2010 Working Papers

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

Substitution Patterns of the Random Coefficients Logit
Thomas J. Steenburgh & Andrew Ainslie

Previous research suggests that the random coefficients logit is a highly flexible model that overcomes the problems of the homogeneous logit by allowing for differences in tastes across individuals. The purpose of this paper is to show that this is not true. We prove that the random coefficients logit imposes restrictions on individual choice behavior that limit the types of substitution patterns that can be found through empirical analysis, and we raise fundamental questions about when the model can be used to recover individuals' preferences from their observed choices.

Aggregate Leverage and Preemptive Selling by Individual Financial Institutions
Antonio E. Bernardo & Ivo Welch

Our paper studies an economy in which each financial institution takes into account that if it has to sell its assets after others have already sold, the price will be lower. This causes preemptive selling, driven not by actual margin calls, but by the fear of future margin calls. Financial institutions cannot determine their optimal capitalizations in isolation, but need to know the aggregate capitalization. The resulting equilibrium is fragile: Small changes in model parameters can cause large changes in the equilibrium allocation of risk. Our model is a natural complement to Allen and Gale (2004).

Legal Protection in Retail Financial Markets
Bruce I. Carlin & Simon Gervais

Given the importance of sound advice in retail financial markets and the fact that financial institutions outsource their advice services, how should consumer protection law be set to maximize social welfare? We address this question by posing a theoretical model of retail markets in which a firm and a broker face a bilateral hidden action problem when they service clients in the market. All participants in the market are rational, and prices are set based on consistent beliefs about equilibrium actions of the firm and the broker. We characterize the optimal law, and derive how the legal system splits the blame between parties to the transaction. We also analyze how complexity in assessing clients and conflicts of interest affect the law. Since these markets are large, the implications of the analysis have great welfare import.

Libertarian Paternalism, Information Sharing, and Financial Decision-Making
Bruce I. Carlin, Simon Gervais & Gustavo Manso

We develop a theoretical model to study the welfare effects of libertarian paternalism on information acquisition, social learning, and financial decision-making. Individuals in our model are permitted to appreciate and use the information content in the default options set by a social planner. We show that in some circumstances the presence of default options can decrease welfare by slowing information propagation in the economy. An extension of the model shows that partial information disclosures by the social planner can increase individuals' incentives for gathering and sharing information, but that this does not affect the set of circumstances in which the absence of default options is optimal. Our analysis also considers a setting in which individuals can sell their information to others. We show that default options cause the quality (and price) of advice to decrease, which may lower social welfare. Finally, we study the effects of procrastination and excessive trust in the social planner on our analysis.

Optimal Portfolio Liquidation with Distress Risk
David B. Brown, Bruce I. Carlin & Miguel Sousa Lobo

We analyze the problem of an investor who needs to unwind a portfolio in the face of recurring and uncertain liquidity needs, with a model that accounts for both permanent and temporary price impact of trading. We first show that a riskneutral investor who myopically deleverages his position to meet an immediate need or cash always prefers to sell more liquid assets. If the investor faces the possibility of a downstream shock, however, the solution differs in several important ways. If the ensuing shock is sufficiently large, the non-myopic investor unwinds positions more than immediately necessary and, all else being equal, prefers to retain more of the assets with low temporary price impact in order to hedge against the possible distress. More generally, optimal liquidation involves selling strictly more of the assets with a lower ratio of permanent to temporary impact, even if these assets are relatively illiquid. The results suggest that properly accounting for the possibility of future distress should play an important role in managing large portfolios.

Buffer-Stock Models of Money Demand and the Conduct of Monetary Policy
James R. Lothian, Michael R. Darby & Michael Tindall

Popular wisdom informs us that one of the prime victims of the American financial deregulation of the last decade has been the demand for money function. While there is some evidence that the demise of standard monetary relations has been oversold (see Rasche 1987, 1988, and Darby, Mascaro, and Marlow, 1989), it is with some trepidation that we agreed to reexamine functional forms which we helped develop in 1980.

