AFA Poster Session
Friday, Jan. 6, 2017 8:00 AM – 11:00 AM
Sheraton Grand Chicago, Chicago Ballroom VII
Agency Issues in Corporate Bond Trading
AbstractIn an O.T.C. market like the one for corporate bonds, dealer intermediation is essential to execute a trade. Moreover, the incentives of the dealers and those of their customers are likely to be non-aligned. This paper analyzes the relational nature of broker-dealer business and investigates how adverse selection leads to agency issues.
Results suggest that dealers set the execution price to shift the risk of informed trading to their clients. Shortages of funding liquidity appear to exacerbate this behavior. During the great financial crisis, dealers "leaned their clients against the wind" without compensating them for liquidity provision.
Despite the increasing transparency brought by electronic trading, these agency issues are likely to remain present on the speculative segment of the market, where adverse selection is the most harmful to traders. This paper proposes policy measures in order to overcome these agency issues.
Agency Trading and Principal Trading
AbstractIn some markets (e.g. equities), intermediaries execute trades as agents and earn flat commissions while in other markets (e.g. currencies), as principals and earn mark-ups. We argue this choice is driven by the need to incentivize intermediaries to obtain better prices. In principal trading, intermediaries internalizes the execution outcome but need to be compensated for bearing execution risk. In agency trading, investors need to evaluate agents against price benchmarks, and that requires having access to information about trading activities around the same time. Therefore, agency trading is more likely 1) in markets with high transparency and turnover and 2) when intermediary risk aversion is high. Cross-market outcomes are consistent with theory. We further validate prediction 2) using shocks to intermediary capital during financial crisis.
Analyst Recommendations and International Stock Market Returns
AbstractThis paper documents that analyst recommendations aggregated at the country level predict international stock market returns. A trading strategy based on past country-level recommendations yields an abnormal return of around one percent per month. Aggregate analyst recommendations also help to predict changes in gross domestic product after accounting for survey-based forecasts. Overall, our results suggest that analyst recommendations aggregated at the country level provide useful information to guide international asset allocation.
Are Open Market Share Repurchase Programs Really Flexible?
AbstractI use the recent financial crisis and utilize the predetermined variations in stock repurchase program ending dates to show that open market share repurchase programs are not as flexible as one might expect. My difference-in-difference estimator shows that once firms have announced such programs, they sacrifice real activities to finish them. Specifically, firms with open market share repurchase programs ending after December 2007 cut 1.9 percentage points more of capital investment, four employees more per million dollars of capital stock, and 9 percentage points more of R&D expense to fund the share repurchases than otherwise similar firms with programs ending before December 2007. The reductions represent a 7%-15% decrease of pre-crisis levels. The freed-up capital indeed goes toward the share repurchase programs: firms buyback on average 84% of the predetermined amount of the shares.
Credit Supply Shocks and Labour Outcomes: Evidence from a Change in the Accounting Norms of Bank Pension Plans
AbstractThis paper investigates the link between firm credit constraints and employment outcomes by relying on a unique bank-firm-employee matched dataset available at the Bank of Portugal. We identify credit-constrained firms by using the introduction of an accounting reform in 2005 that leads to large and heterogeneous increases in the accounting value of bank pension plan liabilities. The subsequent higher bank contributions to their pension plans and provisions to Tier 1 capital negatively impact bank credit supply. We document, first, that treated firms do not perfectly substitute and hence borrow less. Second, this adverse credit supply shock translates into a decrease in firm employment. Third, that in the short run, less educated and more junior workers are the first ones affected.
Board Independence and Cash Holdings
AbstractWe examine the effect of board independence on cash holdings using the 2003 NYSE and NASDAQ board independence requirements as an exogenous shock. Noncompliant firms forced to raise board independence increase their cash holdings, especially when firms are transparent and have an abundant supply of local directors. Part of the cash increase comes from a reduction in acquisition spending. Investors respond positively to the announcement of the deals that survive the spending cut. Finally, the increase in board independence causes the market to place a greater value on cash holdings. Our results suggest that better corporate governance improves cash policy and spending.
Scooping Up Own Debt On the Cheap: The Effect Of Corporate Bonds Buyback on Firm's Credit Condition
AbstractThe paper constructs a structural model to study the effect of corporate bonds buyback on the firm's credit conditions. The model implies that the firm strategically choose how much debt to buy back and the buyback reduces the firm's probability of default. In contrast to commonly perceived deleverage channel, the model highlights a novel channel that buying back bonds on the cheap transfers value from bondholders to equity holders and incentivizes the equity holders to choose a much lower assets value to declare default. The lowered default boundary furthermore reduces debt overhang and increases return to equity. The virtuous cycle does not stop until the marginal benefit of bonds buyback equals its marginal cost. The model also implies that when bonds market liquidity dries up, the firm should buy back more bonds, as the shortage of liquidity is independent of the firm's fundamental but depresses the market price of bonds. The paper also provides empirical evidences for the implications.
Does the Board of Directors Learn from Short Sellers? Evidence from CEO Turnovers
AbstractWe provide evidence that the board of directors learns about CEO quality from information contained in short sales: Forced CEO turnover is positively related to short interest even when controlling for a range of other firm performance indicators. The sensitivity is higher in firms with more independent boards. Using an instrumental variable approach, we show that there is a negative feedback effect from CEO turnover probability to short selling. A negative feedback loop is consistent with short sellers incorporating that boards learn from their information. The results suggest that short selling can benefit the real economy by providing information to decision makers.
