2009 Working Papers

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

A Unifying Approximate Dynamic Programming Model for the Economic Lot Scheduling Problem
D. Adelman, C. Barz
We formulate the well-known economic lot scheduling problem (ELSP) with sequence dependent setup times and costs as a semi-Markov decision process. Using an afƒine approximation of the bias function, we obtain a semi-infinite linear program determining a lower bound for the minimum average cost rate. Under a very mild condition, we can reduce this problem to a relatively small convex quadratically constrained linear problem by exploiting the structure of the objective function and the state space. This problem is equivalent to the lower bound problem derived by Dobson (1992) and reduces to the well-known lower bound problem introduced in Bomberger (1966) for sequence-dependent setups. We thus provide a framework that unifies previous work, and opens new paths for future research on tighter lower bounds and dynamic heuristics.

Fairness Monitoring: Contextualizing Fairness Judgments in Organizations
Chris Long, Corinne Bendersky & Calvin Morrill
We argue that different types of perceived managerial controls – mechanisms to direct subordinates’ tasks – increase the importance of particular aspects of fairness to subordinates in organizations. We introduce the concept of fairness monitoring to characterize the ongoing cognitive and behavioral sensemaking processes that individuals use to identify and then selectively examine contextually relevant types of fairness information. In scenario and survey studies, we find that subordinates who perceive market controls engage in distributive fairness monitoring, subordinates who perceive bureaucratic controls engage in procedural fairness monitoring, and subordinates who perceive clan controls engage in interpersonal fairness monitoring. We also find that managers who promote the type of fairness that their subordinates monitor most closely engender higher levels of subordinate job satisfaction than those who do not.

Multiplex Ties and Individual Performance: Interdependence in Networks
Neha Shah, Corinne Bendersky & Christian Waldstrom
Organizational network scholars have found that informal instrumental (i.e., work-based) relationships at work positively affect performance. The networks they study are comprised of both primarily-instrumental ties (that include exchanges of work-related information) and multiplex ties (that include exchanges of both instrumental and social information). The previous organizational network research does not differentiate these relationships because scholars assume that the instrumental component of these relationships drives performance consequences. When we analyze their separate effects on performance, however, we find that only multiplex relationships significantly influence performance. Furthermore, our results indicate diminishing performance returns associated with maintaining too many multiplex relationships. These findings, which we replicate in both student and financial services organizational samples, suggest that our existing understanding of how social networks influence performance needs to include more complex measures that better match the relationships people actually have at work.

The cost of status attainment: Performance effects of individual’s status mobility in task groups
Corinne Bendersky & Neha Shah
Although we know that considerable benefits accrue to individuals with high social status, we do not know the performance effects of gaining or losing status in one's group over time. In two longitudinal studies, we measure the status positions of middle managers currently enrolled in a part-time MBA program at the beginning and end of their study group's life. In both samples, we compare the individual performance (course grades) of the students who gained or lost status to those who maintained high and low stable status positions in their groups. We find that higher status at the end of the group's life is associated with higher performance. We also find, however, that the performance of individuals who gain or lose status over time does not correspond to their final status positions. Instead, those who gain status – including those who eventually attain high status – perform worse than do those who maintain high status positions for the whole quarter, and they perform no better than did those in stable low status positions throughout. Those who lose status over time actually perform as well as those who maintain high status. We interpret these results to suggest that people might trade off resources they could apply to individual performance for opportunities to enhance their status. After replicating this effect in our second sample, we identify over-investment in increasing dominance and generosity as behavioral mechanisms through which individuals successfully gain status to the detriment of their own performance.

Information acquisition and full surplus extraction
Sushil Bikhchandani
It is well-known that when agents’ types are correlated, the mechanism designer can extract the entire surplus. This creates an incentive for agents to acquire information about other agents’ types. Robust lotteries (are payment schemes that) support full extraction and partially robust lotteries support efficient implementation in the presence of information acquisition opportunities. Necessary and sufficient conditions for existence of robust and partially robust lotteries are derived. If an agent’s information signal spans the set of other agents’ types then robust lotteries do not exist. However, by inducing agents to report their signal realizations the mechanism designer may be able to extend the type space so that robust lotteries exist.

Transitive Regret
Sushil Bikhchandani & Uzi Segal
Preferences may arise from regret, i.e., from comparisons with alternatives forgone by the decision maker. We ask whether regret-based behavior is consistent with non-expected utility theories of transitive choice. We show that the answer is no. If choices are governed by ex ante regret and elation then non-expected utility preferences must be intransitive.

Brand History, Geography, and the Persistence of Brand Shares
Bart J. Bronnenberg, Sanjay K. Dhar & Jean-Pierre H. Dube
We study persistence in the geographic variation in market shares of branded goods in consumer packaged goods industries across 50 U.S. city-markets. We match scanner data on local market shares and survey data on local quality perceptions for the largest brands in 34 consumer packaged goods industries. These data are then matched with historic information on the year and US city-market in which each brand was first launched. We find that these consumer brands have persistently higher market shares in markets closest to their respective cities-of-origin than in markets farthest from their respective cities-of-origin, where they were typically launched later. For 6 of the 34 industries, we collected more complete historic entry data with which we can determine the local order of entry among the top brands in each of the 50 U.S. city-markets. We find a persistent effect from differences in the order-of-entry of competing brands on their current relative brand shares and quality perceptions across US cities. The historic order of entry also appears to correlate with the current rank-order of brand shares across cities, leading to large asymmetries across markets in brand shares and in quality perceptions. This persistence is particularly striking since many of the brands studied herein originated during the mid-to-late 19th and early 20th centuries, roughly a century prior to the sample period of the market share and quality perception data.