International Transmission Afloat
James R. Lothian & Michael R. Darby

Almost eleven years ago to the day, Anna Schwartz and we began a detailed study of inflation under the Bretton Woods System and in the year that immediately followed its breakdown. At the time, the consensus view among economists and in a sizeable portion of the financial community was that floating exchange rates, though perhaps not a panacea, certainly were to be welcomed rather than avoided.

The International Transmission of Inflation
Michael R. Darby & James R. Lothian

Inflation became the dominant economic, social, and political problem of the industrialized West during the 1970s. This book is about how the inflation came to pass and what can be done about it.

IQ and Stock Market Participation
Mark Grinblatt, Matti Keloharju & Juhani T. Linnainmaa

An individual’s IQ stanine, measured early in adult life, is monotonically related to his stock market participation 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 are used with both an instrumental variables approach and regression procedures that control for family effects. These supplemental data show that our results apply to both females and males, and that omitted familial and non-familial variables are unlikely to account for our findings. IQ also is related to diversification: high IQ investors are more likely to hold mutual funds and larger numbers of stocks, other things equal.

Do Promotions Benefit Manufacturers, Retailers or Both?
Shuba Srinivasan, Koen H. Pauwels, Dominique Hanssens & M. G. Dekimpe

While there has been strong managerial and academic interest in price promotions, much of the focus has been on the impact of such promotions on category sales, brand sales and brand choice. In contrast, little is known about the long-run impact of price promotions on manufacturer and retailer revenues and margins, although both marketing researchers and practitioners consider this a priority area (Marketing Science Institute 2000). Do promotions generate additional revenue and for whom? Which brand, category and market conditions influence promotional benefits and their allocation across manufacturers and retailers?To answer these questions, we conduct a large-scale econometric investigation of the effects of price promotions on manufacturer revenues, retailer revenues and margins.

Identifying Organizational Faultlines with Latent Class Cluster Analysis
Barbara S. Lawrence
& Michael J. Zyphur

Faultline theory proposes that when the distribution of individuals’ attributes in groups are aligned they create homogeneous subgroups, characterized by within-group similarities and between-group differences. As homogeneity increases, these differences are increasingly likely to acquire meaning to subgroup members and thus to influence behavior. While the face validity of faultlines is appealing, empirical methods have been difficult. The most commonly used, Fau and FLS, have several limitations, for instance difficulty with integrating nominal, categorical, and continuous variables. This paper proposes latent class cluster analysis (LCCA) as an additional analytical tool. After reviewing the literature involving interdependent attributes, the most common faultline measures are described and compared with LCCA. A study of faultlines in a large organization is presented. LCCA induces a five-class model of organizational faultlines. A comparison of work-related communication contacts indicates that subjects have more within-subgroup than between-subgroup contacts, supporting the criterion-related validity of the faultline solution.

Careers, Social Context and Interdisciplinary Thinking
Barbara S. Lawrence

Scholars have engaged in studies of careers, individuals' work experiences over time, since the early 20th century. Although much has been written about the need for interdisciplinary research, limited work exists. This paper presents a comparative technique that facilitates interdisciplinary thinking. Using data from a large organization, three stories are applied to the associations between social context and career outcomes: a different disciplines story, a multiple disciplines story and an interdisciplinary story. The results suggest that the best career satisfaction outcome results from the multiple disciplines story, whereas the best performance and salary outcomes result from the interdisciplinary story.

Neighborhoods: A Tacit Social Structure Connecting Individuals and Organizations
Barbara S. Lawrence & Michael J. Zyphur

We propose and inductively explore neighborhoods, a tacit social structure connecting individuals and organizations. Neighborhoods are clusters of individuals' organizational reference groups, in which the people each individual knows are demographically-similar to the people other individuals know. Because of their internal similarity, neighborhoods circumscribe the social information individuals receive and thus plausibly generate shared perceptions and meaning. Using latent class cluster analysis on data from a large organization, we induce five neighborhoods. While individuals' own attributes are related to those of others in their neighborhood, their attributes frequently differ from those in their neighborhood. Neighborhoods discriminate between individuals’ career-related perceptions and social network attributes.

