-then-rank, consider-only, or choice data. Potential decision rules include elimination by aspects, acceptance by aspects, lexicographic by features, and a mixed-rule lexicographic by aspects (LBA) that nests the other rules. We provide a dynamic program that makes estimation practical for a moderately large numbers of aspects.
Preference Markets: Organizing Securities Markets for Opinion Surveys with Infinite Scalability
Ely Dahan, Arina Soukhoroukova & Martin Spann
Preference markets address the need for scalable, fast and engaging market research. For faster new product development decisions, we implement a flexible prioritization methodology for product features and concepts, one that scales up in the number of testable alternatives, limited only by the number of participants. Preferences are measured by trading stocks whose prices are based upon share of choice of new products and features. We develop a conceptual model of scalable preference markets, and test it experimentally. Our conceptual model posits that individuals: (a) develop expectations of others based on self preferences, (b) use those expectations when buying and selling stocks, (c) have their opinions differentially weighted by the market pricing mechanism, resulting in a consensus of opinions, (d) learn from trading, and further converge towards consensus. Four studies confirm (a) - (d). Beyond accuracy, advantages of the methodology include speed (less than one hour per trading experiment), scalability (question capacity grows linearly in the number of traders), flexibility (questions in mixed formats can be answered simultaneously), and respondent enthusiasm for the method.
Market prices are well known to efficiently collect and aggregate diverse information regarding the economic value of goods and services, particularly for financial securities. We propose a novel application of the price discovery mechanism in the context of marketing research: to use pseudo-securities markets to measure consumer preferences over new product concepts. A securities-trading approach may yield significant advantages over traditional methods for measuring consumer preferences such as surveys, focus groups, concept tests, and conjoint studies, which are costly to implement, time-consuming, and often biased. Our approach differs from prior research on simulated markets and experimental economics in that we do not require any exogenous, objective “truth” such as election outcomes or box office receipts on which to base our securities market. Our trading experiments show that the market prices of securities designed to represent product attributes and features are remarkably efficient and accurate measures of preferences, even with relatively few traders in the market. The STOC method may offer a particularly efficient screening mechanism for firms developing new products and services, and deciding where to invest additional product-development dollars.
Consider a mass customizer who produces multiple variants of a product in make-to-order fashion, and who also produces some standard variants as make-to-stock. We evaluate pricing and production issues from a joint marketing and operations perspective. Marketing determines prices while operations chooses between three production strategies as it sets capacity. A key result is that under the logit-based assumption for our marketing model, it is optimal for all mass-customized products to be priced at the same absolute dollar markup, implying all add-on options are priced at cost. Operations considers the following production strategies: 1) a focus strategy where the firm produces custom variants in a flexible plant and standard items in an efficient plant; 2) a pure-spackling strategy where it produces everything in a flexible plant, first manufacturing custom products as demanded each period, and then filling in, or spackling, the production schedule with make-to-stock output of standard products to restock inventory; or 3) a layered-spackling strategy where it uses an efficient plant to make some of its standard items and a flexible plant where it spackles. A second key result is to identify the optimal production strategy as determined by the tradeoff between the cost premium for flexible (as opposed to efficient) production capacity and the opportunity costs of idle capacity. We illustrate our framework with data from a messenger bag manufacturer. Spackling amortizes fixed costs more effectively and thus has the potential to increase profits from mass customization.
Tailored Capacity: Speculative and Reactive Fabrication of Fashion Goods
Kyle Cattani, Ely Dahan & Glen M. Schmidt
Consider a fashion goods retailer choosing a strategy for contracting production of its products. It can 1) speculate by contracting for a certain quantity to be produced well ahead of uncertain demand at relatively low unit cost, 2) react by waiting until demand is known, and only then contracting for just the right quantity at a higher unit cost, or 3) hedge its bets by speculating on a portion of the total quantity, and reacting to demand for the rest. Using a two-product two-stage model, we identify the conditions under which each strategy is preferred, and determine capacity requirements. We find that fashion retailing often benefits from the dual strategy due to relatively higher obsolescence costs. But the use of the dual strategy is sensitive to the cost premium for reactive capacity and to the makeup of reactive production costs as either largely variable or fixed.
This paper examines academic earmarks and their role in the funding of university research. It provides a summary and review of the evidence on the supply of earmarks by legislators. It then discusses the role of university lobbying for earmarks on the demand side. Finally, the paper examines the impact of earmarks on research quantity and quality.
The present research demonstrates that increasing a consumer’s empathy with a service provider can increase that consumer’s satisfaction with the service. In Study 1, customers at a cafe who were induced to empathize with the clerk felt more satisfied with the service, and in Study 2, such empathizing customers were better tippers. Study 3 corroborated this finding of an empathy-satisfaction relation using dispositional empathy, showing that naturally occurring levels of empathy were positively related to consumers’ feelings of satisfaction in a long-term service relationship (personal fitness training). Study 4 found that the positive effect of empathy on consumer satisfaction held true for a negative service situation (for female but not for male consumers), indicating that the effect was not the result of consumers becoming more sensitive to the valence of the service situation. In addition, the overall results suggest that the effect was not mediated by more favorable attitudes toward the service provider or by more favorable attributions of responsibility to the service provider. Instead, we suggest that empathy may make consumers more cooperative and that being satisfied is one way consumers “cooperate” with a service provider. These findings exemplify how responses to a marketing situation can be managed by manipulating the mental state of consumers rather than by altering the attributes of the goods or services being offered.
Does Load Lead to Decision Bias or Are We Biased Against Load?
Aimee Drolet, Mary Frances Luce & Itamar Simonson
We examine moderators of the impact of cognitive load on choice strategies and susceptibility to decision bias. In four studies, we investigate the conditions under which load increases the compromise effect. Overall, our research shows that the ultimate influence of load on bias is contingent on motivational factors that determine how choice processes would have progressed under conditions of no load. Our findings indicate that there is no de facto impact of load on bias. Instead, the biasing effects of reduced resources are confined to consumers who have sufficient motivation to resolve choice problems and avoid biased (e.g., based on preferences rather than compromise position) choice outcomes. The implications of our research for the reliance on load to study consumer choice and for the two-system view of consumer decision making are discussed.
In three longitudinal experiments, conducted both in the field and lab, we investigate the recollection of mixed emotions. Results demonstrate that mixed emotions are generally underreported at the time of recall, an effect which appears to grow over time and does not occur to the same degree with unipolar emotions. Importantly, the decline in memory of mixed emotions is: (a) not explained by differential importance levels across the distinct types of emotion experiences, and (b) distinct from the pattern found for the memory of negative emotions. These results imply that recall difficulty is diagnostic of the complexity of mixed emotions rather than of any association with negative affect. Finally, we show that one reason for these effects is the felt conflict which arises when experiencing mixed (vs. unipolar) emotions. Implications for consumer memory and behavior are discussed.