Modeling Unobserved Consideration Sets for Household Panel Data
Erjen Van Nierop, Richard Paap, Bart J. Bronnenberg, Philip Hans Franses & Michel Wedel
We propose a new method to model consumers' consideration and choice processes. We develop a parsimonious probit type model for consideration and a multinomial probit model for choice, given consideration. Unlike earlier models of consideration ours is not prone to the curse of dimensionality, while we allow for very general structures of unobserved dependence in consideration among brands. In addition, our model allows for state dependence and marketing mix effects on consideration. Unique to this study is that we attempt to establish the validity of existing practice to infer consideration sets from observed choices in panel data. To this end, we use data collected in an on-line choice experiment involving interactive supermarket shelves and post-choice questionnaires to measure the choice protocol and stated consideration levels. We show with these experimental data that underlying consideration sets can be successfully retrieved from choice data alone and that there is substantial convergent validity of the stated and inferred consideration sets. We further find that consideration is a function of point-of-purchase marketing actions such as display and shelf space, and of consumer memory for recent choices. Next, we estimate the model on IRI panel data. We have three main results. First, compared with the single-stage probit model, promotion effects are larger and are inferred with smaller variances when they are included in the consideration stage of the two-stage model. Promotion effects are significant only in the two-stage model that includes consideration, whereas they are not in a single-stage choice model. Second, the price response curves of the two models are markedly diferent. The two-stage model offers a nice intuition for why promotional price response is different from regular price response. In addition and consistent with intuition, the two-stage model also implies that merchandizing has more effect on choice among those who did not buy the brand before than among those who already did. It is explained why a single-stage model does not harbor this feature. In fact, the single-stage model implies the opposite for smaller or more expensive brands. Third, we find that the consideration of brands does not covary greatly across brands once we take account of observed effects. Managerial implications and future research are also discussed.

Effects Of Word-of-Mouth Versus Traditional Marketing: Findings From An Internet Social Networking Site
Michael Trusov, Randolph E. Bucklin & Koen Pauwels
The authors study the effect of word-of-mouth (WOM) marketing on member growth at an Internet social networking site and compare it with traditional marketing vehicles. Because social network sites record the electronic invitations sent out by existing members, outbound WOM may be precisely tracked. WOM, along with traditional marketing, can then be linked to the number of new members subsequently joining the site (signups). Due to the endogeneity among WOM, new signups, and traditional marketing activity, the authors employ a Vector Autoregression (VAR) modeling approach. Estimates from the VAR model show that word-of-mouth referrals have substantially longer carryover effects than traditional marketing actions. The long-run elasticity of signups with respect to WOM is estimated to be 0.53 (substantially larger than the average advertising elasticities reported in the literature) and the WOM elasticity is about 20 times higher than the elasticity for marketing events, and 30 times that of media appearances. Based on revenue from advertising impressions served to a new member, the monetary value of a WOM referral can be calculated; this yields an upper bound estimate for the financial incentives the firm might offer to stimulate word-of-mouth.

Obfuscation, Learning, and the Evolution of Investor Sophistication
Bruce Ian Carlin & Gustavo Manso
We develop a dynamic model to study the interaction between obfuscation and investor sophistication in retail financial markets. Taking into account different learning mechanisms within the investor population, we characterize the optimal timing of obfuscation for a profit-maximizing monopolist. We show that educational initiatives that are directed to facilitate learning by investors may induce producers to increase wasteful obfuscation, further disorienting investors and decreasing overall welfare. Obfuscation decreases with competition among firms, but increases with higher investor participation in the market.

Naïve Diversification and Partition Dependence in Capital Allocation Decisions: Field and Experimental Evidence
David Bardolet, Craig R. Fox & Daniel Lovallo
We explore the role of a cognitive bias in organizational capital allocation decisions by managers. Previous research on capital investment has identified a tendency in multi-business firms toward cross-subsidization from well performing to poorly performing divisions, a phenomenon that has previously been attributed to social/political factors and/or incentives (Stein 2003). However, evidence for this phenomenon relies on strong assumptions concerning rational allocations and the extant evidence for the purported mechanisms is indirect. The present paper advances a methodology for cleanly demonstrating a counter-normative bias toward even allocation. Our first study uses archival data to show that firms' internal capital allocations are biased toward equality over the number of business units into which the firm is partitioned, an effect that is consistent with the cognitive bias known as naïve diversification (Bernatzi and Thaler 2001). In three further experimental studies, we show that this bias persists in a simplified experimental setting in which social/political and incentive-based mechanisms can be ruled out. In those experiments, experienced managers were provided information concerning forecast returns of capital allocations to various divisions of a hypothetical firm. We find that allocations exhibited partition dependence, varying systematically with the salient grouping of divisions.