Choice of Order Size and Price Discovery: The Last Digit Puzzle
AbstractI claim that uninformed traders prefer ending the size of their orders with a zero (e.g. 110 shares) but it is not the case for informed traders, creating an information channel and providing a signal. I propose the Last Digit Hypothesis (LDH): i) some traders exhibit a last digit preference for the digit 0 and other traders do not while ii) the latter are better able to trade on information than the former. The LDH predicts that a trade arising from a marketable order with a size ending with a 0 on average contributes less to price discovery than other trades. My empirical findings support the LDH. However, the LDH is not an equilibrium since informed traders have an incentive to mimic the preferences of uninformed traders to avoid detection and face little constraints or costs to do so. It is puzzling that I find no evidence of such mimicking.
CoCo Bonds and Risk: The Market View
AbstractThis paper investigates the impact of CoCo bond design on their market prices. Focusing on two CoCo bond features which are associated with CoCo risk, I find that (1) investors are aware of the incentive problem created in write down CoCo bonds, and demand a yield premium for that feature. Additionally, and consistent with the theory on moral hazard, this premium is higher for banks which suffer from a larger conflict of interest in the first place. Moreover, I find that (2) investors take the threat of automatic CoCo capital triggers seriously, in the sense that they reward a larger buffer towards the trigger threshold with a higher price. These insights provide important clues towards the role of CoCo bond investors' monitoring, as well as the role of CoCo bonds in the mix of regulatory capital.
Customer Friendly Finance
Abstract"In the United States, customer owned firms are responsible for 35% of consumer insurance and 10% of consumer banking, yet receive little theoretical or empirical attention. In this paper, I propose a theory of internal finance for the customer owned firm. I show that its growth, pricing, and capital structure are tied together: higher
sales tomorrow are achieved through higher prices today and lower leverage today. This result does not hold for a shareholder owned firm. I document stylized facts from the credit union industry and find that they are consistent with the theory’s predictions. I discuss empirical implications for other customer owned firms, such as mutual insurance companies and agricultural credit associations."
Do Venture Capital-Driven Management Changes Enhance Corporate Innovation in Private Firms?
AbstractUsing a hand-collected dataset on top management teams in venture capital-backed private firms, I analyze the effect of top management changes on subsequent corporate innovation in these firms. I find that top management changes are associated with significantly more and higher quality corporate innovation, as measured by patent counts and patent citations, respectively. I show that top management changes in these firms are likely to be venture-driven and that the effect of top management changes on corporate innovation is stronger for firms in which venture capitalists have greater power. An instrumental variable analysis using a plausibly exogenous shock to the supply of outside managers available for hire implies a positive causal effect of top management changes on corporate innovation. Further, I find that adding new managers has a significantly positive effect on innovation, while removing existing managers does not. Delving deeper into the educational background and employment history of each new manager added to the management team, I find that adding seasoned CEOs has a significantly positive effect on innovation, while adding senior managers with a prior technical background does not. I also analyze the possible mechanisms through which top management changes affect corporate innovation, and establish that one such mechanism is through new management teams hiring a greater number of inventors for a given investment size. Finally, I find that both top management changes and corporate innovation output have a positive impact on the probability of a successful exit (IPO/acquisition).
Does History Repeat Itself? Business Cycle and Industry Returns
AbstractWe document that industries with a higher historical Sharpe Ratio have higher expected returns conditional on the business cycle. A long-short sector rotation strategy generates annualized alpha of 11.91% (14.02%) in Fama-French three-factor (five-factor) model from 1985 to 2014. Our sector rotation strategy alpha is not due to industry momentum or other related anomalies and is less likely to be driven by a risk-based explanation. Firms in our long portfolio have better fundamentals, more upward revisions of analyst forecasts, and more positive analyst forecast errors. Our results suggest that investors do not fully incorporate business cycle variation in cash flow growth and highlight the importance of business cycle on the cross-sectional return dispersion of industry portfolios.
The Dollar Ahead of FOMC Target Rate Changes
AbstractI find that the U.S. dollar appreciates over the two-day period before contractionary monetary policy decisions at scheduled Federal Open Market Committee (FOMC) meetings and depreciates over the two-day period before expansionary monetary policy decisions. The federal funds futures rate forecasts these dollar movements with a 22% R-squared. A high federal funds futures spread three days in advance of an FOMC meeting not only predicts the target rate rise, but also predicts a rise in the dollar over the subsequent two-day period. A simple trading strategy, which exploits this predictability, exhibits a 0.93 Sharpe ratio. My findings imply that information about monetary policy changes is reflected first in the fixed income markets, and only later becomes reflected in currency markets.
Dynamic-Agency Based Asset Pricing in a Production Economy
AbstractWe present an asset pricing model in a production economy where neither firms nor workers can fully commit to labor compensation contracts. We embed optimal dynamic contracting in our general equilibrium setup to provide a unified explanation of macroeconomic quantity dynamics and asset market returns. With a risk aversion of four, our model generates an unlevered equity premium of 4% per year, a volatility of the stock market return of 14% per year, and a low and smooth risk-free rate. On the quantities side, it successfully replicates the empirical evidence of the low volatility of aggregate consumption growth and large variations in aggregate investment over the business cycle.
Extrapolative Expectations and the Second-Hand Market for Ships
AbstractThis article investigates the joint behaviour of vessel prices, net earnings, and second-hand activity in the dry bulk shipping industry. We develop and estimate empirically a behavioural asset pricing model with microeconomic foundations that can account for some distinct characteristics of the market. Namely, among other features, our partial equilibrium model reproduces the actual volatility of vessel prices, the average trading activity in the market, and the positive correlation between net earnings and second-hand transactions. In order to explain the formation of vessel prices, we depart from the rational expectations benchmark of the model, incorporating extrapolative expectations on the part of investors. In contrast to the majority of financial markets’ behavioural models, however, in our environment agents extrapolate fundamentals, not past returns. This form of extrapolation is consistent with the nature of the industry. Accordingly, we introduce two types of investors who hold heterogeneous beliefs about the cash flow process. Formal estimation of the model indicates that a heterogeneous beliefs environment, where both agent types extrapolate fundamentals, while simultaneously under(over)estimate their competitors’ future demand responses, can explain the positive relation between net earnings, prices and second-hand vessel transactions. To the best of our knowledge, the second-hand market for vessels had never been examined from the perspective of a structural, behavioural economic model in the shipping literature before.
