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Volume 58: Issue 5 (October 2003)

Stock Valuation and Learning about Profitability

Pages: 1749-1789  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00587  |  Cited by: 677

Ľuboš Pástor, Veronesi Pietro

We develop a simple approach to valuing stocks in the presence of learning about average profitability. The market‐to‐book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firm's lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

Currency Orders and Exchange Rate Dynamics: An Explanation for the Predictive Success of Technical Analysis

Pages: 1791-1819  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00588  |  Cited by: 151

Carol L. Osler

This paper documents clustering in currency stop‐loss and take‐profit orders, and uses that clustering to provide an explanation for two familiar predictions from technical analysis: (1) trends tend to reverse course at predictable support and resistance levels, and (2) trends tend to be unusually rapid after rates cross such levels. The data are the first available on individual currency stop‐loss and take‐profit orders. Take‐profit orders cluster particularly strongly at round numbers, which could explain the first prediction. Stop‐loss orders cluster strongly just beyond round numbers, which could explain the second prediction.

S&P 500 Index Additions and Earnings Expectations

Pages: 1821-1840  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00589  |  Cited by: 251

Diane K. Denis, John J. McConnell, Alexei V. Ovtchinnikov, Yun Yu

Stock price increases associated with addition to the S&P 500 Index have been interpreted as evidence that demand curves for stocks slope downward. A key premise underlying this interpretation is that Index inclusion provides no new information about companies' future prospects. We examine this premise by analyzing analysts' earnings per share (eps) forecasts around Index inclusion and by comparing postinclusion realized earnings to preinclusion forecasts. Relative to benchmark companies, companies newly added to the Index experience significant increases in eps forecasts and significant improvements in realized earnings. These results indicate that S&P Index inclusion is not an information‐free event.

The Presidential Puzzle: Political Cycles and the Stock Market

Pages: 1841-1872  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00590  |  Cited by: 380

Pedro Santa‐Clara, Rossen Valkanov

The excess return in the stock market is higher under Democratic than Republican presidencies: 9 percent for the value‐weighted and 16 percent for the equal‐weighted portfolio. The difference comes from higher real stock returns and lower real interest rates, is statistically significant, and is robust in subsamples. The difference in returns is not explained by business‐cycle variables related to expected returns, and is not concentrated around election dates. There is no difference in the riskiness of the stock market across presidencies that could justify a risk premium. The difference in returns through the political cycle is therefore a puzzle.

Risk Management with Derivatives by Dealers and Market Quality in Government Bond Markets

Pages: 1873-1904  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00591  |  Cited by: 38

Narayan Y. Naik, Pradeep K. Yadav

This paper investigates how bond dealers manage core business risk with interest rate futures and the extent to which market quality is affected by their selective risk taking. We observe that dealers use futures to take directional bets and hedge changes in their spot exposure. We find that, cross‐sectionally, a dealer with longer (shorter) risk exposure sells (buys) a larger amount of exposure the next day. However, this risk control takes place via the futures market and not the spot market. Finally, we find strong support for the price effects of capital constraints emphasized by Froot and Stein (1998).

Empirical Tests for Stochastic Dominance Efficiency

Pages: 1905-1931  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00592  |  Cited by: 235

Thierry Post

We derive empirical tests for the stochastic dominance efficiency of a given portfolio with respect to all possible portfolios constructed from a set of assets. The tests can be computed using straightforward linear programming. Bootstrapping techniques and asymptotic distribution theory can approximate the sampling properties of the test results and allow for statistical inference. Our results could provide a stimulus to the further proliferation of stochastic dominance for the problem of portfolio selection and evaluation. Using our tests, the Fama and French market portfolio is significantly inefficient relative to benchmark portfolios formed on market capitalization and book‐to‐market equity ratio.

An Empirical Analysis of Analysts' Target Prices: Short‐term Informativeness and Long‐term Dynamics

Pages: 1933-1967  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00593  |  Cited by: 300

Alon Brav, Reuven Lehavy

Using a large database of analysts' target prices issued over the period 1997–1999, we examine short‐term market reactions to target price revisions and long‐term comovement of target and stock prices. We find a significant market reaction to the information contained in analysts' target prices, both unconditionally and conditional on contemporaneously issued stock recommendation and earnings forecast revisions. Using a cointegration approach, we analyze the long‐term behavior of market and target prices. We find that, on average, the one‐year‐ahead target price is 28 percent higher than the current market price.

Value versus Glamour

Pages: 1969-1995  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00594  |  Cited by: 86

Jennifer Conrad, Michael Cooper, Gautam Kaul

The fragility of the CAPM has led to a resurgence of research that frequently uses trading strategies based on sorting procedures to uncover relations between firm characteristics (such as “value” or “glamour”) and equity returns. We examine the propensity of these strategies to generate statistically and economically significant profits due to our familiarity with the data. Under plausible assumptions, data snooping can account for up to 50 percent of the in‐sample relations between firm characteristics and returns uncovered using single (one‐way) sorts. The biases can be much larger if we simultaneously condition returns on two (or more) characteristics.

