Market Mispricing

Paper Session

Saturday, Jan. 7, 2017 10:15 AM – 12:15 PM

Sheraton Grand Chicago, Sheraton Ballroom IV
Hosted By: American Finance Association
  • Chair: Christopher Polk, London School of Economics and Political Science

Lazy Prices

Lauren Cohen
,
Harvard Business School
Christopher Malloy
,
Harvard Business School
Quoc Nguyen
,
University of Illinois-Chicago

Abstract

We explore the implications of a subtle “default” choice that firms make in their regular reporting practices, namely that firms typically repeat what they most recently reported. Using the complete history of regular quarterly and annual filings by U.S. corporations from 1995-2014, we show that when firms make an active change in their reporting practices, this conveys an important signal about the firm. Changes to the language and construction of financial reports have strong implications for firms’ future returns: a portfolio that shorts “changers” and buys “non-changers” earns up to 188 basis points per month (over 22% per year) in abnormal returns in the future. These reporting changes are concentrated in the management discussion (MD&A) section. Changes in language referring to the executive (CEO and CFO) team, or regarding litigation, are especially informative for future returns.

Real Anomalies: Are Financial Markets a Sideshow?

Jules van Binsbergen
,
University of Pennsylvania
Christian Opp
,
University of Pennsylvania

Abstract

We examine the importance of financial market imperfections such as asset pricing
anomalies on the real economy. In order to assess distortions quantitatively, we
estimate the joint dynamic distribution of firm characteristics that have been linked
to financial imperfections and other firm variables, such as investment, capital, and
value added. Based on a model that matches these joint dynamics we then evaluate
the counterfactual dynamic distribution of these quantities absent financial market
imperfections and find that they can cause large and persistent deviations. This
implies that financial intermediaries that can reduce and/or eliminate such market
imperfections can provide large value added to the economy. We show that both
the persistence and the amount of mispriced capital are a major determinant of
the real economic consequences. Our framework can be extended to address the
welfare costs of incomplete risk sharing and other financial market imperfections.

Overpriced Winners

Kent Daniel
,
Columbia University
Alexander Klos
,
University of Kiel
Simon Rottke
,
University of Munster

Abstract

A strong increase in a firm’s market price over the past year is generally associated with higher future abnormal returns, consistent with the momentum anomaly. However, for a small set of firms for which arbitrage is limited, high past returns forecast strongly negative future abnormal returns. We propose a dynamic model in which increased unwarranted optimism by a set of speculators leads to dynamic mispricing effects. Consistent with this model, we show a set of firms with high past returns, low institutional ownership, and high recent changes in short interest earns persistently low returns going forward. A “Betting Against Winners” strategy that goes short the overpriced winners and long other winners generates a Sharpe-ratio of 1.08; its returns cannot be explained by commonly used risk-factors.

Are Stocks Real Assets? Sticky Discount Rates in Stock Markets

Michael Katz
,
AQR Capital Management, LLC
Hanno Lustig
,
Stanford University
Lars Nielsen
,
AQR Capital Management, LLC

Abstract

Local stock markets adjust sluggishly to changes in local inflation. When the local rate of
inflation increases, local investors subsequently earn lower real returns on local stocks, but
not on local bonds or foreign stocks, suggesting that local stock market investors use sticky
long-run nominal discount rates that are too low when inflation increases because they are
slow to update the inflation expectations in discount rates. Small amounts of stickiness in
inflation expectations suffice to match the real stock return predictability induced by inflation
in the data. We also consider other explanations, such as nominal cash flow extrapolation.
Discussant(s)
Gerard Hoberg
,
University of Southern California
Malcolm Baker
,
Harvard Business School
Dong Lou
,
London School of Economics and Political Science
Luis Viceira
,
Harvard Business School
JEL Classifications
  • G1 - Asset Markets and Pricing