Internal and External Influences on Adoption Decisions in Multi-Unit Firms: The Moderating Effect of Experience
Daniel H. Simon & Marvin B. Lieberman

Facing uncertainty about whether to adopt a new technology, firms rely on both external and internal sources of information. Firms may learn vicariously about the desirability of adoption; a large body of research has demonstrated a tendency for firms to imitate rival adopters. Organizations with multiple units may also learn from their own experience once an initial unit of the firm has adopted. We use data on the establishment of websites by consumer magazines during the early Internet era to test the hypothesis that multi-unit firms pay less attention to rivals after an initial unit of the firm has adopted. Consistent with this hypothesis, we find that the influence of rivals drops sharply following the initial adoption. One explanation for the shift is that vicarious learning becomes less valuable once richer information becomes available from internal sources.

Corporate Bond Default Risk: A 150-Year Perspective
Kay Giesecke, Francis A. Longstaff, Stephen Schaefer & Ilya Strebulaev

We study corporate bond default rates using an extensive new data set spanning the 1866-2008 period. We find that the corporate bond market has repeatedly suffered clustered default events much worse than those experienced during the Great Depression. For example, during the railroad crisis of 1873-1875, total defaults amounted to 36 percent of the par value of the entire corporate bond market. We examine whether corporate default rates are best forecast by structural, reduced-form, or macroeconomic credit models and find that variables suggested by structural models outperform the others. Default events are only weakly correlated with business downturns. We find that over the long term, credit spreads are roughly twice as large as default losses, resulting in an average credit risk premium of about 80 basis points. We also find that credit spreads do not adjust in response to realized default rates.

A Multiplier Approach to Understanding the Macro Implications of Household Finance
YiLi Chien, Harold L. Cole & Hanno N. Lustig

Our paper examines the impact of heterogeneous trading technologies for households on asset prices and the distribution of wealth. We distinguish between passive traders who hold fixed portfolios of stocks and bonds, and active traders who adjust their portfolios to changes in expected returns. To solve the model, we derive an optimal consumption sharing rule that does not depend on the trading technology, and we derive an aggregation result for state prices. This allows us to solve for equilibrium prices and allocations without having to search for market-clearing prices in each asset market separately. We show that the fraction of total wealth held by active traders, not the fraction held by all participants, is critical for asset prices, because only these traders respond to variation in state prices and hence absorb the residual aggregate risk created by non-participants. We calibrate the heterogeneity in trading technologies to match the equity premium and the risk-free rate. The calibrated model reproduces the skewness and kurtosis of the wealth distribution in the data. In contrast to existing models with heterogeneous agents, our model matches the high volatility of returns and the low volatility of the risk-free rate.

Countercyclical Currency Risk Premia
Hanno N. Lustig , Nikolai L. Roussanov & Adrien Verdelhan

Currency excess returns are highly predictable, more than stock returns, and about as much as bond returns. We show that in a general, no-arbitrage setup, expected currency excess returns have two components: a dollar risk premium and a carry trade risk premium. The average forward discount across all countries is a good measure of the market price demanded by US investors for bearing US-specific risk, and thus a good predictor of currency excess returns. Predicted excess returns are strongly counter-cyclical because they inherit the cyclical properties of US-specific risk prices. Macroeconomic and financial variables, like the rate of industrial production growth, thus helps to predict the dollar risk premium. We investigate one-month to one-year ahead predictability and obtain R2s up to 38 percent on portfolios of currency excess returns using the average forward discount and industrial production growth as predictors. US-specific variables that predict the dollar risk premium have no forecasting power on the carry trade risk premium. These findings point towards a risk-based view of exchange rates.