In this paper I analyze whether restrictions to capital mobility reduce vulnerability to external shocks. More specifically, I ask if countries that restrict the free flow of international capital have a lower probability of experiencing a large contraction in net capital flows. I use three new indexes on the degree of international financial integration and a large multi-country data set for 1970-2004 to estimate a series of random-effect probit equations. I find that the marginal effect of higher capital mobility on the probability of a capital flow contraction is positive and statistically significant, but very small. Having a flexible exchange rate greatly reduces the probability of experiencing a capital flow contraction. The benefits of flexible rates increase as the degree of capital mobility increases. A higher current account deficit increases the probability of a capital flow contraction, while a higher ratio of FDI to GDP reduces that probability.
In this paper I use historical data to analyze the relationship between crises and growth in Latin America. I calculate by how much the region's GDP per capita has been reduced as a consequence of the recurrence of external crises. I also analyze the determinants of major balance of payments crises. The main conclusion is that it is unlikely that Latin America will, on average, experience a major improvement in long run growth in the future. It is possible that some countries will make progress in catching up with the advanced nations. This, however, will not be the norm; most Latin American countries are likely to fall further behind in relation to the Asian countries and other emerging nations. Not everything, however, is grim. My analysis also suggests that fewer Latin America countries will be subject to the type of catastrophic crises that affected the region in the past. Latin America's future will be one of "No crises and modest growth."
In this paper I analyze the nature of external adjustments in current account surplus countries. I ask whether a realignment of world growth rates -- with Japan and Europe growing faster, and the U.S. growing more slowly -- is likely to solve the current situation of global imbalances. The main findings may be summarized as follows: (a) There is an important asymmetry between current account deficits and surpluses. (b) Large surpluses exhibit little persistence through time. (c) Large and abrupt reductions in surpluses are a rare phenomenon. (d) A decline in GDP growth, relative to long term trend, of 1 percentage point results in an improvement in the current account balance -- higher surplus or lower deficit -- of one quarter of a percentage point of GDP. Taken together, these results indicate that a realignment of global growth -- with Japan and the Euro Zone growing faster, and the U.S. moderating its growth -- would only make a modest contribution towards the resolution of global imbalances. This means that, even if there is a realignment of global growth, the world is likely to need significant exchange rate movements. This analysis also suggests that a reduction in China's (very) large surplus will be needed if global imbalances are to be resolved.
Housing Wealth, Financial Health, and Consumption: New Evidence from Micro Data
Raphael Bostic, Stuart A. Gabriel and Gary Painter
Fluctuations in the stock market and in house values over the course of recent years have led to renewed macroeconomic policy debate as regards the effects of financial and housing wealth in the determination of consumer spending. This research assembles a unique matched sample of household data from the Survey of Consumer Finance and the Consumer Expenditure Survey to estimate the consumption effects of financial and housing wealth. The research further evaluates the consumption effects of deviations from trend and volatility in the wealth measures. Further, the micro-data permit numerous innovations in the assessment of wealth effects, including an analysis of the impact of wealth on both durable goods and total consumption as well as a comparison of estimated elasticities as derive from gross versus after-debt wealth measures. Findings also assess the robustness of the estimated wealth effects among age cohorts and for credit-constrained households.
The U.S. government provides extensive support for the secondary mortgage market through both implicit and direct subsidization of the federally chartered GSEs, Fannie Mae and Freddie Mac. In exchange, under the 1992 GSE Act, Fannie Mae and Freddie Mac are obliged to purchase a substantial share of their loans in targeted, underserved neighborhoods. This study investigates two phenomena associated with this policy: the degree to which the GSEs respond to the loan purchase guidelines and the extent to which GSE activity crowds out purchases by private secondary market entities. A simple conceptual model suggests that crowd out could be pronounced when primary lenders retain few loans in portfolio. This is important because the share of conforming loans held in portfolio by primary lenders fell from roughly 40 percent in 1994 to nearly zero in 2004. Evidence based on the 1994-2004 HMDA data confirms that the GSEs have been responsive to the HUD affordable housing goals. However, instrumental variable estimates suggest that crowd out associated with GSE activity increased over time as primary lenders held fewer loans in portfolio. In 2004, GSE crowd out was 100 percent, implying a sharply diminished impact of GSE activity on the supply of mortgage credit. To some extent, increased GSE crowd out is a natural consequence of the expansion and increasing sophistication of the secondary market. Nevertheless, our findings weaken the case for continued government support of these institutions.
In our multistage search model, the seller’s reservation price is affected by the offer price distribution, while the optimal asking price is chosen so as to maximize the return from search. We show that a greater dispersion in offer prices leads to a higher reservation price and a higher optimal asking price, which in turn results in a higher expected transaction price. Under the assumption that offer prices are normally distributed, a higher dispersion of offer prices also reduces time on the market for overpriced properties.
Secondary Markets, Risk, and Access to Credit Evidence From the Mortgage Market
Yongheng Denga, Stuart A. Gabriel, Kiyohiko G. Nishimurac & Diehang Zhenga
Secondary markets for credit are widely believed to improve efficiency and increase access to credit. In part, this is because of their greater ability to manage risk. However, the degree to which secondary markets expand access to credit is virtually unknown. Using the mortgage market as an example, we begin to fill that gap. Our conceptual model suggests that secondary credit markets have potentially ambiguous effects on interest rates, but unambiguous positive effects on the number of loans issued. We focus our empirical analysis on the latter using 1992-2004 HMDA files for conventional, conforming, home purchase loans in conjunction with Census tract data.
We provide a model of the effects of catastrophic risk on real estate financing and prices and demonstrate that insurance market imperfections can restrict the supply of credit for catastrophe-susceptible properties. Using unique micro-level data, we find that earthquake risk decreased commercial real estate loan provision by 22 percent in our California properties in the 1990's. The effects are more severe in African-American neighborhoods. We show that the 1994 Northridge earthquake had only a short-term disruptive effect. Our basic findings are confirmed for hurricane risk, and our model and empirical work have implications for terrorism and political perils.
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.
We model the contrasting capital-labor decisions of financially constrained and unconstrained firms. We show that financially restricted firms use relatively more labor than physical capital because informed employees provide more efficient financing than uninformed capital suppliers. We demonstrate that constrained firms cannot easily attract new employees to replace existing staff. Their greater employee retention aligns owner-worker incentives and encourages workers to make firm-specific investments. Constrained firms, however, gradually suffer from their inability to replace low-quality workers, such that their relative labor productivity decreases over time. Empirical tests utilizing instrumental variables confirm several implications of the theory.