Feedback Loops in Industry Trade Networks and the Term Structure of Momentum
AbstractIndustries are economically linked through customer-supplier trade flows. We show that industry shocks propagating along this inter-sectoral trade network can feed back to the originating industry, causing an ``echo'' -- intermediate-term autocorrelation in returns. Adopting techniques from graph theory, we find that the strength of the trade network feedback is a crucial determinant of the echo effect in industry returns. Consistent with limited-information models, the relation between feedback strength and echo strategy profits is strongest in industries with less analyst coverage along the feedback loop and with higher information frictions. Overall, our results identify inter-sectoral trade networks as important conduits of industry shocks and provide the first explanation for the echo effect.
Fighting Fire with Fire: Mitigating Information Asymmetry with Open-Market Repurchase Programs
AbstractFirms strongly favor stock buybacks as a payout policy, distributing more than $600 billion to shareholders through open-market repurchase programs in 2014 alone. Evidence suggests that managers exercise tremendous discretion over the timing of actual buys. And this discretion, combined with private information, allows for trade execution at favorable prices. Traditionally, the literature assumes that only the firm possesses private information and concludes that buybacks undertaken in such environments of asymmetric information engender adverse selection trading costs, which harm shareholders with liquidity needs. This paper reassesses this view by considering a setting in which the firm competes against other informed parties. Our model differs from previous multi-agent trading games because realized profits from the firm's buybacks also accrue to other informed traders, dampening the effects of increased competition. This analysis identifies sufficient conditions, under which stock repurchase
programs reduce adverse selection costs rather than impose them."
Financial Innovation and Borrowers: Evidence from Peer-to-Peer Lending
AbstractI study how the emergence of the financial technology-driven public market for consumer debt in the form of peer-to-peer (P2P) lending affects credit provided by traditional financial intermediaries. I show that innovation in the way hard information is processed influences both the supply of and the demand for credit from financial intermediaries. On the supply side, credit intermediaries rely on certification by P2P lenders in their decision to increase access to credit for borrowers. This finding is consistent with increased accuracy of screening and information cascading to other lenders when multiple lenders make credit decisions sequentially. On the demand side, P2P lending induces refinancing of expensive credit card debt by highly creditworthy borrowers and increases debt-financed consumption by financially-constrained borrowers. I find no evidence that increased access to credit results in higher delinquencies. The results suggest that P2P lending mitigates financing frictions through repricing of credit and reduced credit rationing due to lower costs and/or improved accuracy of costly state verification. I conclude that financial technology innovation can resolve some imperfections in the credit market.
Fire Buys of Central Bank Collateral Assets
AbstractWhen central banks provide unlimited liquidity, banks raise their demand for collateral assets, and the short-term scarcity of collateral securities leads to higher prices, the Fire Buy premium. To avoid collateral scarcity, central banks increase the set of eligible collateral assets. However, if the risk-shifting channel is open for these newly eligible securities, banks prefer to pledge them and pay another premium, the Risk-Shifting premium. With the full fixed-income trading book of 26 German banks, I identify each trade of each bank and investigate how unlimited liquidity provision affects collateral prices. Also, I match banks' trades with their balance sheet and show how funding liquidity impacts premia payment. I quantify the Fire Buy premium to be 22.5 bps, which demonstrates that unlimited central bank liquidity provision imposes extra costs on banks exactly during stress periods; and the Risk-Shifting premium on BBB-rated assets to be 20.4 bps, which prices the severity of the risk-shifting channel in the Eurosystem. My results speak in favor of more differentiation among counterparties in the ECB haircut policy.
Firm Boundaries and Political Uncertainty: Evidence Using State Elections in India
AbstractUsing subsidiary-level data for Indian firms and staggered elections across Indian states, I find that political uncertainty's impact on firm performance varies by organizational form. I find that the gap in leverage ratio between subsidiaries of conglomerate and stand-alone firms widen by 15% in states with elections vis-à-vis other states. Political uncertainty is also associated with relatively lower investment and higher borrowing cost for the stand-alone firms. The results are consistent with the possibility of being driven largely by the (reduced) supply of capital than the (subdued) demand for it. This paper introduces political uncertainty as a new dimension in the long standing literature that compares diversified and single segment firms.
Golden Handcuffs and Corporate Innovation: Evidence from Defined Benefit Pension Plans
AbstractIn this study, I exploit a natural experiment of defined benefit (DB) plans to identify the effects of deferred compensation on corporate innovation. Using DB pension and patenting data, I find that from 1990 to 2007, firms with higher DB plan value secured more patents and patent citations. An instrumental variable approach and a treatment effects model both support the causal effect of DB plans on corporate innovation. Further analysis reveals that DB plans foster innovation through longer tenures, greater productivity, and more risk-taking on the part of employees. Consistent with bonding theory, my findings suggest the bright side of DB plans despite recent pension freezes.
How Do Hurricanes Affect Life Insurance Premiums? -The Effects of Financial Constraints on Pricing
AbstractI identify effects of financial constraints on firms’ real activities, using a sample of insurance groups (conglomerates) that contain both life and P&C (property & casualty) subsidiaries. Following losses in P&C subsidiaries, financial constraints in the overall group are. I present a model in which life insurance pricing is affected by shocks to the P&C affiliate’s financial condition. In this model, following adverse P&C shocks, premiums should fall for life policies that increase statutory capital and rise for policies that decrease capital. Using a sample of 207 life insurance companies between 1999 and 2013, I find that P&C losses lead to changes in life insurance premiums as the model predicts. The effects are concentrated in more financially constrained firms, which are more likely affected by shocks to financial conditions. I also find that life insurers make more transfers to the rest of the group following larger P&C losses. Moreover, these results hold instrumenting for losses using state-level data on the value of weather-related damages, suggesting that losses to P&C affiliates do cause changes in life insurance premiums and internal capital transfers. Overall, these findings suggest that firms’ financial constraints affect firms’ real activities.