How Does the U.S. Government Finance Fiscal Shocks?
Antje Berndt, Hanno N. Lustig & Sevin Yeltekin

We develop a method for identifying and quantifying the fiscal channels that help finance government spending shocks and apply it to postwar U.S. data. We define fiscal shocks as surprises in defense spending and show that they are more precisely identified when defense stock data are used in addition to aggregate macroeconomic data. Our results show that in the postwar period, over 9% of the U.S. government's unanticipated spending needs were financed by a reduction in the market value of debt and more than 73% by an increase in primary surpluses. We provide evidence that longer maturity debt is more effective at absorbing fiscal risk and discuss the implications of this result for active management of public debt.

Is the Volatility of the Market Price of Risk Due to Intermittent Portfolio Re-Balancing?
YiLi Chien, Harold L. Cole & Hanno N. Lustig

Our paper examines whether intermittent portfolio re-balancing on the part of some stock market investors can help to explain the counter-cyclical volatility of aggregate risk compensation in financial markets. To answer this question, we set up an incomplete markets model in which CRRA-utility investors are subject to aggregate and idiosyncratic shocks and have heterogeneous trading technologies. In our model, a large mass of passive investors do not re-balance their portfolio shares in response to aggregate shocks, while a smaller mass of active investors adjust their portfolio each period to respond to changes in the investment opportunity set. We find that intermittent re-balancers amplify the effect of aggregate shocks on the time variation in risk premia by a factor of four in a calibrated version of our model.

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.

The Cross-Section and Time-Series of Stock and Bond Returns
Ralph S. Koijen, Hanno N. Lustig & Stijn Van Nieuwerburgh

We propose an arbitrage-free stochastic discount factor (SDF) model that jointly prices the cross-section of returns on portfolios of stocks sorted on book-to-market dimension, the cross-section of government bonds sorted by maturity, the dynamics of bond yields, and time series variation in expected stock and bond returns. Its pricing factors are motivated by a decomposition of the pricing kernel into a permanent and a transitory component. Shocks to the transitory component govern the level of the term structure of interest rates and price the cross-section of bond returns. Shocks to the permanent component govern the dividend yield and price the average equity returns. Third, shocks to the relative contribution of the transitory component to the conditional variance of the SDF govern the Cochrane-Piazzesi (2005, CP) factor, a strong predictor of future bond returns, price the cross-section of book-to-market sorted stock portfolios. Because the CP factor is a strong predictor of economic activity one- to two-years ahead, shocks to the importance of the transitory component signal improving economic conditions. Value stocks are riskier and carry a return premium because they are more exposed to such shocks.

The Wealth-Consumption Ratio
Stijn Van Nieuwerburgh, Hanno N. Lustig & Adrien Verdelhan

We set up an exponentially affine stochastic discount factor model for bond yields and stock returns in order to estimate the prices of aggregate risk. We use the estimated risk prices to compute the no-arbitrage price of a claim to aggregate consumption. The price-dividend ratio of this claim is the wealth-consumption ratio. Our estimates indicate that total wealth is much safer than stock market wealth. The consumption risk premium is only 2.2 percent, substantially below the equity risk premium of 6.9 percent. As a result, the average US household has more wealth than one might think; most of it is human wealth. Nearly all of the variation in total wealth can be traced back to changes in long-term real interest rates. Contrary to conventional wisdom, we find that events in bond markets, not stock markets, matter most for understanding fluctuations in total wealth.

Internationally Correlated Jumps
Kuntara Pukthuanthong & 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.