Partition Dependence in Binary Option and Prediction Markets: Field and Lab Evidence
Ulrich Sonnemann, Colin F. Camerer, Craig R. Fox & Thomas Langer
Financial instruments such as binary options, credit-default swaps, and catastrophe bonds offer a fixed payment if a future event occurs. Markets for such instruments are prediction markets in which prices reflect aggregate subjective beliefs of events occurring. Psychology experiments have shown that judged probabilities can be affected by the partition of the state space (“partition-dependence”). We report evidence from field data on macroeconomic derivatives and horse racing markets, and lab data from short-run (two-hour) and long-run (seven-week) experiments on pricing events in two different partitions. All four markets show some evidence of partition-dependence in market prices and judgments.

Housing Risk and Return: Evidence From A Housing Asset-Pricing Model
Karl Case, John Cotter & Stuart A. Gabriel
This paper investigates the risk-return relationship in determination of housing asset pricing. In so doing, the paper evaluates behavioral hypotheses advanced by Case and Shiller (1988, 2002, 2009) in studies of boom and post-boom housing markets. The paper specifies and tests a housing asset pricing model (H-CAPM), whereby expected returns of metropolitan-specific housing markets are equated to the market return, as represented by aggregate US house price time-series. We augment the model by examining the impact of additional risk factors including aggregate stock market returns, idiosyncratic risk, momentum, and Metropolitan Statistical Area (MSA) size effects. Further, we test the robustness of H-CAPM results to inclusion of controls for socioeconomic variables commonly represented in the house price literature, including changes in employment, affordability, and foreclosure incidence. Consistent with the traditional CAPM, we find a sizable and statistically significant influence of the market factor on MSA house price returns. Moreover we show that market betas have varied substantially over time. Also, we find the basic housing CAPM results are robust to the inclusion of other explanatory variables, including standard measures of risk and other housing market fundamentals. Additional tests of the validity of the model using the Fama-MacBeth framework offer further strong support of a positive risk and return relationship in housing. Our findings are supportive of the application of a housing investment risk-return framework in explanation of variation in metro-area cross-section and time-series US house price returns. Further, results strongly corroborate Case-Shiller behavioral research indicating the importance of speculative forces in the determination of U.S. housing returns.

Human Capital Spillovers, Labor Migration and Regional Development in China
Yuming Fu & Stuart A. Gabriel
This study applies unique data from the 1990s period of economic liberalization in China to evaluate the effects of human capital spillovers on urbanization and regional agglomeration of human capital. We examine these effects via a utility maximizing directional migration model, which accounts for heterogeneous migration costs and benefits among population strata. We use model estimates to decompose and evaluate human capital spillover effects as derive from three distinct sources, including productivity effects (social returns to schooling), skill premia (skill complementarity in production), and non-wage benefits (quality of life and learning opportunities). In contrast to extant literature emphasizing skill complementarity, we find significantly stronger non-wage than wage effects in the determination of regional human capital agglomeration. However, among low-skill migrants, non-wage benefits are substantially reduced—due likely to urban segregation that deprives low-skill migrants of social externalities. This finding suggests limited human capital spillovers among low-skill migrants and hence dampened long-run growth benefits to Chinese urbanization. Finally, we find that urban concentration of skilled workers was more important than foreign direct investment, the prominent source of technology transfer in China during the 1990s, in attracting skilled workers

Is Conduit Lending to Blame? Asymmetric Information, Adverse Selection, and the Pricing of CMBS
Xudong An, Yongheng Deng & Stuart A. Gabriel
While portfolio lenders face a decision to hold for investment or sell newly-originated commercial mortgages, conduit lenders originate loans exclusively for sale in securitization markets. In so doing, conduit lenders may have alleviated a “lemon’s problem” in selection of loans for sale, resulting in reduced mortgage risk premia and improved pricing of conduit commercial mortgages. In this paper, we investigate the adverse selection hypothesis, via theoretical modeling and empirical evaluation of pricing of conduit- versus portfolio-backed commercial mortgage backed securities (CMBS) and loans. Results of an information economics model indicate that conduit lending helped to mitigate “lemons discounts” in sales of portfolio loans in CMBS markets. Empirical analysis of 141 CMBS deals and 16,760 CMBS loans show that upon controlling for well-established determinants of loan pricing, conduit loans enjoyed a 30 bps pricing advantage over portfolio loans in the CMBS market. Empirical results are robust to alternative model specifications. Results suggest the importance of mitigation of adverse selection problems associated with loan sales to re-structuring of securitization markets.

Capital Structure Effects on Prices of Firm Stock Options: Tests Using Implied Market Values of Corporate Debt
Robert Geske & Yi Zhou
This paper introduces a new methodology for measuring and analyzing capital structure effects on option prices of individual firms in the economy. By focusing on individual firms we examine the cross sectional effects of leverage on option prices. Our methodology allows the market value of each firm's debt to be implied directly from two contemporaneous, liquid, at-the-money option prices without the use of any historical price data. We compare Geske's parsimonious model to the alternative models of Black Scholes (BS) (1973), Bakshi, Cao, and Chen (BCC, 1997) (stochastic volatility (SV), stochastic volatility and stochastic interest rates (SVSI), and stochastic volatility and jumps (SVJ)), and Pan (2002) (no-risk premia (SV0), volatility-risk premia(SV), jump-risk premia (SVJ0), volatility and jump risk premia (SVJ)) which allows state-dependent jump intensity and adopts implied state-GMM econometrics. These alternative models do not directly incorporate leverage effects into option pricing, and except for Black-Scholes these model calibrations require the use of historical prices, and many more parameters which require complex estimation procedures. The comparison demonstrates that firm leverage has significant statistical and economic cross sectional effects on the prices of individual stock options. The paper confirms that by incorporating capital structure effects using our methodology to imply the market value of each firm's debt, Geske's model reduces the errors pricing options on individual firms by 60 percent on average, relative to the models compared herein (BS, BCC, Pan) which omit leverage as a variable. However, we would be remiss in not noting that after including leverage there is still room for improvement, and perhaps by also incorporating jumps or stochastic volatility at the firm level would result in an even better model.