‘I’ll Have What She’s Having’: Identifying Social Influence in Household Mortgage Decisions
AbstractPrior literature has largely ignored the importance of social interactions in determining household mortgage decisions. In this paper, we investigate the possibility that household mortgage decisions are influenced by social interaction, a potentially important economic force explaining variations in mortgage choices. We identify the existence of these effects in several important household mortgage choices: from which lender to borrow, whether to choose an adjustable or fixed interest rate, and if and when to refinance. Social influence effects are difficult to identify given the propensity for unobservable correlations to bias results. Therefore, we use a mixed methods approach. We first use geolocated mortgage data to estimate the effects of peer activity on the census block while controlling for peer activity at the census block group level. Second, we match households moving from different zip codes to a common third zip code. We complement these two empirical strategies in the lab by experimentally assigning peers and peer decisions in a variety of ways. We find that households are causally affected by their neighbors when making mortgage decisions. Specifically, in our preferred specifications we find that as the proportion of a household’s peers recently choosing an adjustable rate mortgage (ARM) increases from the 25th percentile to the 75th percentile a household’s probability of choosing an ARM increases from 15.1% to 15.7%. And that as the proportion of a household’s peers who have refinanced at some point in the last six months increases from the 25th percentile to the 75th percentile the household’s probability of refinancing this quarter increases from 2.3% to 2.6%. These results confirm the importance in accounting for social influence effects in household mortgage decisions.
Mobility of Skilled Labor, Capital Structure and Investment
AbstractHow does inalienability of human capital affect firms' capital structures and what is the magnitude of this effect? I find that firms that rely on relatively more high skill and high mobility employees at the same time, operate with lower financial leverages, to reduce the risk of losing their talents in financial distress. Employing court decisions as a source of exogenous variation in labor mobility, I show that when employees have less barriers to leave the firm, high-skilled firms reduce their leverage significantly, while low-skilled firms do not change their financial structure. To quantify the importance of this channel, I estimate a dynamic model in which a firm hires skilled labor and finances investment by issuing equity and defaultable debt. Wages are not paid in default states and are only partially paid when the firm is distressed. If future wages are expected to be less than a reservation value, not only new workers cannot be hired, but the current workers also leave the firm depending on their mobility. The model predicts that if firms are not constrained by labor concerns, leverage, investment and firm value would rise by 16%, 3.4%, and 2.1%, respectively. This can be partially achieved if the firm pays wages by its debt, instead of cash or equity.
Insider Ownership, Governance Mechanisms and Corporate Bond Pricing Around the World
AbstractWe investigate the effect of insider ownership on corporate bond yield spreads from 2003 to 2014 using a sample of 10,470 bonds issued by 1,222 non-financial firms from 48 countries. We find that greater insider ownership is reflected in higher yield spreads, consistent with the hypothesis that bondholders associate insider ownership with increased risk of tunnelling. In support of this argument, we also find that involvement in related-party transactions, a form of tunnelling, is more likely to occur in firms with a higher percentage of shares held by insiders. Additionally, the positive impact of insider ownership on spreads is attenuated in firms with more shareholder rights provisions.
Interbank Connections and Financial Stability
AbstractIn this paper, I study how interconnectedness of a bank is related to its financial stability. In addition, I ask what mechanisms amplify/mitigate such relationship. Using a detailed US home loan database, I consider linkages that are formed between banks due to exposure to common housing markets. I then investigate the role of such linkages in explaining financial stability around the 2007 financial crisis. The main result of the paper is that in the event of a large shock, interlinkages facilitate contagion of distress and make banks riskier. In the absence of a shock (i.e., during the pre-crisis period), there is no evidence of such negative relationship between interconnections and stability. Furthermore, I provide evidence that high exposure to leverage and securitization activity of other banks exacerbate the contagion effect of interlinks, while exposure to liquidity ratio of other banks mitigates this effect.
Intermediary Funding Costs and Short-Term Risk Premia
AbstractWe build a theory of short-term risk premia dynamics based on funding costs. The theory builds on a framework of intermediary asset pricing in a market microstructure setting. Financial intermediaries facilitate trading by market making. To fund these trading activities, intermediaries earn a risk premium. This risk premium increases in intermediary leverage and asset idiosyncratic risks. We test our theory across multiple asset classes, including equities, bonds, and currencies. Conditional on a large price shock, high intermediary leverage and asset idiosyncratic risk raise short-term risk premia by about 100 to 170 basis points. We also find evidence of risk sharing and capacity constraints among intermediaries. Intermediary leverage and asset idiosyncratic volatility are important factors in explaining the time series of risk premia in equities, bonds, and currencies.
Investment Timing with Costly Search for Financing
AbstractI develop a dynamic model of investment timing in which a manager must first choose when to search for external financing. The manager incurs a private cost from search, leading to inefficient delay in financing and investment. Increasing taxes or lowering the manager's initial equity stake increases the delay. This realistic generalization of the investment timing problem is straightforward to extend. I find that subjecting the firm to insolvency shocks disciplines the manager which reduces delays. When I introduce time varying financial conditions, the model predicts investment waves, financing waves, market timing, and IPO withdrawals consistent with empirical evidence. Finally, adding heterogeneous investors produces empirical predictions on investor-firm matching.