Recent Trends in Trading Activity
Tarun Chordia, Richard Roll & Avanidhar Subrahmanyam

We explore the sharp uptrend in trading activity during recent years. Higher turnover has been associated with more frequent smaller trades, which have progressively formed a larger fraction of trading volume over time. Evidence indicates that secular decreases in trading costs have influenced the turnover trend. Turnover has increased the most for stocks with the greatest level of institutional holdings, suggesting professional investing as a key contributor to the turnover trend. Variance ratio tests suggest that more institutional trading has increased information-based trading. The sensitivity of turnover to past returns has increased significantly, revealing a more widespread use of quantitative trading strategies.

Volume in Redundant Assets
Richard Roll, Eduardo Schwartz & Avanidhar Subrahmanyam

Why do multiple contingent claims on the same asset attract volume? We address this issue by empirically analyzing the joint time-series of volume on the S&P 500 index and three contingent claims on the index, namely, the options, the futures, and the ETF. All series are highly cross-correlated but do not share calendar regularities; for example, an increase in volume in January occurs only in the spot index market. Vector autoregressions indicate that all series are jointly determined. Consistent with the informational role of markets for contingent claims, there is evidence that trading activity in these markets predicts shifts in the term structure and the credit spread, as well as returns around macroeconomic announcements.

Bayesian Applications in Marketing!
Peter E. Rossi & Greg M. Allenby

In this chapter, we review applications of Bayesian methods to marketing problems. Key aspects of marketing applications include the discreteness of response or outcome data and relatively large numbers of cross-sectional units, each with possibly low information content. Discrete response data require the development of non-standard likelihoods and low information content requires careful use of informative priors. One particularly important form of informative prior is embodied in hierarchical models. Given the importance of the prior, it is important to assure flexibility in the prior specification. Non-standard likelihoods and flexible priors make marketing a very challenging area for Bayesian applications.

State Dependence and Alternative Explanations for Consumer Inertia
Jean-Pierre Dubé, Günter J. Hitsch & Peter E. Rossi

For many consumer packaged goods products, researchers have documented inertia in brand choice, a form of persistence whereby consumers have a higher probability of choosing a product that they have purchased in the past. Using data on margarine and refrigerated orange juice purchases, we show that the finding of inertia is robust to flexible controls for preference heterogeneity and not due to autocorrelated taste shocks. Thus, the inertia is at least partly due to structural, not spurious state dependence. We explore three economic explanations for the observed structural state dependence: preference changes due to past purchases or consumption experiences which induce a form of loyalty, search, and learning. Our data are consistent with loyalty, but not with search or learning. Properly distinguishing among the different sources of inertia is important for policy analysis, because the alternative sources of inertia imply qualitative differences in firm’s pricing incentives and lead to quantitatively different equilibrium pricing outcomes.

Cash Flow Multipliers and Optimal Investment Decisions
Holger Kraft & Eduardo Schwartz

By postulating a simple stochastic process for the firm's cash flows in which the drift and the variance of the process depend on the investment policy of the firm, we develop a theoretical model, determine the optimal investment policy and, given this policy, calculate the ratio of the current value of the firm and the current cash flow which we call the “cash flow multiplier". The main contribution of the paper, however, is empirical. Using a very extensive data set comprised of more than 13,000 firms over 44 years we examine the determinants of the cash flow multiplier using as explanatory variables macro and firm specific variables suggested by the theoretical model. We find strong support for the variables suggested by the model. Perhaps the most interesting aspect of the paper is the formulation of a parsimonious empirical asset pricing model, based on the fundamental discounted cash flow approach but using current macroeconomic variables and firm specific variables easily observable for its implementation. We obtain valuation equations that could potentially form part of a new valuation framework which does not require estimating future cash flows nor risk adjusted discount rates.