Do Smart Investors Outperform Dumb Investors?
Mark Grinblatt, Matti Keloharju, Juhani Linnainmaa
This study analyzes whether high IQ investors exhibit superior investment performance. It combines equity return, trade, and limit order book data with two decades of scores from an intelligence test administered to nearly every Finnish male of draft age. Controlling for wealth, trading frequency, age, and determinants of the cross-section of stock returns on each day, we find that high IQ investors exhibit superior stock-picking skills, particularly for purchases, and superior trade execution for both purchases and sales.

IQ and Stock Market Participation
Mark Grinblatt, Matti Keloharju & Juhani Linnainmaa
An individual’s IQ stanine, measured early in adult life, is monotonically related to his stock market participation decision later in life. The high correlation between IQ and participation, which exists even among the 10% most affluent individuals, controls for wealth, income, and other demographic and occupational information. Supplemental data from siblings is used with both an instrumental variables approach and paired difference regressions to show that our results apply to both females and males, and that omitted familial and non-familial variables cannot account for our findings.

Marketing Spending and the Volatility of Revenues and Cash Flows
Marc Fischer, Hyun Shin, & Dominique M. Hanssens
While volatile marketing spending, as opposed to even-level spending, may 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. From market response theory, we derive predictions about the influence of these variables on revenue and cash-flow volatility. Based on a broad sample of 99 pharmaceutical brands in four clinical categories and four European countries, the authors test for the empirical relevance of our predictions and assess the magnitude of the different sources of marketing-induced performance volatility.
The authors find broad support for the expected volatility effects. The results suggest that volatile marketing spending may incur negative financial side effects such as greater financing costs or higher opportunity costs of cash holdings. Thus common volatility-increasing marketing practices such as advertising pulsing may be effective at the top-line, but could turn out to be ineffective after all costs are taken into account.

Does Public Ownership of Equity Improve Earnings Quality?
Dan Givoly, Carla Hayn & Sharon P. Katz
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 stronger demand by investors and creditors for quality reporting. In contrast, the "opportunistic behavior" hypothesis posits that public equity firms, because their managers have a greater incentive to manage earnings, have lower earnings quality than their private equity peers. Assessing various attributes of earnings quality, 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.

Finance and Labor: Perspectives on Risk, Inequality, and Democracy
Sanford M. Jacoby
We live in an era of financialization. Since 1980, capital markets have expanded around the world; capital shuttles the global instantaneously. Shareholder concerns drive executive decision making and compensation, while the fluctuations of stock markets are a source of public anxiety. So are the financial scandals that have regularly occurred in recent years: junk bonds in the 1980s; lax accounting and stock manipulation in the early 2000s; and debt securitization today. We also live in an era of rising income inequality and employment risk. The gaps between top and bottom incomes and between top and middle incomes have widened since 1980. Greater risk takes various forms, such as wage and employment volatility and the shift from employers to employees of responsibility for pensions and, in the United States, for health insurance. There is an enormous literature on financial development and another on inequality. But relatively few studies consider the intersection of these phenomena. Standard explanations for rising inequality -- skill-biased technological change and trade -- account for only 30 percent of the variation in aggregate inequality. What else matters? We argue here that an omitted factor is financial development. This study explores the relationship between financial markets and labor markets along three dimensions: contemporary, historical, and comparative. For the world's industrialized nations, we find that financial development waxes and wanes in line with top income shares. Since 1980, however, there have been national divergences between financial development -- defined here as the economic prominence of equity and credit markets -- and inequality. In the U.S. and U.K., there remains a strong positive correlation but in other parts of Europe and in Japan the relationship is weaker.

Women’s and Men’s Career Referents: How Gender Composition and Comparison Level Shape Career Expectations 
Donald E. Gibson & Barbara S. Lawrence
This study examines how women’s and men’s career referents, the people they see as having similar careers, affect career expectations. We raise two questions. First, what is the relative effect of the gender composition and comparison level of career referents on such expectations? Second, what happens to career expectations when women and men identify career referents at the same comparison level? Current research suggests that women have lower career expectations than men because they compare themselves with women who hold lower-level positions than the career referents identified by men. Thus, if women and men identify with similar level career referents, their career expectations should be equal. However, this chain of reasoning has not been tested. Using data collected from a large organization, we identify both the specific individuals women and men perceive as having similar careers and these referents’ career levels, defined as their hierarchical level in the firm. The results show that the level of career referents is more important than their gender composition in explaining individuals’ career expectations. In contrast to extant explanations, the results show that even when women identify career referents at the same levels as men, they still exhibit significantly lower career expectations. Drawing on social comparison theory, we speculate this occurs because men’s expectations are bolstered by extreme upward comparisons, whereas women’s expectations are dampened, perhaps because they see high achieving others as representing a less probable goal.