Leverage, labor commitment, and employee layoffs
AbstractThis paper empirically investigates whether the Works Council - a government remedy for the agency problems between employees and shareholders – can prevent that leverage disciplines labor by employee layoffs. Works Councils can only prevent that leverage disciplines labor by employee layoffs when we consider the different type of employee layoffs and when the Work Councils consist of more economically vulnerable low-wage employee representatives such as blue-collar workers, younger workers, or female (educated) workers. Overall, the evidence indicates that Works Council can be seen as an important mechanism to solve or act to prevent agency problems between employees-shareholders.
Long-Term Finance and Economic Development: The Role of Liquidity in Corporate Debt Markets
AbstractWhat are the linkages between debt markets liquidity, corporate bonds maturity, and the real economy? This paper provides a framework in which entrepreneurs choose and finance investment projects in a production economy subject to trading frictions in financial markets and time-to-build constraints in investment. Entrepreneurs have access to bonds of different maturities which price depends on the liquidity of secondary markets. Higher liquidity in secondary markets reduces borrowing costs in primary markets and entrepreneurs choose to enter in longer-term projects which are more productive. Therefore, development in corporate debt markets liquidity promotes economic development. Preliminary estimates show that variations in corporate debt markets liquidity can account for the cross-country variation on corporate debt maturity.
Macro News, Micro News, and Stock Prices
AbstractI present evidence of a complementary relation between macro announcements and firm-specific news by examining how macro news affects investors’ reactions to earnings announcements. It is well known that investors tend to react to earnings news slowly and there are drifts following firms’ earnings announcements. The presence of macro news significantly impacts investors’ reactions to earnings news: immediate price reaction is 17% stronger and the drift is 71% weaker when important macro news is released on the same day. This effect also exists when earnings news is released on days with a large number of macro announcements. I further investigate several potential explanations and find that institutional investors pay substantially more attention to announcing firms on macro-news days. The results cannot be explained by changes in risk, information transmission from macro news or strategic timing. Overall, these findings provide new evidence that the market is more efficient on macro-news days and investor attention is allocated rationally and is not always limited by the quantity of information.
Mandatory Compensation Disclosure, CFO Pay, and Corporate Financial Reporting Practices
AbstractWe use the SEC’s mandated disclosure rule on CFO pay in 2006 to examine the effect of compensation disclosure on executive pay and corporate financial reporting practices. In a panel of S&P1500 firms, we find that total compensation of the CFO increases dramatically relative to the CEO. The effect is the most salient at firms that never or rarely disclosed CFO pay before 2006. The results are consistent with the view that the CFO requires additional compensation for lost private benefits due to more intense monitoring. We also find more negative unexpected earnings and deteriorated financial reporting quality in these firms after 2006. CFO (but not CEO) turnover increases significantly.
Measuring Trust in Institutions: An Experimental Study Using Time Preference Elicitation
AbstractTrust is an important driver of economic interactions. We propose a new way of experimentally measuring trust in institutions which draws on the experimental method used to elicit time preferences. Our method enables the elicitation of levels of trust towards institutions in an incentivized way and is not identified by the participants as a measure of trust. In contrast to other measures of trust, it can easily be translated into the meaningful metric of subjective probability of trustworthiness of the opponent. We are measuring trust in two institutions, a formal Philippine microfinance institution (MFI) and informal local money lenders. We show that our trust measure is able to differentiate between treatments. It implies subjective probabilities of payment completion between 0.24 and 0.60 relative to the control treatment with payment securement. The trust in the formal institution is robustly measured to be higher than in the informal institution. Unincentivized survey measures go in the same direction but suggest a much stronger difference.
Investment Style Misclassification and Mutual Fund Performance
AbstractMutual fund investors rely on the information provided in a mutual fund’s prospectus when selecting funds. In addition to that the SEC mandates funds to stick to their stated investment style. However, previous research has shown that, over shorter horizons, a substantial proportion of funds in fact deviate from their stated investment style. Previous empirical findings regarding the impact of this behavior on fund performance is mixed. In this paper, we extend the previous literature by introducing a novel measure to evaluate long-term style deviation. Our measure of fund style misclassification is more granular, incorporates parameter uncertainty in its measurement and allows for statistical inference. Using a sample of 1,866 US equity funds over the 2003-2015 period we document that: 1) about 14% of individual funds are significantly misclassified, 2) in the long run misclassified funds significantly underperform well-classified funds by 0.92% per year based on alpha from the Carhart model, and 3) misclassified funds appear to be younger, smaller in size and charge higher expense ratios. From this we infer that monitoring long-term style deviation is critically important for investors. Maintaining a consistent style is a crucial ingredient for achieving good long-term risk-adjusted performance.
Payout Policy and Real Estate Prices
AbstractThis paper studies the impact of real estate prices on the payout policy of firms. Firms use corporate real estate (CRE) assets as collateral to obtain debt. Through this collateral channel, positive shocks to the value of CRE assets allow firms to increase their leverage in order to finance not only investments but also payouts. We find that a $1 increase in the value of CRE assets results in a 0.34 cents increase in cash dividends and a 0.33 cents increase in share repurchases. These effects are stronger in firms with fewer investment opportunities (i.e., firms with lower Tobin's Q) and are not symmetric in periods of decreasing CRE value. We also find that firms that experienced positive shocks to the value of their CRE assets smooth their dividends more.
Peer Effects across Firms: Evidence from Security Analysts
AbstractWe study peer effects among workers in the same occupation across firms in the context of
security analysts (i.e., we study whether the productivity of a worker is a function of her peers in other firms). We use microdata concerning analysts as well as an identification strategy that employs one feature of social networks: the existence of partially overlapping peer group. The results show strong evidence of spillovers in terms of peers’ outcomes and characteristics. We find a significant positive causal effect of peers’ accuracy on an analysts’ accuracy. For example, a one standard deviation in peers’ earnings forecast accuracy increases an analyst’s accuracy by 25.7%. We also find that peers’ characteristics have a significant effect on earnings forecast accuracy, and the estimate of the social multiplier is around 1.46.