The primary purpose of this paper is to examine whether existing market leverage has a significant statistical and economic effect on the pricing of S&P 500 index put options. If actual measured leverage is both statistically and economically relevant to pricing these options, then it is important to isolate the magnitude of its effect independent of other assumed possible complexities such as stochastic volatility, stochastic interest rates, and jumps. This is the first paper to attempt to isolate the leverage effects in stock index put options. To analyze these effects we use the Geske (1979) compound option model. The Geske model is closed form, implies stochastic equity volatility, is consistent with Modigliani and Miller, incorporates debt refinancing, and includes possibly differential default and bankruptcy. Black-Scholes (1973) is a special case of the Geske model. This paper is the first to present a market D/E ratio derived from option theory using only contemporaneous market price data. We show that during the years 1996-2004 the aggregate market based debt to equity (D/E) ratio of the firms comprising the S&P 500 equity index varies from about 40-120 percent. We also present evidence during this 8 year period the implied volatility most often exhibits a smile not a skew. Next and more importantly we are the first to report the details of the statistically significant economic effects that market leverage has on pricing S&P 500 index put options. We show that Geske’s compound option model is superior to Black-Scholes (BS) and Bakshi, Cao, and Chen (BCC) (1997) models. BCC can include stochastic volatility, stochastic volatility and stochastic interest rates, and stochastic volatility and jumps. When compared to BS (BCC) using matched pairs of options, Geske’s model is closer to the market price on 90% (65-90%) of the in the money options and 99% (65-90%) of the out of the money options. Furthermore, we present the considerable statistical and economic significance of Geske’s net dollar improvement, net percent improvement, and net basis point improvement relative to BS and BCC. We also demonstrate that the improvement is directly (and monotonically) related to both the amount of leverage in the market and the time to expiration of the option.
The purpose of this paper is to examine whether leverage has a significant statistical and economic effect on the pricing of S&P 500 index options. This is the first paper to directly test for leverage effects in stock index options. To analyze these effects we use the Geske (1979) compound option model. The Geske model is closed form, implies stochastic equity volatility, is consistent with Modigliani and Miller, incorporates debt refinancing, and includes possibly differential default and bankruptcy. Black-Scholes (1973) is a special case of the Geske model. In this paper we show that during the years 1996-2004 the aggregate market based debt to equity (D/E) ratio of the firms comprising the S&P 500 equity index varies from about 40-120 percent. We believe this is the first presentation of a market D/E ratio derived from option theory. Next and more importantly we are the first to report the details of the statistically significant economic effects that market leverage has on pricing S&P 500 index call options. We measure that the Geske model improves the net option valuation of listed in the money (or out of the money) S&P 500 index call options on average by about 35% (28%) compared to Black-Scholes values. We demonstrate that the improvement is directly (and monotonically) related to both the time to expiration of the option and the amount of leverage in this market index. For options with longer expirations and/or periods of higher market leverage the improvement is greater, ranging from about 40% to 80%. We also demonstrate economic significance in basis points by showing that dealers making a book in index options can expect benefits of at least several 100 basis points using Geske instead of Black-Scholes.
Are Mutual Fund Fees Competitive? What IQ-Related Behavior Tells Us
Mark Grinblatt, Seppo Ikäheimo & Matti Keloharju
This study analyzes the fees of mutual funds and the choices of mutual fund investors. Using a comprehensive dataset on males in two Finnish provinces, we find that the fees of funds selected by high IQ investors are not significantly lower than the fees of funds selected by low IQ investors. This conclusion controls for a variety of fund and individual attributes that explain mutual fund fees and mutual fund choices. This suggests that fees are set competitively in the fund industry.
The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and updating of reference prices, generates predictable equilibrium prices that will be interpreted as possessing momentum. Cross-sectional empirical tests are consistent with the model. A variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Past returns have no predictability for the cross-section of returns once this variable is controlled for.
Social Influence and Consumption: Evidence from the Automobile Purchases of Neighbors
Mark Grinblatt, Matti Keloharju & Seppo Ikaheimo
This study analyzes the automobile purchase behavior of all residents of two Finnish provinces over several years. Using a comprehensive dataset with location coordinates at the individual consumer level, it finds that the purchases of neighbors, particularly in the recent past and by those who are geographically most proximate, influence a consumer’s purchases of automobiles. There is little evidence that emotional biases, like envy, account for the observed social influence on consumption.
The Valuation Effects of Stock Splits and Stock Dividends
Mark Grinblatt, Ronald W. Masulis & Sheridan Titman
This study presents evidence which indicates that stock prices, on average, react positively to stock dividend and stock split announcements that are uncontaminated by other contemporaneous firm-specific announcements. In addition, it documents significantly positive excess returns on and around the ex-dates of stock dividends and splits. Both announcement and ex-date returns were found to be larger for stock dividends than for stock splits. While the announcement returns cannot be explained by forecasts of imminent increases in cash dividends, the paper offers several signaling based explanations for them. These are consistent with a cross-sectional analysis of the announcement period returns.
Marketing Spending and the Volatility of Revenues and Cash Flows
M. Fischer, H. Shin & D.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 responsiveness of own 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 marketing profession is being challenged to assess and communicate the value created by its actions on shareholder value. These demands create a need to translate marketing resource allocations and their performance consequences into financial and firm value effects. The objective of this paper is to integrate the existing knowledge on the impact of marketing on firm value. We first frame the important research questions on marketing and firm value and review the important investor response metrics and relevant analytical models, as they relate to marketing. We next summarize the empirical findings to date and offer nine empirical generalizations on the marketing-finance interface, pertaining to the impact of brand equity, customer equity, customer satisfaction, R&D and product-quality, and specific marketing-mix actions on firm value. We conclude by formulating an agenda for future research challenges in this emerging area.
The customer equity paradigm is readily implemented in relationship businesses where the distinction between a prospect and an existing customer is unambiguous. That enables firms in such industries to be customer and long-term focused in the allocation of their marketing resources. This is not the case in frequently purchased product categories, where customers may switch back and forth between competing brands, and even consume multiple brands in the same time period. However, by adopting an always-a-share customer definition and using a probabilistic classification of active and inactive customers, we demonstrate that measures of customer equity may still be obtained in such categories, using readily available scanner panel data. We illustrate our approach for the leading national and private-label brands in two CPG categories and show that the brands’ sources of customer equity and the impact of their marketing activities are very different. As a result, the brands’ customer equity levels may be evolving in different directions that are not readily apparent. We discuss the managerial implications of our findings and offer several areas for future research.