Ethical Misfit or the Demand for Leniency? The Impact of Behavioral Attributes on Employee Tenure
Lamar Pierce & Jason Snyder

In this paper we argue that while ethical misfit between firms and employees may increase the likelihood of attrition, the interaction between organizational and employee ethics may be much more complex. Customer demand for individual and organizational characteristics may impact employee tenure independent of one another. Furthermore, misfit may also create complementarities that benefit both the employer and employee. We use over six million vehicle emissions tests to empirically demonstrate that separating these effects is critical to understanding the role of misfit. We identify pre-hiring levels of fraudulent testing leniency for individual inspectors and facilities, showing that neither ethical fit nor complementarity of misfit has substantial impact on the longevity of tenure. Instead, we find that both inspector and facility leniency lead to longer tenure, with little evidence of interaction between employer and employee ethics.

Board Quality and the Cost of Debt Capital: The Case of Bank Loans
L. Paige Fields, Donald R. Fraser & Avanidhar Subrahmanyam

We analyze the relation between comprehensive measures of board quality and the cost as well as the non-price terms of bank loans. We show that firms with higher quality boards and even a single (non-insider) advisory board member borrow at lower interest rates. This relation exists even after controlling for ownership structure, CEO compensation policy, and shareholder protection as well as the size and financial characteristics of the borrower. We also show that board quality and other governance characteristics influence the likelihood that loans will have covenant requirements, but the relations differ by covenant type. Firms with high quality boards are less likely to have loans with financial ratio restrictions or collateral requirements, though these covenants are more likely when CEO cash compensation is high or when the percentage of incentive-based pay is low. Overall, the quality of the board plays an important role in lowering the cost of debt.

Investor Sentiment and Price Momentum
Constantinos Antoniou, John A. Doukas & Avanidhar Subrahmanyam

This paper sheds empirical light on whether investor sentiment affects the profitability of price momentum strategies. We hypothesize that when investors are optimistic, their expectations will be more miscalibrated relative to those obtained from objective probabilities, and arbitrage will be more difficult with short-selling constraints. Our results show that momentum rises only when investors are optimistic, and that optimistic momentum portfolios experience long-run reversals. These results provide support to the behavioral theories, suggesting that short-run momentum and long-run reversal commonly arise from investors' behavioral biases.

Advance Booking Programs for Managing Supply, Demand, and Price Risks
Soo-Haeng Cho & Christopher S. Tang

While advance booking programs have been shown to be effective for firms to manage uncertain demand, the effectiveness of such programs is unclear when supply, demand, and price risks are present in a supply chain. Motivated by an advance booking program for managing these three types of risks in a flu vaccine supply chain, we present a two-stage Stackelberg game model to examine the dynamic interactions between a manufacturer and a retailer over two stages. In each stage, both firms enter a Stackelberg game: the manufacturer sets his wholesale price and the retailer determines her order quantity. However, when making the decisions in the second stage, both firms take into account the decisions chosen in the first stage as well as the information about supply and demand revealed after the first stage. Our analysis shows that the advance booking program is always beneficial to the manufacturer but not to the retailer especially when a supply shortage is likely to occur. Interestingly, we find that supply uncertainty and demand uncertainty affect the firms’ profits in an opposite manner under the advance booking program: the firms’ expected profits tend to decrease in supply uncertainty, but they tend to increase in demand uncertainty.

Optimal Reservation Deposit Policies in the Presence of Rational Customers and Retail Competition
George Georgiadis & Christopher S. Tang

We study two reservation deposit policies for a service firm to increase its revenue through higher capacity utilization. First, under the "no deposit" policy, the firm requires no reservation deposit and imposes no “no show” penalty. Anticipating potential “no shows,” a firm may overbook; hence, there is no guarantee that the reserved service will be provided under the no deposit policy. On the contrary, under the “guarantee deposit” policy, a guarantee deposit is required for each customer to make a non-cancelable reservation. To honor the reserved service under the guarantee deposit policy, the firm will not overbook. We analyze each deposit policy as a Stackelberg game in which the firm acts as the leader who selects the booking capacity under the no deposit policy (or the required deposit under the guarantee deposit policy), and each customer acts as the follower who decides whether to reserve or not. Our model incorporates rational customer behavior so that each customer will take other customers' behavior into consideration. Using the firm's optimal booking capacity (optimal required deposit) in equilibrium under the no deposit policy (the guarantee deposit policy), we compare the firm's expected profits under these two policies in a monopolistic environment. Our results suggest that the firm should charge a higher optimal retail price under the no deposit policy, and adopt the no deposit policy when the demand rate is below a certain threshold. By analyzing a game of duopolistic competition between two firms, we develop the conditions under which the firms will adopt a particular pair of deposit policies in equilibrium, and we show this game can lead to a Prisoner's Dilemma. Moreover, when both firms charge the same retail price, we show the existence of an equilibrium in which both firms adopt the no deposit policy.