Acquisition vs. Internal Development as Modes of Market Entry
Gwendolyn K. Lee & Marvin B. Lieberman
An established firm can enter a new market through acquisition or internal development. Predictions that the choice of entry mode depends on "relatedness" between the new market and the firm's existing businesses have repeatedly failed to gain empirical support. We resolve ambiguity in prior work by developing dynamic measures of relatedness, and by making a distinction between entries inside versus outside a firm's primary business domain. Using a fine-grained data set on the telecommunications sector, we find that inside a firm's primary business domain, acquisitions are used to fill persistent gaps near the firm's existing businesses, whereas outside that domain, acquisitions are used to extend the enterprise in new directions.

Industry Learning Environments and the Heterogeneity of Firm Performance
Natarajan Balasubramanian & Marvin B. Lieberman
This paper characterizes inter-industry heterogeneity in rates of learning-by-doing, and examines how industry learning rates are connected with firm performance. Using plant-level data from the US manufacturing sector, we measure the industry learning rate as the coefficient on cumulative output in a production function. We find that learning rates vary considerably among industries and are higher in industries with greater R&D, advertising, and capital intensity. More importantly, we find that higher rates of learning are associated with wider dispersion of Tobin's q and profitability among firms in the industry. These findings suggest that learning intensity represents an important characteristic of the industry environment that affects the range of firm performance.

Counterparty Credit Risk and the Credit Default Swap Market
Navneet Arora, Priyank Gandhi & Francis A. Longstaff
Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue by studying the CDS spreads quoted by a broad cross-section of dealers selling protection on the same underlying firm. This unique data set allows us to identify directly how the credit risk of the dealer affects the prices of these controversial credit derivatives. We find that counterparty credit risk is significantly priced in the CDS market. The magnitude of the effect, however, is relatively modest and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties. We also find that the pricing of counterparty credit risk became much more significant after the Lehman bankruptcy. Surprisingly, counterparty credit risk is significantly related to the credit protection spreads offered by U.S. dealers, but not to those offered by non-U.S. dealers.

How Does the Market Value Toxic Assets?
Francis A. Longstaff & Brett Myers
How does the market value “toxic” structured-credit securities? This issue is central to understanding the current financial crisis and identifying effective policy measures. We study this issue by focusing on the valuation of what is possibly the most toxic of all toxic assets: the first-loss or equity tranche of a CDO. Surprisingly, we find that there are many similarities between CDO equity and bank stock. For example, we find that a single factor explains more than 64 percent of the variation in bank and CDO equity returns. The intuition for this is that both CDO equity and bank stock represent levered first-loss residual claims on an underlying debt portfolio. After controlling for differences in leverage, the excess returns from CDO equity are virtually identical to those from bank stock. This is particularly striking since bank stock is a claim on an actively-managed debt portfolio while CDOs are based on more-passively-managed portfolios. We find that both CDO equity and bank returns are driven by “shadow banking” factors such as counterparty credit risk, the availability of collateralized financing for debt securities, and the liquidity of the derivatives market. These results suggest that the market valuation of even the most-distressed types of structured-credit securities is consistent with economic fundamentals.

Municipal Debt and Marginal Tax Rates: Is there a Tax Premium in Asset Prices?
Francis A. Longstaff
We study the marginal tax rate incorporated into short-term tax-exempt municipal rates using a unique new data set from the municipal swap market. By applying an affine term-structure framework, we are able to identify both the marginal tax rate and the credit/liquidity spread in one-week tax-exempt rates. Furthermore, we obtain maximum likelihood estimates of the risk premia associated with these variables. The average marginal tax rate during the sample period is 41.6 percent. We find that the marginal tax rate is significantly positively related to returns in the stock and bond markets. The risk premium associated with the marginal tax rate is negative, consistent with the strong contracyclical nature of aftertax fixed-income cash flows which increase in bad states of the economy as personal income and the effective marginal tax rates applied to those cash flows decline.

How Sovereign is Sovereign Credit Risk?
Francis A. Longstaff, Jun Pan, Lasse H. Pedersen & Kenneth J. Singleton
Is sovereign credit primarily country specific? Or is it driven largely by global macroeconomic factors? We study this issue using an extensive set of sovereign credit default swap data. The results indicate that the majority of sovereign credit risk can be linked to global factors. We find that a single principal component accounts for more than 66 percent of the variation in sovereign credit spreads. Furthermore, sovereign credit spreads are much more related to the U.S. stock and high-yield markets, global risk premia and liquidity patterns than they are to local economic measures. We also find that excess returns from investing in sovereign credit are largely compensation for bearing global macroeconomic risk. In particular, there is little or no country-specific credit risk premium after controlling for global risk factors.