Product innovation is the key revenue driver in the motion picture industry. Since major studios typically launch fewer than twenty movies per year, the financial performance of a single release can have a major effect on the studio’s profitability. In this paper we study how single movie releases impact the investor valuation of the studio. We analyze the change in post-launch stock price and predict the direction and magnitude of excess returns, based on the revenue expectation built up for a movie release. 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 comprising over three hundred movies released by the largest studios. 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 performance 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.
Product Innovations, Marketing Investments and Stock Returns
S. Srinivasan, K. Pauwels, J. Silva-Risso & D.M. Hanssens
Under increased scrutiny from top management and shareholders, marketing managers feel the need to measure and communicate the firm value of their actions. In particular, how do customer value creation (through product innovation) and customer value communication (through marketing investments) affect stock returns? This paper examines conceptually and empirically how product innovations and marketing investments for such product innovations lift stock returns by improving the outlook on future cash flows. We address these questions with a large-scale econometric analysis of product innovation and associated marketing mix in the automobile industry. We find that investors react favorably to companies that launch innovations, particularly pioneering innovations, backed by substantial advertising support, in large and growing categories. Finally, we quantify the stock return benefits of increasing advertising support for new-to-the-company versus new-to-the-world products.
Does Public Ownership of Equity Improve Earnings Quality?
Dan Givoly, Carla Hayn & Sharon P. Katz
To better understand how equity investors influence earnings quality, we compare the quality of accounting numbers produced by two types of public firms - those with publicly-traded equity and those with privately-held equity that are nonetheless considered public by virtue of having publicly-traded debt. We develop and test two hypotheses. The demand hypothesis holds that earnings of public equity firms are of higher quality than earnings of private equity firms due to the stronger demand by investors and creditors stemming from, among other concerns, higher litigation risk. The opportunistic behavior hypothesis posits that public equity firms have lower earnings quality than their private equity peers due to management intervention in the earnings process as a result of capital market considerations as well as their own equity-based compensation. We identify a number of attributes associated with the notion of earnings quality - persistence and estimation error of accruals, prevalence of earnings management, timeliness of loss versus gain recognition (conditional conservatism) and the extent of conservatism due to the use of asset-decreasing accounting principles (unconditional conservatism). The results indicate that, consistent with the opportunistic behavior hypothesis, private-equity firms have higher quality accruals and a lower propensity to manage income than public equity firms. However, in line with the demand hypothesis, public equity firms' financial reports are generally more conservative.
We investigate the relation between predictable market returns and predictable analyst forecast errors. Perfect correlation between predictable components of forecast errors and abnormal returns would lend credence to the view that pricing anomalies are not merely an artifact of inadequately controlled risk. Our evidence implies an imperfect correlation. Moreover, we find that while the predictable component of abnormal returns is significantly associated with future forecast errors, trading strategies based directly on the predictable component of forecast errors are not profitable. Further implications of our findings are that predictable components of analysts' forecast errors are robust with respect to loss functions and analysts' earnings forecasts may significantly diverge from the market expectations.
Finance and Labor: Perspectives on Risk, Inequality, and Democracy
Sanford M. Jacoby
Research has not paid adequate attention to financial development as a factor causing greater inequality and risk. Yet rather than there being a direct effect, the association between financial and labor markets is mediated by political coalitions at the national and corporate levels. Here we trace the historical interplay between financial markets, corporate governance, regulatory politics, and inequality in the United States. There is close examination of equity-market changes since 1980 and their impact on organized labor's efforts to re-regulate finance.
Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy. A modified Taylor Rule would depend on a long-term measure of inflation having little to do with the phase in the cycle, and, in place of Taylor's output gap, housing starts and the change in housing starts, which together form the best forward-looking indicator of the cycle of which I am aware. This would create pre-emptive anti-inflation policy in the middle of the expansions when housing is not so sensitive to interest rates, making it less likely that anti-inflation policies would be needed near the ends of expansions when housing is very interest rate sensitive, thus making our recessions less frequent and/or less severe.
We study the nature of sovereign credit risk using an extensive sample of CDS spreads for 26 developed and emerging-market countries. Sovereign credit spreads are surprisingly highly correlated, with just three principal components accounting for more than 50 percent of their variation. Sovereign credit spreads are generally more related to the U.S. stock and high-yield bond markets, global risk premia, and capital flows than they are to their own local economic measures. We find that the excess returns from investing in sovereign credit are largely compensation for bearing global risk, and that there is little or no country-specific credit risk premium. A significant amount of the variation in sovereign credit returns can be forecast using U.S. equity, volatility, and bond market risk premia.
We solve a model with two i.i.d. Lucas trees. While the corresponding one-tree model produces a constant price-dividend ratio and i.i.d. returns, the two-tree model produces interesting asset-pricing dynamics. Investors want to rebalance their portfolios after any change in value. Since the size of the trees is fixed, prices must adjust to offset this desire. As a result, expected returns, excess returns, and return volatility all vary through time. Returns display serial correlation and are predictable from price-dividend ratios. Return volatility differs from cash-flow volatility and return shocks can occur without news about cash flows.
A Multiplier Approach to Understanding the Macro Implications of Household Finance
YiLi Chien, Harold Cole & Hanno Lustig
Our paper examines the impact of heterogeneous investment opportunities on the distribution of asset shares and wealth in an equilibrium model. We develop a new method for computing equilibria in this class of economies. This method relies on an optimal consumption sharing rule and an aggregation result for state prices that allows us to solve for equilibrium prices and allocations without having to search for market-clearing prices in each asset market. In a calibrated version of our model, we show that the heterogeneity in trading opportunities allows for a closer match of the wealth and asset share distribution as well as the moments of asset prices. We distinguish between “passive” traders who hold fixed portfolios of equity and bonds, and “active” traders who adjust their portfolios to changes in the investment opportunity set. In the presence of non-participants, the fraction of total wealth held by active traders is critical for asset prices, because only these traders respond to variation in state prices and hence help to clear the market, not the fraction of wealth held by all agents that participate in asset markets.
IT, Corporate Payouts, and the Growing Inequality in Managerial Compensation
Hanno Lustig, Chad Syverson, Stijn Van Nieuwerburgh
Three of the most fundamental changes in the economy since the early 1970s have been (1) the increase in the importance of organizational capital in production, (2) the increase in managerial income inequality, and (3) the increase in payouts to the owners of firms. There is a unified explanation for these changes: The arrival and gradual adoption of information technology since the 1970s has stimulated the accumulation of organizational capital in existing firms. Since owners are better diversified than managers, the optimal division of rents from this organizational capital has the owners bear most of the cash-flow risk. In our model, the IT revolution benefits the owners and the managers in large successful firms, but not the managers in small firms. The resulting increase in managerial compensation inequality and the increase in payouts to owner’s compare favorably to those we establish in the data.