Household Credit Uncertainty and the Real Interest Rate
AbstractI introduce aggregate uncertainty about the debt limits faced by heterogeneous households in a Bewley-Huggett economy with a financial sector and government bonds in exogenous supply. Uncertainty about households’ debt contracts results from aggregate shocks to the balance sheets of financial intermediaries supplying credit to households, which sometimes give rise to credit crises. In the rational expectations equilibrium, agents internalize the existence of (endogenous) stochastic credit regimes, which creates an additional precautionary savings motive. When the economy transits from a regime of easy credit to a regime of tight credit, the interest rate drops because of the combined effects of i) deleveraging and ii) the precautionary savings motive created by the uncertainty about future debt limits. A low and persistent interest rate environment arises, with households holding more assets and less debt. Consumption is smoother over the cycle than in a model in which the transition to a tight credit regime is unexpected. Thus an extended period of low interest rates is not necessarily associated with a massive drop in aggregate consumption, which is a feature of the post-financial crisis US data that classical models of the liquidity trap fail to generate.
Regulations in Two Lemon Markets: An Application in Cross-Border Listing
AbstractI analyze a model where two independent regulators in two open economies strategically set regulatory stringency in their domestic lemon market. Since firms are allowed to enter either market, foreign regulation affects domestic firms' outside options. I then link the regulations to the fundamentals of the two economies. When the difference in fundamentals between the two economies is moderate, there exists an equilibrium in which the strong economy has stricter regulation than the weak economy, and the good firms in the weak economy flow to the strong economy to signal for their type. When the difference in fundamentals between the two economies is either too large or too small, the equilibrium outcome is the same as the case when both economies are closed. In terms of global welfare, there exist inefficient regions of fundamentals where the strong economy under-regulates, while the weak economy over-regulates.
Social Connections and Information Production: Evidence from Mutual Fund Portfolios and Performance
AbstractWhile connected investors have access to information in their social network (information diffusion effect), social connections also reduce their incentives to acquire costly information, since they can free ride on connected peers ("free riding on friends" effect). In this paper, I find this negative "free riding on friends" effect of social connections dominates information diffusion effect in the mutual fund industry, using fund managers' connections built upon their prior career experiences. First, I find that connected funds are more likely to hold the same stocks and to trade in the same direction, relative to unconnected funds. Second, I find that funds with lower network centrality earn higher alphas, even after controlling for other fund and manager characteristics. A one-standard-deviation increase in eigenvector centrality predicts a decrease of 29-37 basis points in annualized fund alphas. Third, when I define a stock-level variable PMC (Peripheral minus Central) as the difference in average portfolio weights between peripheral funds and central funds, I find that stocks with higher PMC have significantly higher abnormal stock returns. A one-standard-deviation increase in PMC predicts an increase of 1.48%-1.52% in the next quarter risk-adjusted returns (annualized). Finally, I find that PMC predicts firms' future earnings surprises.
Options Listing, Information Acquisition and Peer Firm Value
AbstractThis paper studies the effect of listing of equity options on industry peer stock prices and firm value. I find that options listing leads to a decline in information acquisition on peer firms as investors reallocate more resources towards listed stocks at the expense of peer stocks following listing. This reallocation leads to a decline in informational efficiency and market quality for peer stocks. Further, lower informational efficiency negatively affects firm value and profitability for peer firms. Contrary to the extant literature, these findings highlight a negative externality generated by options listing on the stock market which have important implications for industry peer firms.
Terrorist Attacks and Investor Risk Preference: Evidence from Mutual Fund Flows
AbstractUsing domestic and transnational terrorist attacks in the U.S. from 1970-2010, we find that in the month after a spike in attacks, mutual fund investors display a significant increase in risk averse portfolio choices. The drop in demand for risky funds is evident in the cross-section of equity and bond funds; it varies with the risk level of the fund and the assets in which it is invested. The response to attacks depends on the investors’ proximity to the attack and the attacks’ saliency. In accordance with related studies, the change in investor risk preference is transitory.
What Is Wrong With Representative Agent Equilibrium Models?
AbstractDespite the ability to match an increasing number of data moments, equilibrium models, employing the widely used Representative Agent simplifying construct, do not properly fit the data, why? Using a flexible econometric model I provide, as a function of a set of key drivers capturing violations to the models' key assumptions, a joint model-free test for the Representative Agent Equilibrium Models (RAEMs) in the literature as well as the conditional probability of their failures over time. I find such probabilities to be counter-cyclical, right-skewed and on average high (around 47%). RAEMs are rejected in periods of high illiquidity (market frictions) where the investors’ level of disagreement (asymmetric information) is above the median and aggregate expectations are irrationally downward biased. These periods are followed by a decreasing demand to hold the market and, inconsistently with RAEMs predictions, low realized returns. During economic recessions, models are more likely to fail due to market frictions, while in normal times by the asymmetry in information.
Spillover Duration of Stock Returns and Systemic Risk
AbstractCommon systemic risk measures focus on the instantaneous occurrence of triggering and systemic events. However, in this article we show that daily tail stock returns exhibit substantial persistence, auto-serially and cross-serially. In particular, lower tail returns can trigger downward spirals of tail returns. The vulnerability towards downward spirals increases with the institution's size. To quantify the systemic risk related to tail return spillovers, we develop the Conditional Shortfall Probability (CoSP). We show that CoSP exhibits a substantially smaller estimation error than other systemic risk measures. Our empirical results show that a substantially larger fraction of financial companies exhibits significant tail return spillovers to the American non-financial sector than to the global financial sector. Still, the aggregate spillover risk is larger with respect to the financial market than with respect to non-financial markets. Moreover, the aggregate vulnerability of the overall financial sector towards spillover risk is larger than of single financial subsectors.