Technological Change and the Growing Inequality in Managerial Compensation
Hanno N. Lustig, Chad Syverson & Stijn Van Nieuwerburgh
Three of the most fundamental changes in US corporations since the early 1970s have been (1) the increased importance of organizational capital in production, (2) the increase in managerial income inequality and pay-performance sensitivity, and (3) the secular decrease in labor market reallocation. Our paper develops a simple explanation for these changes: a shift in the composition of productivity growth away from vintage-specific to general growth. This shift has stimulated the accumulation of organizational capital in existing firms and reduced the need for reallocating workers to new firms. We characterize the optimal managerial compensation contract when firms accumulate organizational capital but risk-averse managers cannot commit to staying with the firm. A calibrated version of the model reproduces the increase in managerial compensation inequality and the increased sensitivity of pay to performance in the data over the last three decades.

Homeland Security: Theme of the New Deal
Daniel J.B. Mitchell
The New Deal had a central theme: economic security. But it lacked an economic model for achieving it. Although New Deal remedies are sometimes described as Keynesian, they were not based on Keynes and his macroeconomic model. Rather, there was a hodge-podge of theories and approaches, shifts in direction, contradictions, and a lack of timely empirical data on which to base policy. In contrast, the Obama administration, facing the Great Recession, has a (new) Keynesian model, but no central theme. The current agenda is diffuse, perhaps a reflection of a broader range of economic problems and social issues.

A Comparative Anatomy of REITs and Residential Real Estate Indexes: Returns, Risks and Distributional Characteristics
Richard Roll & John Cotter
Real Estate Investment Trusts (REITs) are the only truly liquid assets related to real estate investments. We study the behavior of U.S. REITs over the past three decades and document their return characteristics. REITs have somewhat less market risk than equity; their betas against a broad market index average about .65. Decomposing their covariances into principal components reveals several strong factors. REIT characteristics differ to some extent from those of the S&P/Case-Shiller (SCS) residential real estate indexes. This is partly attributable to methods of index construction. Our examination of REITs suggests that investment in real estate is far more risky than what might be inferred from the widely-followed SCS series.

Global Market Integration: An Alternative Measure and its Application
Kuntara Pukthuanthong & Richard Roll
Many previous studies of international markets have attempted to measure integration by correlations among broad stock market indexes. Yet such correlations have been found to poorly mimic other measures of integration. We show that a simple correlation between two stock markets is likely to be a poor indicator of integration for a very simple reason: when there are multiple factors driving returns, such as global macro factors or even industry factors, two markets can be perfectly integrated and yet still be imperfectly correlated. Perfect integration implies that the same international factors explain 100% of the broad index returns in both countries, but if the countries differ in their sensitivities to these factors, they will not exhibit perfect correlation. We derive a new integration measure based on the explanatory power of a multi-factor model and use it empirically to investigate recent trends in global integration. For most countries, there has been a marked increase in measured integration, but this is not indicated by simple correlations among countries.

Internationally Correlated Jumps
Kuntara Pukthuanthong-Le & Richard Roll
Stock returns are characterized by extreme observations, jumps that would not occur under the smooth variation typical of a Gaussian process. We find that jumps are prevalent in most countries. This has been noticed before in some countries, but there has been little investigation of whether the jumps are internationally correlated. Their possible inter-correlation is important for investors because international diversification is less effective when jumps are frequent, unpredictable and strongly correlated. Government fiscal and monetary authorities are also interested in jump correlations, which have implications for international policy coordination. We investigate using daily returns on broad equity indexes from 82 countries and for several competing statistical measures of jumps. Various jump measures are not in complete agreement but a general pattern emerges. Jumps are internationally correlated but not as much as returns. Although the smooth variation in returns is driven strongly by systematic global factors, jumps are more idiosyncratic.

Liquidity Skewness
Richard Roll & Avanidhar Subrahmanyam
Bid-ask spreads have declined on average but have become increasingly right-skewed. Higher right-skewness is consistent with more competition among market makers; which inhibits their ability to cross-subsidize between periods of high and low asymmetric information, unlike a monopolistic market maker who can maintain a relatively constant spread. Confirming this intuition, differences in spreads between earnings announcements and normal periods have increased considerably. Skewness also is cross-sectionally related to information proxies such as institutional holdings and analyst following.

O/S: The Relative Trading Activity in Options and Stock
Richard Roll, Eduardo Schwartz & Avanidhar Subrahmanyam
While many studies have focused on trading volume in the stock market, little is known about why derivatives volume varies in the cross-section or over time. We study time-series properties as well as the determinants of the options/stock trading volume ratio (O/S) using a comprehensive cross-section and time-series of data on equities and their listed options. O/S is related to many intuitive determinants such as delta and trading costs, and it also varies with institutional holdings, analyst following, and analyst forecast dispersion. O/S is higher around earnings announcements (suggesting increased trading in the options market), and higher O/S predicts lower abnormal returns after the earnings announcement, suggesting that options trading improves market efficiency.

Real Interest Rates, Expected Inflation, and Real Estate Returns: A Comparison of the U.S. and Canada
Kuntara Pukthuanthong & Richard Roll
In the United States, but not in Canada, nominal interest on residential housing mortgages is a deductible expense for the personal income tax. This suggests that changes in nominal interest rates could conceivably have differing impacts on real estate values in the two countries. The inflation component of nominal interest should have a negative impact on Canadian real estate, but its effect should be strictly less negative in the US and could even be positive. Using real estate investment trusts along with expected inflation imputed from inflation-indexed bonds in both countries, we find empirical support for a material and significant difference. In Canada, increases in nominal interest rates driven by inflation have a negative impact. The US impact is minimal and ambiguous in sign.