I introduce bankruptcy into a complete markets model with a continuum of ex ante identical agents who have power utility. Shares in a Lucas tree serve as collateral. Bankruptcy gives rise to a second risk factor in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints. The risk is measured by one moment of the wealth distribution, which multiplies the standard Breeden-Lucas stochastic discount factor. The economy is said to experience a negative liquidity shock when this growth rate is high, a large fraction of agents faces severely binding solvency constraints and the trading volume is low in financial markets. The adjustment to the Breeden-Lucas stochastic discount factor induces time variation in equity, bond and currency risk premia that is consistent with the data.
The Wealth-Consumption Ratio: A Litmus Test for Consumption-based Asset Pricing Models
Hanno Lustig, Stijn Van Nieuwerburgh & Adrien Verdelhan
We propose a new method to measure the wealth-consumption ratio, the price-dividend ratio of a claim to aggregate consumption. It combines no-arbitrage restrictions with data on stock returns, bond returns, and bond yields. The estimated wealth-consumption ratio is much higher on average than the price-dividend ratio on stocks and has much lower volatility. This implies that the consumption risk premium is substantially below the equity risk premium, or that total wealth is less risky than stock market wealth. Measuring the wealth-consumption ratio is important because changes in the wealth-consumption ratio enter as the second asset pricing factor besides consumption growth in the two leading representative-agent asset pricing models, the external habit model and the long-run risk model. The benchmark calibrations of these two asset pricing models have dramatically different implications for the wealth-consumption ratio, motivating our measurement exercise. The smoothness of the wealth-consumption ratio suggests that there may be less time-variation in market prices of risk than commonly inferred from equity prices alone.
We construct a model with a large number of agents who have constant relative risk aversion (CRRA) preferences. We show that the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In the equilibrium, which features trade and binding solvency constraints, as opposed to Constantinides and Duffie (1996), households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore we show that the cross-sectional wealth and consumption distributions are not affected by aggregate shocks. Equilibrium consumption allocations can be obtained by solving for an equilibrium in a version of the model without aggregate shocks, as in Bewley (1986), and then re-scaling the allocation by aggregate income. These results hold regardless of the persistence of idiosyncratic shocks, and arise even when households face tight solvency constraints, but only a weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.
This paper analyzes the market for corporate control and acquisitions by explicitly modeling a typical firm's choice whether to become a potential acquirer or target. I add synergistic motives to a multitask principal-agent framework with moral hazard between managers and shareholders. I argue that the terms of an M&A deal are determined not in isolation but in a market equilibrium context, therefore the merger transaction is embedded in a dynamic general-equilibrium search model. This framework links explicit and implicit incentives in a novel way. By modeling the choice explicitly I reconcile the evidence that in mergers target shareholders gain whereas acquirer shareholders seem to lose or gain nothing, yet most of the time they do not block the acquisition. Apart from that, it is shown that Golden Parachutes are an optimal form of compensation regarding merger-related incentives. The model also explains financial intermediation in the M&A market. I establish efficiency results and explain how merger waves might arise, in addition to other (testable) implications.
Practicing managers live in a world of 'extremes' but management research is based on Gaussian statistics that rule out those extremes. On occasion, deviation amplifying mutual causal processes among interdependent data points cause extreme events characterized by power laws. They seem ubiquitous; we list 80 kinds of them -- half each among natural and social phenomena. We draw a line in the sand between Gaussian (based on independent data points, finite variance and emphasizing averages) and Paretian statistics (based on interdependence, positive feedback, infinite variance, and emphasizing extremes). Quantitative journal publication depends almost entirely on Gaussian statistics. We draw on complexity and earthquake sciences to propose redirecting Management Studies. Conclusion: No statistical findings should be accepted into Management Studies if they gain significance via some assumption-device by which extreme events and infinite variance are ignored. The cost is inaccurate science and irrelevance to practitioners.
The new governor took office in the midst of a major state budget crisis. At the time he took office, it was unclear that state could pay its bills if drastic action were not taken. Yet the incoming governor was committed to a no-tax-increase program. Through borrowing, the state managed to surmount its budget crisis. As the economy recovered and resulting tax revenue flowed in, it even was able to engage in major construction projects. When he stood for re-election, the governor was overwhelmingly returned to office for a second term. Sadly, however, the economy began to slow during that second term. Fears mounted that the state could face a renewed budget crisis. This description may seem to depict the career to date of Arnold Schwarzenegger. He inherited a budget crisis from Gray Davis who he replaced in the 2003 recall. But the introductory vignette actually refers to the story of George Deukmejian (“Duke”) who was first elected in 1982, inheriting a budget crisis from Jerry Brown. (Deukmejian’s construction projects leaned towards prisons for most of his terms in office, needed as state sentencing laws tightened, rather than the roads and other infrastructure pushed by Schwarzenegger.) And as it turned out, the economic downturn that began to take shape towards the end of Deukmejian’s second term indeed did produce a major budget crisis, a legacy he left for his successor, Pete Wilson.
One of the most fundamental macroeconomic questions is: How are wages determined? The assumptions that underlie this question help to determine how economic evidence is interpreted and then how monetary and fiscal policy are set. Yet, these underlying assumptions are rarely explicitly or self-consciously acknowledged or examined. Our goal is to examine the evolution of one of these key underlying assumptions, the "wage-push" view of wage setting; or, in other words, to provide an intellectual and policy history of the concept.
We consider the distribution planning problem in the motion picture industry. This problem involves forecasting theater-level box office revenues for a given movie and using these forecasts to choose the best locations to screen a movie. We first develop a method that predicts theater-level box office revenues for a given movie as a function of movie attributes and theater characteristics. These estimates are then used by the distributor to choose where to screen the movie. The distributor’s location selection problem is modeled as an integer programming based optimization model that chooses the location of theaters in order to optimize profits. We tested our methods on realistic box office data and show that it has the potential to significantly improve the distributor’s profits. We also develop some insights into why our methods outperform existing practice, which are crucial to their successful practical implementation.
Corporate Serial Acquisitions: An empirical test of the learning hypothesis
Nihat Aktas, Eric de Bodt & Richard Roll
Recent empirical papers report a declining trend in the cumulative abnormal return (CAR) of acquirers during an M&A program. Does this necessarily imply that acquiring CEOs are infected by hubris and are not learning from previous mistakes? We first confirm the existence of this declining trend on average. However, we find a positive CAR trend for CEOs likely to be infected by hubris, which is significantly different from the negative trend found for CEOs who are more likely to be rational. We also explore the time between successive deals and find empirical evidence to suggest that many CEOs learn substantially during acquisition programs.