Managerial Beliefs and Corporate Financial Policies
Ulrike Malmendier, Geoffrey Tate & Jon Yan

We measure the impact of individual managerial beliefs on corporate financing. First, managers who believe that their firm is undervalued view external financing as overpriced, especially equity. We show that such overconfident managers use less external finance and, conditional on accessing risky capital, issue less equity than their peers. Second, CEOs with Depression experience have less faith in capital markets and lean excessively on internal financing. Third, CEOs with military experience pursue more aggressive policies, including heightened leverage. CEOs' press portrayals confirm these differences in beliefs. Overall, measurable managerial characteristics have significant explanatory power beyond traditional capital-structure determinants.

Seeking an Aggressive Competitor: How Product Life Expansion Can Increase All Firms' Profits
Raphael Thomadsen

Conventional wisdom suggests that a firm's profits will decrease when a competitor expands its product line because the firm's sales will decrease in the presence of the new product. This paper shows that this intuition is incomplete because a competitor's product-line expansion can soften price competition. Thus, one firm's product-line expansion can cause all firms to be more profitable. We first provide an analytical model that demonstrates the possibility of profit-increasing competitor entry. We then present conditions under which a competitor's product-line expansion increases profits under two common empirical models: the mixed-logit and geographic spatial models. The results suggest that profit-increasing competitor entry is not only a theoretical possibility, but also a realistic empirical prediction. Geographic competition is especially conducive to this result.

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

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

Reading the Tea Leaves: Why Serial Correlation Patterns in Analysts' Forecast Errors are not Evidence of Inefficient Information Processing
Juhani T. Linnainmaa & Walter N. Torous

Forecast errors are serially uncorrelated when agents possess full information about a firm. However, if there are multiple firm types and types are unobservable, agents update as if dealing with the average firm. Consequently, agents underreact to signals from some firms and overreact to signals from others. Applying this explanation to analysts’ forecasts, our model predicts that, first, analysts must overreact as well as underreact to earnings announcements; second, serial correlation patterns in analysts’ forecast errors diminish over time; third, the largest reduction in serial correlation occurs with the receipt of initial signals; fourth, analysts’ forecasts are initially biased but the bias also diminishes over time; and fifth, because signal size is informative about firm type, analysts update differentially in response to small versus large signals. We confirm these predictions using analyst forecast data from I/B/E/S. Our findings suggest that an absence of serial correlation in forecast errors is not the appropriate benchmark for rational analyst behavior.

Pay for Performance? CEO Compensation and Acquirer Returns in BHCs
Kristina Minnick, Haluk Unal & Liu Yang

We examine how managerial incentives a¤ect acquisition decisions in the banking industry. We find that higher pay-for-performance sensitivity (PPS) leads to value-enhancing acquisitions. Banks whose CEOs have higher PPS have significantly better abnormal stock returns around the acquisition announcements. On average, acquirers in the High-PPS group outperform their counterparts in the Low-PPS group by 1:4% in a three-day window around the announcement. Ex ante, higher PPS helps to prevent value-destroying acquisitions, while at the same time promote value-enhancing acquisitions. The positive market reaction can be rationalized by post-merger performance. Following acquisitions, banks with higher PPS experience greater improvement in their operating performance.

Knowledge Assets