The Elapsed Time Between Acquisitions
Nihat Aktas, Eric De Bodt & Richard Roll
Acquirer cumulative abnormal returns (CARs) have been investigated intensively for more than three decades. CARs measure shareholders' wealth changes conditional on a deal announcement. The unconditional acquirer shareholders' expected profit is, however, the product of the acquirer's CAR and the probability of doing the deal. This probability element of mergers and acquisitions has been mostly overlooked in the literature. Since the probability cannot be observed directly, we use the time between successive deals as a proxy and provide a systematic empirical analysis of its determinants.

A Rational Expectations Equilibrium with Informative Trading Volume
Jan Schneider
A large number of empirical studies find that trading volume contains information about the distribution of future returns. While these studies indicate that observing volume is helpful to an outside observer of the economy it is not clear how investors within the economy can learn from trading volume. In this paper I show how trading volume helps investors to evaluate the precision of the aggregate information in the price. I construct a model that offers a closed form solution of a rational expectations equilibrium where all investors learn from (1) private signals, (2) the market price and (3) aggregate trading volume.

An Equilibrium Model of Informed Trading and Portfolio Rebalancing
Jan Schneider
A key intuition of standard rational expectations models is that private information about future payoffs can by itself not generate trading. Trading is only possible if there is an additional motive for trading such as for example liquidity trading. In this paper I show how this misleading intuition results from an assumption that all of these models have in common: investors have negative exponential (CARA) utility functions. I develop a rational expectations equilibrium where uninformed investors are willing to trade with informed investors even though they know that they trade with someone who possesses superior information.

Towards a Common European Monetary Union Risk Free Rate
Sergio Mayordomo, Juan Ignacio Pena & Eduardo S. Schwartz
A common European bond would yield a common European Monetary Union risk free rate. We present tentative estimates of this common risk free for the European Monetary Union countries from 2004 to 2009 using variables motivated by a theoretical portfolio selection model. First, we analyze the determinants of EMU sovereign yield spreads and find significant effects of the credit quality, macro, correlation, and liquidity variables. However, their effects are different before and after the current financial crisis, being stronger in the latter period. Robustness tests with different data frequencies, benchmarks, liquidity variables, cross section regressions and balanced panels confirm the initial results. We propose four different estimates of the common risk free rate and show that, in most cases, this common rate could imply savings in borrowing costs for all the countries involved.

Ethical Fit, Diversity, and Attrition: Behavioral Evidence from Emissions Inspections
Lamar Pierce & Jason A. Snyder
In this paper we explore how person-organization (P-O) ethical fit affects the tenure of employees. We argue that the ethical misfit between employees and their organization is asymmetric, such that one direction can have a stronger effect on attrition than the other. We also present the role that ethical diversity within the organization can have in mediating this effect through potential person-group (P-G) fit in subgroups or subcultures. Using a unique dataset of over 6 million vehicle emissions tests, we identify pre-hiring levels of testing fraud for individual inspectors and facilities, finding that the P-O ethical misfit strongly influences the longevity of tenure. Furthermore, we show that the effects of misfit on attrition are asymmetric, and that ethical diversity also influences attrition. We further argue that using pre-hire behavioral data, when available, can be an important methodology in understanding the role of fit in performance and attrition.

Terrorism and International Business: The Case of Banking
Robert Grosse & Robert Spich
This paper raises security issues to a strategic, rather than an operational level in international business. Banks (and other firms) need to deal with the issue of terrorist risk as a strategic concern, rather than as a simple cost in an operational context. We have identified and examined four general (universal) security risks facing banks, and presented empirical evidence from several countries to show the dimensions of the risks and a structured method for exploring and dealing with these risks. The specific cases of the 9/11 terrorist attack in New York, ATM bombings in South Africa, kidnapping of bank employees in Colombia, and laundering of terrorist money in the US are examined. We offer a security exposure classification system, to assist the strategic decision makers to make better sense of the security challenge they are facing, with a specific analytical model, the CRR model, to assess and compare relative terrorist events outcomes in banking.

Optimal Financial Naivete
Avanidhar Subrahmanyam
When agents first become active investors in financial markets, they are relatively inexperienced. Much of the literature focuses on the incentives of presumably sophisticated informed agents to produce information, and not on the naive agents. However, unsophisticated agents are important aspects of financial markets and worth analyzing further. In this paper, we provide a theoretical perspective that addresses the issue of how many naive traders would one expect in a financial market where policy makers try to educate the naive agents. We show that such policy trades off the effects of naive trades on price efficiency versus the losses incurred by these traders in financial markets. The optimal proportion of naive agents varies with the value of information, the noise in private signals, and the inherent sensitivity of corporate investment to prices. We also show that the policy tool of encouraging insider trading can deter naive investors and thus improve corporate governance and the efficacy of corporate investment.