How Employee Stock Options and Executive Equity Ownership Affect Long-term IPO Operating Performance
Kuntara Pukthuanthong, Richard Roll & Thomas Walker
To ascertain whether the form of managerial compensation affects a firm's long-term operating performance, we track IPOs for five years after the expiration of the stabilization period. New public companies perform better when managers receive a balanced combination of stock option grants and equity ownership. Firms with unbalanced compensation arrangements, large option grants and little equity ownership or vice versa, do not perform as well. This empirical finding is consistent with a theoretical explanation based on managerial risk aversion and the alignment of managerial and owner incentives.
Investor Reaction to Inter-Corporate Business Contracting: Evidence and Explanation
Fayez A. Elayan, Kuntara Pukthuanthong & Richard Roll
We examine the stock market reaction to 1227 inter-corporate ordinary business contract announcements reported by Dow Jones between January 1, 1990 and December 31, 2001. Around contract announcement dates, we find statistically significant positive average abnormal returns and abnormal trading volume for contractors, but insignificant positive abnormal returns and negative abnormal volume for contractees. Cross-sectionally, contract announcement period returns are higher for contractors who are small relative to the contract size, have higher return volatility, larger market-to-book ratios, and higher profitability. The announcement period returns of contract awarding firms are not significant and are only marginally related to cross-sectional explanatory factors. The results are consistent with two explanatory stories: contractor quasi rents induced by the winner's curse and information signaling about contractor production costs. The results are not consistent with perfect competition, with contracts having positive net present values for both parties, and with a behavioral version of incomplete contracting theory.
Learning, Hubris, and Corporate Serial Acquisitions
Nihat Aktas, Eric de Bodt & Richard Roll
Recent empirical research has shown that, from deal to deal, serial acquirers' cumulative abnormal returns (CAR) are declining. This has been most often attributed to CEOs hubris. We question this interpretation. Our theoretical analysis shows that (i) a declining CAR from deal to deal is not sufficient to reveal the presence of hubris, (ii) if CEOs are learning, economically motivated and rational (in the sense of maximizing their own utility function based on unbiased beliefs), a declining CAR from deal to deal should be observed, (iii) predictions can be derived about the impact of learning and hubris on the time between successive deals and, finally, (iv) predictions about the CAR and about the time between successive deal trends lead to testable empirical hypotheses.
Market efficiency, the timely incorporation of information into prices, remains a central and controversial issue in finance. The short-horizon predictability of returns from past order flows is an inverse indicator of efficiency. We analyze this predictability for NYSE stocks that traded every day from 1993 through 2002. Mid-quote return predictability is diminished when bid-ask spreads are narrower. Such predictability has declined over time with the minimum tick size. Variance ratios of five-minute and daily returns suggest that prices were closer to random walk benchmarks during decimal regimes than during regimes with higher tick sizes (and wider spreads). These findings support the notion that liquidity stimulates arbitrage activity, which, in turn, enhances market efficiency. Further, as the tick size decreased, open-close/close-open return variance ratios increased, while return autocorrelations decreased. This suggests an increased incorporation of private information into prices during more liquid regimes.
Deviations from no-arbitrage relations should be related to market liquidity, because liquidity facilitates arbitrage. Further, a wide futures/cash basis may trigger arbitrage trades and affect liquidity. We test these ideas by studying the dynamic relation between stock market liquidity and the index futures basis. Liquidity and the basis forecast each other in addition to being contemporaneously correlated. There is evidence of two-way Granger causality between the short-term absolute basis and liquidity, and liquidity Granger-causes longer-term absolute bases. Shocks to the absolute basis predict future stock market liquidity. The evidence suggests that liquidity enhances the efficiency of the futures/cash pricing system.
Negotiation Under the Threat of an Auction: Friendly deals, ex-ante competition and bidder returns
Nihat Aktas, Eric de Bodt & Richard Roll
Observable (ex-post) competition in the merger and acquisition (M&A) market seems to be very low. In this paper, we focus on the role of ex-ante competition and show that, when this is taken into account, the M&A market is more competitive than it seems. We first provide a theoretical analysis where we model takeovers as a two-stage process. The initial stage corresponds to a one-to-one negotiation with the target. If the negotiation fails, there is a second stage in which either a takeover battle among rivals occurs, or the target firm organizes a competitive auction. One of the main empirical predictions is that the higher the anticipated competition in the second stage, the higher the bid offered in the first stage. We then provide an empirical test of this prediction using a dataset of friendly deals for which, by construction, no ex-post competition is observable. We use the deal frequency in a given industry as a proxy for ex-ante competition, and we show that this variable is negatively related to the share of the value creation kept by the acquirer.
We study the effect of options trading volume on the value of the underlying firm after controlling for other variables that may affect firm value. The volume of options trading might have an effect on firm value because it helps to complete the market (allocational efficiency) and because the options market impounds information faster than the stock market (informational efficiency). We find that firms with more options trading have higher values. This result holds for all sample firms and for the subset of firms with positive options volume.
Share turnover has increased dramatically over the past several years. We explore possible causes. Higher turnover is associated with more frequent smaller orders, which have progressively formed a larger fraction of trading volume over time. However, institutions seem also to be contributing because share turnover has increased the most for stocks with the greatest level of institutional holdings. Changes in tick size can explain some but not all of the turnover increase. The increase in turnover does not appear to have been accompanied by greater production of private information. Some of the volume increase appears to be driven by enhanced sensitivity of turnover to past returns, perhaps revealing a more widespread use of quantitative trading strategies.
We study the drift in returns of portfolios formed on the basis of the stock price reaction around earnings announcements. The Earnings Announcement Return (EAR) captures the market reaction to unexpected information contained in the company’s earnings release. Besides the actual earnings news, this includes unexpected 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, 0.7% more than a strategy based on the traditional measure of earnings surprise, SUE. More importantly, 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 SUE. 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. A strategy that exploits both pieces of information generates abnormal returns of about 11% on an annual basis.
We provide evidence that trading frictions have an economically important impact on the execution and the profitability of option strategies which involve writing out-of-the money put options. Margin requirements, in particular, limit the notional amount of capital that can be invested in the strategies and frequently force investors to close down positions and realize losses. The economic effect of frictions is stronger when the investor seeks to write options more aggressively. Although margins may be effective in reducing counterparty default risk, they also impose a friction that may help perpetuate mispricings by limiting investors from supplying liquidity to the option market.