The Information Content of Sudden Insider Silence
AbstractThis paper explores the information content of insider sudden silence. We show that routine-based insiders strategically choose to be silent when they possess private information not yet reflected in stock prices. Consistent with our hypothesis, insider silence following routine sell (buy) predict positive (negative) future abnormal return as well as earnings surprise. The return predictability of insider silence is stronger among firms with worse information environment and facing higher arbitrage costs, suggesting that investors underweight the information in insider silence. We also find that insider silence forecasts future firm fundamentals (e.g., ROA, cash flows, analyst revision) and sophisticated investors trade in the direction predicted by the information of insider silence in the following quarter. A long-short portfolio that exploits insiders' strategic silence behavior generates abnormal returns up to 10.4% annually.
The Money Multiplier and Stock Market Returns
AbstractThe money multiplier, the ratio of inside mony to outside money, predicts stock market excess returns at a quarterly frequency in the United Sates since 1959. The quarterly change in the multiplier predicts returns with a positive sign, while the level predicts returns with a negative sign. These findings are consistent with theories of financial intermediation which emphasise the response of inside money growth to procyclical net credit, whether such credit originates in the formal banking sector or not.
The Real Effects of Short Selling Constraints: Cross-Country Evidence
AbstractWe examine the effect of short selling constraints on stock prices and corporate investment. To do so, we exploit world-wide regulatory interventions to permit short selling. We find that a drop in short selling constraints causes stock prices and crash risk to drop, and price efficiency to increase. Corporate investment also drops, is accompanied by a drop in debt and equity, and becomes more responsive to growth opportunities. Our results suggest that short selling constraints can alleviate distortions in stock prices and corporate investment. Our results are consistent with stakeholders inferring information from stock prices and adjusting investment accordingly.
The Securitization Flash Flood
AbstractWhat caused the flood of securitized products in the years immediately preceding the crisis? This paper presents evidence that demand for safe collateral in repo markets made it attractive for financial institutions to issue securitized products. Using the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) as a natural experiment that shocked the demand for collateral, this paper establishes collateralized borrowing in short-term debt markets as a contributing factor to the rise of mortgage securitization. Hand-collected data on underlying collateral of over 900 repurchase contracts reveals underwriters of securitized products increased use of mortgage-based repos in the months following the law change. Highlighting an important connection between repo markets and securitization activity, this paper draws attention to an unintended consequence of bankruptcy law which has important policy implications.
The Term Structure of CAPM Alphas and Betas
AbstractPortfolio alpha and beta estimates are foundational for investment management decisions and for the broader asset pricing literature. Using monthly returns to calculate these coefficients, however, is inappropriate for investors with longer investment horizons. This is because alphas and betas are horizon-dependent and have term structures that are flat only under special conditions that don't generally hold. This paper documents what these conditions are and examines the empirical term-structure of CAPM alphas and betas for size, value, and momentum long-short portfolios. It finds that betas can reverse sign as the return horizon lengthens, turning a risky asset into a hedge, as is the case for size, or vice versa, as is the case for momentum. This impacts alphas to the point where by a 10-year horizon, size's alpha is comparable in magnitude to momentum's while momentum's loses statistical significance. These findings are made possible by developing a novel conditional moment estimation methdology that's non-parametric and modifies the standard realized approach so that it can be properly applied to long-horizon returns.
The Term Structure of Short Selling Costs
AbstractI derive the term structure of short selling costs using the put-call parity relationship. The shape of the term structure is determined by informed investors’ beliefs of when negative information will enter the market and correct the overpricing. I show that forward costs predicts future costs and stock returns, consistent with the expectations hypothesis in the model. I also find that an upward sloping curve around the earnings announcement increases the probability of a negative earnings surprise by 8.1%, supporting the prediction that short selling costs are higher when negative information is more likely to arrive.
Operating Lease and Credit Rating
AbstractThis paper documents how firms’ concern about credit rating downgrading and their attempts to get credit rating upgrading affect their choice between the use of debt and lease. Firms near a credit rating change tend to use less debt relative to operating lease to finance their new projects. This effect becomes more evident when firms’ rating concern becomes stronger. This effect is also more significant when firms’ cost of equity finance is higher. The finding is consistent with the empirical evidence that the use of operating lease has much less impact on firm’s credit rating compared to the use of debt. The result is surprising because rating agencies are fully aware of firms’ use of off-balance-sheet finance and would adjust it when they assess firms’ creditworthiness. There are two possible reasons for the result. First, the operating lease obligations are usually underestimated. Second, auditors tolerate more misstatement in disclosed off-balance-sheet items than they do in recognized balance sheet items.
Size Premium, Distress Risk and Distress Anomaly
AbstractAs documented in Fama and French (1992), small firms' expected equity returns are usually larger than big firms.' Notably, Fama and French (1995) attributed this return pattern, dubbed as size premium, to a notion that small firms are assigned a higher risk premium because they face greater risk of distress. However, "distress anomaly" papers including Campbell, Hilscher, and Szilagyi (2008) empirically have shown that firms with greater distress risk tend to generate lower expected returns thus imply that small firms are assigned a lower risk premium (empirically confirmed by Fama and French (2015)). In this paper, I attempt to reconcile these two seemingly contradicting set of results. I assume that firm's true distress risk exposure is determined by Z-score (Altman (1968)) and firm size. To the extent that distress risk is sensitive to firm size, the model captures size premium. Moreover, I assume that the firm size's sensitivity to distress risk changes over Z-score. This leads to a hump-shaped return profile over Z-score and, more interestingly, implies hump-shaped size premium over Z-score. Moreover, consistent with the model's implication, I empirically find that unconditional size premium increases by more than three times after I exclude low-Z firms. Lastly, I extend the model to show that size premium depends on government debt. I empirically find that government's debt and size premium are negatively correlated.