Sell-side Illiquidity and the Cross-Section of Expected Stock Returns
Avanidhar Subrahmanyam, Michael J. Brennan, Tarun Chordia, Qing Tong
The demand for immediacy is likely to be stronger for sellers of securities than for buyers since investors are more likely to have a pressing need to raise cash than to exchange cash for securities. Secondly, previous literature suggests that market makers will react asymmetrically to orders for the purchase and sale of securities. We estimate separate buy- and sell-side price impact measures for a large cross-section of stocks over more than 20 years, and find pervasive evidence that sell-side illiquidity exceeds buy-side illiquidity. Thus, the time-series of the value weighted average difference between buy- and sell-side illiquidity is overwhelmingly positive over our sample period. Further, both illiquidity measures co-move significantly with the TED spread, a measure of funding liquidity. In the cross-section, sell-side illiquidity is priced far more strongly than buy-side illiquidity. Indeed, our evidence indicates that the illiquidity premium in asset returns emanates almost entirely from the sell side.

The First Law of Petropolitics
Romain Wacziarg
We examine empirically the relationship between crude oil prices and the ebb and flow of democratic institutions, in order to test the hypothesis that high oil prices undermine democracy. We find strictly no evidence in favor of this so-called "First Law of Petropolitics" (Friedman, 2006).

The Political Economy of Ethnolinguistic Cleavages
Klaus Desmet, Ignacio Ortuño-Ortín & Romain Wacziarg
This paper proposes a new method to measure ethnolinguistic diversity and offers new results linking such diversity with a range of political economy outcomes — civil conflict, redistribution, economic growth and the provision of public goods. We use a linguistic tree, describing the genealogical relationship between the entire set of 6, 912 world languages, to compute measures of fractionalization and polarization at different levels of linguistic aggregation. By doing so, we let the data inform us on which linguistic cleavages are most relevant, rather than making ad hoc choices of linguistic classifications. We find drastically different effects of linguistic diversity at different levels of aggregation: deep cleavages, originating thousands of years ago, lead to measures of diversity that are better predictors of civil conflict and redistribution than those that account for more recent and superficial divisions. The opposite pattern holds when it comes to the impact of linguistic diversity on growth and public goods provision, where finer distinctions between languages matter.

Trade Liberalization and Growth: New Evidence
Romain Wacziarg & Karen Horn Welch
A new data set on openness indicators and trade liberalization dates allows the 1995 Sachs and Warner study on the relationship between trade openness and economic growth to be extended to the 1990s. New evidence on the time paths of economic growth, physical capital investment, and openness around episodes of trade policy liberalization is also presented. Analysis based on the new data set suggests that over the 1950–98 period, countries that liberalized their trade regimes experienced average annual growth rates that were about 1.5 percentage points higher than before liberalization. Postliberalization investment rates rose 1.5–2.0 percentage points, confirming past findings that liberalization fosters growth in part through its effect on physical capital accumulation. Liberalization raised the average trade to GDP ratio by roughly 5 percentage points, suggesting that trade policy liberalization did indeed raise the actual level of openness of liberalizers. However, these average effects mask large differences across countries.

War and Relatedness
Enrico Spolaore & Romain Wacziarg
We develop a theory of interstate conflict in which the degree of genealogical relatedness between populations has a positive effect on their conflict propensities because more closely related populations, on average, tend to interact more and develop more disputes over sets of common issues. We examine the empirical relationship between the occurrence of interstate conflicts and the degree of relatedness between countries, showing that populations that are genetically closer are more prone to go to war with each other, even after controlling for a wide set of measures of geographic distance and other factors that affect conflict, including measures of trade and democracy.

Optimal Reverse-Pricing Mechanisms
Martin Spann, Gerald Haubl & Robert Zeithammer
Reverse pricing is a market mechanism under which a consumer’s bid for a product or service leads to a sale if the bid exceeds a hidden acceptance threshold the seller has set in advance. The seller faces two key decisions in designing such a mechanism: First, he must decide where in the process to collect the revenue, that is, whether to set a minimum markup above cost (and thus define the bid-acceptance threshold given cost) and/or whether to set a fee for the right to bid. Second, the seller must decide whether to facilitate or hinder consumer learning about the current bid-acceptance threshold. We analyze these interrelated decisions for a profit-maximizing firm selling to consumers with heterogeneous product valuations, derive the optimal revenue model, and characterize how the seller strategy should account for consumers learning about the bid-acceptance threshold. The optimal revenue model is to charge a bidding fee upfront and then accept all bids above cost, rather than to charge a positive minimum markup above cost (as is common practice). When consumers learn about the bid-acceptance threshold before they enter the market, the market becomes more efficient. The seller can benefit from such informed consumers when the competition from the outside posted-price firm is relatively weak.

Sequential auctions with information about future goods
Robert Zeithammer
When capacity-constrained bidders have information about a good sold in a future auction, they need to take the information into account in forming today’s bids. The capacity constraint makes even otherwise unrelated goods substitutes and creates an equilibrium link between future competition and current bidding strategy. This paper proves the existence and uniqueness of a monotone symmetric pure-strategy equilibrium under mild conditions on the population distribution of valuations, characterizes general properties of the equilibrium bidding strategy, and provides a simple technique for numerically approximating the bidding strategy for arbitrary valuation distributions. The key property of the equilibrium is that almost all bidders submit positive bids in the first stage, thereby ensuring trade with probability one. Even bidders who strongly prefer the second object submit a positive bid in the first auction, because losing the first auction is informative about the remaining competitors who also lost, and losing with a low bid indicates that these competitors are quite strong. Because of the guaranteed trade, the sequential auction with information about future goods is a very efficient trading mechanism, achieving more than 98 percent of the potential gains from trade across a wide variety of settings.

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