We use a novel pricing model to imply times series of diffusive volatility and jump intensity from S&P 500 index options. These two measures capture the ex-ante risk assessed by investors. We find that both components of risk vary substantially over time, are quite persistent, and correlate with each other and with the stock index. Using a simple general equilibrium model with a representative investor, we translate the implied measures of ex-ante risk into an ex-ante risk premium. We find that the average premium that compensates the investor for the ex-ante risks implicit in option prices, 11.8 percent, is more than 70% higher than the premium required to compensate the same investor for the realized volatility, 6.8 percent. Moreover, the ex-ante equity premium that we uncover is highly volatile, with values between 0.3 and 54.9 percent. The component of the premium that corresponds to jump risk varies between zero and 45.4 percent. The equity premium implied from option prices is shown to significantly predict subsequent stock market returns.
We consider a resource allocation problem in which time is the principal resource. Utility is derived from time-consuming leisure activities, as well as from consumption. To acquire consumption, time needs to be allocated to income generating activities (i.e., work). Leisure (e.g., social relationships, family and rest) is considered a basic good, and its utility is evaluated using the Discounted Utility Model. Consumption is adaptive and its utility is evaluated using a reference-dependent model. Key empirical findings in the happiness literature can be explained by our time allocation model. Further, we examine the impact of projection bias on time allocation between work and leisure. Projection bias causes individuals to overrate the utility derived from income; consequently, individuals may allocate more than the optimal time to work. This misallocation may produce a scenario in which a higher wage rate results in a lower total utility.
Real Options with Uncertain Maturity and Competition
Kristian R. Miltersen & Eduardo S. Schwartz
We develop a new approach to dealing with real options problems with uncertain maturity. This approach is highly applicable to analyze R&D investments and mine or oil exploration projects. These projects are characterized by significant on-going investment costs until completion. Since time to completion is uncertain, the total investment costs will also be uncertain. Despite the fact that these projects include complicated American abandonment/switching options until completion and European options at completion (because of fixed final investment costs) we obtain simple closed form solutions. We apply the framework to situations in which the owner of the project has monopoly rights to the outcome of the project, and to situations in which there are two owners who simultaneously invest, but where only one of them may obtain the rights to the outcome. We expand the real options framework to incorporate game theoretic considerations, including a generalization of mixed strategies to continuous-time models in the form of abandonment intensities.
We analyze trading activity accompanying equities’ switches from “growth” (low book-to-market ratios) to “value” (high book-to-market ratios), and vice versa. We find that a large book/market ratio increase, i.e., a shift from growth to value, is accompanied by a strongly negative small order imbalance. Large order imbalance exhibits weaker patterns across stocks that experience large changes in book/market. The evidence indicates that growth-to-value shifts are more strongly related to small traders than large ones. The interaction of book/market ratios with order flows plays a crucial role in return predictability. Specifically, the predictive ability of book/market ratios for future returns is significantly enhanced for those stocks that have experienced book/market increases as well as high levels of net selling by way of small orders.
We link corporate governance with liquidity as well as the clientele that holds the firm's stock. On the one hand high liquidity can decrease the quality of a firm's governance because it reduces costs of turning over a stock attracting too many short-term agents who have little vested in good governance. On the other hand, liquidity can attract more sophisticated agents and hence improve the quality of a firm's governance. In our cross-sectional analysis, we find that high liquidity is accompanied by poorer governance and vice versa. Further, increased institutional holdings are surprisingly associated with weaker governance in the 1990s, whereas in later years, they are not significantly related to governance. The proportion of orders transacted by small (large) traders is associated with weaker (stronger) governance, supporting the notion that a clientele consisting of small, unsophisticated investors can weaken the discipline imposed by outside investors on management. Given the known relation between corporate governance and stock prices, our results establish an indirect link between governance and liquidity as well as trading activity, which goes beyond the direct channel described in Amihud and Mendelson (1986).
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 due to a lack of sophistication or to naivete, possibly arising from high opportunity costs of learning about accounting conventions and financial markets, small investors are unable to decipher true executive compensation accurately. Expected compensation is therefore higher when small investors form a more significant clientele in the market for a firm’s stock. Our model further suggests that increased information asymmetry between large and small traders may deter the entry of small investors and keep executive compensation in check. Technologies that lower the cost of trading facilitate entry of small investors and raise expected compensation. In general, such compensation can be reduced through requirements that increase disclosure transparency. Empirical tests provide support to the key implication of the model that indirect executive compensation is higher in stocks with more retail investor participation.
Information, Expected Utility, and Portfolio Choice
Jun Liu, Ehud Peleg & Avanidhar Subrahmanyam
We study the consumption-investment problem of an agent with a constant relative risk aversion preference function, who possesses information about the future prospects of a stock. We also solve for the value of information to the agent in closed-form. We find that information can significantly alter consumption and asset allocation decisions. For reasonable parameter ranges, information increases consumption in the vicinity of 25%. Information can shift the portfolio weight on a stock from zero to around 70%. Thus, depending on the stock beta, the weight on the market portfolio can be considerably reduced with information, causing the appearance of under-diversification. We show that the dollar value of information to the agent depends linearly on his wealth and decreases with both the propensity to intermediate consumption and risk aversion. The model suggests that stock holdings of informed agents are positively related to wealth, unrelated to systematic risk, and negatively related to idiosyncratic uncertainty. Empirical tests using executive holdings data lend strong support to these implications.
Many proxies of illiquidity have been used in the literature that relates illiquidity to asset prices. These proxies have been motivated from an empirical standpoint. In this study, we approach liquidity estimation from a theoretical perspective. Our method explicitly recognizes the analytic dependence of illiquidity on more primitive drivers such as trading activity and information asymmetry. More specifically, we estimate illiquidity using structural formulae in line with Kyle’s (1985) lambda for a comprehensive sample of stocks. The empirical results provide convincing evidence that theory-based estimates of illiquidity are priced in the cross-section of expected stock returns, even after accounting for risk factors, firm characteristics known to influence returns, and other illiquidity proxies prevalent in the literature.
Corporate Financial Policies with Overconfident Managers
Ulrike Malmendier, Geoffrey Alan Tate & Jun Yan
We argue that individual characteristics of managers can explain capital structure decisions like debt conservatism and pecking-order financing choices. Moreover, they can explain cross-sectional variation in these decisions despite identical firm characteristics. We link the reluctance of (some) managers to access external capital markets, and in particular equity markets, to managerial overconfidence. Overconfident managers believe that their company is undervalued. We test the overconfidence hypothesis, using several measures of managerial overconfidence. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk. We also classify CEOs based on their characterization in the business press. We find that overconfident CEOs are significantly less likely than other CEOs to issue equity, conditional on tapping public securities markets. Likewise, they issue roughly 30 cents more debt to cover an additional dollar of external financing deficit than their peers. Finally, overconfident CEOs access all external capital markets (including debt markets) more conservatively.