Union Power and the Debt Maturity Structure
AbstractHow do powerful unions affect firms' debt maturity structure? I find that firms increase the fraction of long term debt as a response to unionization. Using a regression discontinuity design I estimate that unionized firms increase by 25% the fraction of long-term debt as compared to union-free firms. I find that financially constrained, less flexible, and small firms exploit the positive effects of union's monitoring activity to change their maturity structure so that to reduce refinancing risks. My findings support the view that bond market values positively the presence of powerful non-financial stakeholders with aligned interests and incentives to monitor over the firm's policies.
Value Creation of Independent Directors with STEM PhD: Evidence from Target Shareholder Gains
AbstractThis paper examines whether independent outside directors who hold a PhD in science, technology, engineering, and mathematics (i.e., STEM directors) enhance shareholder wealth in mergers and acquisitions. Using 772 mergers completed in U.S. between 2005 and 2014, we find that the market responds more favorably to M&A announcements when target firms have STEM directors, but not when their independent directors hold PhDs in other disciplines (e.g., business or law). In subsample tests, we find that the short-term announcement day premium from STEM directors is particularly pronounced for firms with higher R&D intensity, firms in high-tech industries, and firms located in high-tech cities. Further, we find that the short-term premium exists only when STEM directors’ academic discipline is in line with the target firm’s primary operation. Last, we find that target firms are more likely to be acquired by bidders in the same industry than in other industries and by public bidders than private bidders if target firms have STEM directors. Overall, our findings suggest that independent directors with STEM expertise enhance shareholder wealth owing to their technical advisory role in corporate innovation.
Variance Risk in Aggregate Stock Returns and Time-Varying Return Predictability
AbstractThis paper introduces a new out-of-sample forecasting methodology for asset returns using the variance risk premium (VRP). While Bollerslev, Tauchen, and Zhou (2009) demonstrate that the VRP predicts market returns up to six months, I show that the out-of-sample performance is comparably weak. In contrast, my new approach produces an out-of-sample forecast that is both highly statistically and economically significant. Specifically, I find a monthly out-of-sample R-squared of 8% and a trading strategy that produces a 0.1 gain in the annual Sharpe ratio. This new approach is motivated by the `beta representation,' which implies that the market risk premium is related to the price of variance risk by the exposure to variance risk (beta). Hence, empirically, when the slope of the contemporaneous regression of market returns on variance innovation is larger, future returns are more sharply related to the current VRP. Also, when variance shocks explain a greater fraction of market returns, the predictions are more accurate. Furthermore, these results are extendable to the cross-section of exchange rates. The VRP of the S&P 500 Index only predicts returns of currencies that are highly correlated with changes in market variance. For those currencies, the new methodology offers considerable improvements in out-of-sample performance. These results suggest that the variance risk exposure is a key factor that determines whether and how returns are predictable by the VRP.
Too good to be true? – The influence of manager self-descriptions on investor behavior
AbstractWe show that investors base their decisions on perceptions of the responsible investment manager shaped by manager-written texts. Relying on a novel dataset of a European social trading platform including self-descriptions from portfolio managers, we show that a positive emotional tone of these descriptions lowers portfolio inflows. We find no significant differences in performance and risk taking of managers. By testing the underlying mechanism in an experiment, our results reveal that the use of positive tone leads to lower portfolio inflows because managers are perceived as less competent. Our results thus provide evidence of taste-based discrimination with investors misattributing less competence to managers.
Why Don't General Counsels Stop Corporate Crime?
AbstractCorporate fraud is costly, involving hundreds of billions of dollars in lost reputational and out of pocket costs for stakeholders and hundreds of thousands of job losses for employees, suppliers and customers as well as loss of lives. To prevent fraud, general counsels (GCs) are charged as the gatekeepers for the corporation. They understand the law and they are expected to use their legal expertise to advise, intervene and report whenever they are suspicious of fraud. In spite of their legally-mandated central role, however, corporate counsels typically do not appear to discover any corporate wrongdoing. In this paper, we analyze the potential reasons why corporate counsels keep silent in the face of potential wrongdoing in their own firms and propose policy recommendations to better protect shareholders’ interests against self-dealing by top management.
Why is the VIX Index Related to the Liquidity Premium?
AbstractMarket makers' compensation for supplying liquidity depends on short-term price reversal. Previous empirical studies show that when the VIX is high, the short-term price reversal effect is stronger, i.e. market makers charge a higher premium for liquidity provision. The 3-period theoretical model of this paper explains that this is the case for three reasons; when the VIX is high (1) market makers are more risk averse, (2) asset variances are higher, and thereby, an identical asset-specific liquidity shock creates a stronger short-term reversal effect in an individual asset, and (3) asset correlations are higher, and thus, there is a higher risk of spillover of liquidity shocks among assets. Consequently, an escalated level of the VIX index raises market makers' required return for liquidity provision. Our empirical analyses robustly confirm these theoretical findings.
Ambiguous Market Making
AbstractThis paper investigates the impact of informational ambiguity and attitude to it on security prices. Attention is focused on equilibria in which a market maker has an ambiguity in his probability assessment. We show that the equilibrium ambiguous bid-ask spread can be decomposed into the probabilistic spread and an ``ambiguity premium/discount" component characterizing the ambiguity aversion/seeking of the market maker. In particular, for a sufficiently ambiguity averse market maker, the bid-ask spread widens with the informational ambiguity of the market maker, which provides an explanation to drying liquidity and price inefficiency during financial turmoils. An extension to different trade sizes shows that informed traders are more likely to trade large orders when there is a major ambiguous shock to the economy.
- G0 - General