We analyze the impact of winning high-profile tournaments on the subsequent behavior of the tournament winner in the context of chief executive officers of U.S. corporations. We find that the firms of CEOs who achieve "superstar" status via prestigious nationwide awards from the business press subsequently underperform beyond mere mean reversion, both relative to the overall market and relative to a sample of "hypothetical award winners" with matching firm and CEO characteristics. At the same time, award-winning CEOs extract significantly more compensation from their company following the award, both in absolute amounts and relative to other top executives in their firm. They also spend significantly more time and effort on public and private activities outside their company such as assuming board seats or writing books. The incidence of earnings management increases significantly after winning awards. Our results suggest that media-induced superstar culture leads to behavioral distortions beyond mere mean reversion. We also find that the effects are strongest in firms with weak corporate governance, suggesting that firms could prevent the negative consequences.
Expected Returns and the Expected Growth in Rents of Commercial Real Estate
Walter N. Torous, Rossen I. Valkanov & Alberto Plazzi
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.
The Cross-Sectional Dispersion of Commercial Real Estate Returns and Rent Growth: Time Variation and Economic Fluctuations
Alberto Plazzi, Walter N. Torous & Rossen I. Valkanov
We estimate the cross-sectional dispersion of returns and growth in net operating income (NOI) of apartments, industrial, retail and office properties using panel data for U.S. metropolitan areas over the period 1986 to 2002. Cross-sectional dispersion is a measure of the total volatility faced by investors in commercial real estate. To the extent that most of that volatility is difficult to diversify, cross-sectional dispersion may be an appropriate measure of risk. We document that for apartments, industrial, retail, and office properties, the cross-sectional dispersions are time-varying. Interestingly, their time series fluctuations can be explained by macroeconomic variables such as the term spread, default spread, inflation, and the short rate, which capture macroeconomic fluctuations. The total volatilities are counter-cyclical and also exhibit an asymmetrically larger response following negative return shocks, which might be due to leverage and credit channel effects. Finally, we find a positive relation between future returns and their cross-sectional dispersion. This total risk-return trade-off suggests that investors indeed demand compensation for being exposed to total volatility in the commercial real estate market.
This paper explores implications of differential personal taxation for corporate investment and dividend decisions. The personal tax advantage of dividend deferral causes shareholders to generally prefer greater investment in real assets under internal as opposed to external financing. Furthermore, dividend deferral is shown to be costly at the corporate level, causing shareholders in different tax brackets at times to disagree over optimal investment and dividend policies under internal financing. The profitability of internally-financed security investment is shown to depend on a security's tax status and shareholders' tax brackets. However, externally-financed security purchases are unprofitable from a tax standpoint.
Ratings Changes, Ratings Levels, and Predictive Value of Analysts' Recommendations
Brad M. Barber, Reuven Lehavy & Brett Trueman
This paper provides evidence that the documented abnormal returns to analysts’ security recommendations stem from both the ratings levels assigned as well as the changes in those ratings. Conditional on the sign and magnitude of a ratings change, we find buy and strong buy recommendations to be associated with greater returns than are holds, sells, and strong sells. Conditional on the ratings level, upgrades earn the highest returns and downgrades the lowest. We also find that both ratings levels and changes predict future unexpected earnings as well as the associated market reaction. Our results imply that (a) it is possible to enhance investment returns by conditioning on both recommendation levels and changes, (b) the predictive power of analysts’ recommendations reflects analysts’ ability to generate valuable private information about future earnings, not just to shift investor demand, and (c) there exists a degree of inconsistency between analysts’ ratings and the formal ratings definitions issued by securities firms.
M&As should be defined to include mergers, acquisitions, takeovers, tender offers, alliances, joint ventures, minority equity investments, licensing, divestitures, spin-offs, split-ups, carve-outs, leveraged buyouts, leveraged recapitalizations, dual-class recapitalizations, reorganizations, restructuring, and recontracting associated with financial distress and other adjustments. M&As represent a neoclassical theory of how firms seek to enhance their capabilities and resources (the good). Good M&As are positive net present value external investments. What is common to all our sample companies is that (1) M&As represent a wide range of methods to develop growth opportunities. (2) These programs have long and multiple year time horizons. (3) These companies continuously revise the portfolios of products and markets in which they seek to develop value increasing investment programs. These are clear illustrations of a real options approach to capital budgeting decisions. Competing explanations of M&A activities include redistribution theories (the bad) and behavioral theories (the ugly). Redistribution theories hold that M&As are motivated by tax benefits, market power, extractions from bondholders, breach of trust with labor, and shifting pension costs to the government. Behavioral theories include hubris, market misvaluations, agency, and organizational theories. Both the redistribution and behavioral theories argue that M&As represent departures from neoclassical economic behavior. This paper investigates the relative roles of the three competing explanations of M&As.
Mergers and Acquisitions in 2007
Kenneth Ahern & J. Fred Weston
The widely respected UCLA Anderson economic forecast for 2007 reports that real gross domestic product (GDP) growth in 2006 was 3.2% and forecasts 2.0% for 2007. Since business investments and M&A are sensitive to economic conditions, a question is raised about their levels for 2007. Growth rates in real GDP beginning in the third quarter of 2006 through the second quarter of 2007 are estimated at about 1.7% per quarter at annual rates. Real GDP rates for subsequent quarters are expected to rise to over 3.5% per quarter through the end of 2008. These data raise the question of whether M&A activities will decline during 2007.
New theoretical papers and empirical developments have changed the framework required for understanding the nature of payout policies. The institutional developments are the rise of private equity firms, hedge funds, and venture capital firms. Central bank policies and actions are now followed by households as well as firms as closely as wins and losses of major sports terms. The growth of the economies of China and India have changed the competitive structure and dynamics of the global economy, with strong impacts on commodity prices such as gold, steel and nonferrous metals such as aluminum, copper, zinc, etc. The formation of regional economic blocs in Western Europe and its Eurocurrency are having effects similar to those in the United States of North America when the completion of the transcontinental railroad systems in the 1980s resulted in the first common market, resulting in the national scope of business activity. The increased pace of technological change from computers, Internet and the information highway, biological and chemical industry developments have shortened product cycles and intensified competitive pressures. Product market opportunities for the formation of new business firms have also expanded. Continuing reassessment of a firm's external economic, political, cultural, and competitive environments has become imperative, leading to continuing strategic planning processes. Specific policy areas such as human resource management, research and development policies, investment choices as well as payout policies must be made within this broader framework. This central proposition is the organizing framework of this paper.