Corporate Board Composition, Protocols, and Voting Behavior: Experimental Evidence

Pages: 1997-2031  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00595  |  Cited by: 79

Ann B. Gillette, Thomas H. Noe, Michael J. Rebello

We examine voting by a board designed to mitigate conflicts of interest between privately informed insiders and owners. Our model demonstrates that, as argued by researchers and the business press, boards with a majority of trustworthy but uninformed “watchdogs” can implement institutionally preferred policies. Our laboratory experiments strongly support this conclusion. Our model also highlights the necessity of penalties on insiders when there is dissension among board members. However, penalties for dissent appeared to have little impact on the experimental outcomes.

How Investors Interpret Past Fund Returns

Pages: 2033-2058  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00596  |  Cited by: 260

Anthony W. Lynch, David K. Musto

The literature documents a convex relation between past returns and fund flows of mutual funds. We show this to be consistent with fund incentives, because funds discard exactly those strategies which underperform. Past returns tell less about the future performance of funds which discard, so flows are less sensitive to them when they are poor. Our model predicts that strategy changes only occur after bad performance, and that bad performers who change strategy have dollar flow and future performance that are less sensitive to current performance than those that do not. Empirical tests support both predictions.

Financing and Advising: Optimal Financial Contracts with Venture Capitalists

Pages: 2059-2085  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00597  |  Cited by: 416

Catherine Casamatta

This paper analyses the joint provision of effort by an entrepreneur and by an advisor to improve the productivity of an investment project. Without moral hazard, it is optimal that both exert effort. With moral hazard, if the entrepreneur's effort is more efficient (less costly) than the advisor's effort, the latter is not hired if she does not provide funds. Outside financing arises endogenously. This explains why investors like venture capitalists are value enhancing. The level of outside financing determines whether common stocks or convertible bonds should be issued in response to incentives.

Do Spin‐offs Expropriate Wealth from Bondholders?

Pages: 2087-2108  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00598  |  Cited by: 132

William F. Maxwell, Ramesh P. Rao

A wealth transfer from bondholders to stockholders is one of several hypotheses used to explain stockholder gains on the announcement of a spin‐off. However, previous empirical research has not found systematic evidence supporting the wealth expropriation hypothesis. Using a larger sample with comprehensive bond data, we find evidence consistent with wealth expropriation. Bondholders, on average, suffer a significant negative abnormal return during the month of the spin‐off announcement. However, even accounting for the loss to the bondholders, the aggregate value of the publicly traded debt and equity increases on a spin‐off announcement, suggesting that the wealth expropriation hypothesis is not a complete explanation of the stockholder gains. In explaining the magnitude of the losses to bondholders, we find they are a function of the loss in collateral in the spun‐off subsidiary and the level of financial risk of the parent firm. Consistent with a loss to bondholders, firms are more likely to have their credit rating downgraded than upgraded after a spin‐off. Additionally, consistent with the wealth transfer hypothesis, losses to bondholders tend to be more severe, the larger the gains to shareholders.

Anticompetitive Financial Contracting: The Design of Financial Claims

Pages: 2109-2141  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00599  |  Cited by: 77

Giacinta Cestone, Lucy White

This paper presents the first model where entry deterrence takes place through financial rather than product‐market channels. In existing models, a firm's choice of financial instruments deters entry by affecting product market behavior; here entry deterrence occurs by affecting the credit market behavior of investors towards entrant firms. We find that to deter entry, the claims held on incumbent firms should be sufficiently risky, that is, equity. This contrasts with the standard Brander and Lewis (1986) result that debt deters entry. This effect is more marked the less competitive the credit market is—so more credit market competition spurs more product market competition.

Investment, Uncertainty, and Liquidity

Pages: 2143-2166  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00600  |  Cited by: 212

Glenn W. Boyle, Graeme A. Guthrie

We analyze the dynamic investment decision of a firm subject to an endogenous financing constraint. The threat of future funding shortfalls lowers the value of the firm's timing options and encourages acceleration of investment beyond the first‐best optimal level. As well as highlighting another way by which capital market frictions can distort investment behavior, this result implies that (1) the sensitivity of investment to cash flow can be greatest for high‐liquidity firms and (2) greater uncertainty has an ambiguous effect on investment.

Family Firms

Pages: 2167-2201  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00601  |  Cited by: 902

Mike Burkart, Fausto Panunzi, Andrei Shleifer

We present a model of succession in a firm owned and managed by its founder. The founder decides between hiring a professional manager or leaving management to his heir, as well as on what fraction of the company to float on the stock exchange. We assume that a professional is a better manager than the heir, and describe how the founder's decision is shaped by the legal environment. This theory of separation of ownership from management includes the Anglo‐Saxon and the Continental European patterns of corporate governance as special cases, and generates additional empirical predictions consistent with cross‐country evidence.

Asset Trading Volume with Dynamically Complete Markets and Heterogeneous Agents

Pages: 2203-2217  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00602  |  Cited by: 48

Kenneth L. Judd, Felix Kubler, Karl Schmedders

Trading volume of infinitely lived securities, such as equity, is generically zero in Lucas asset pricing models with heterogeneous agents. More generally, the end‐of‐period portfolio of all securities is constant over time and states in the generic economy. General equilibrium restrictions rule out trading of equity after an initial period. This result contrasts the prediction of portfolio allocation analyses that portfolio rebalancing motives produce nontrivial trade volume. Therefore, other causes of trade must be present in asset markets with large trading volume.

Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets

Pages: 2219-2248  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00603  |  Cited by: 64

Rong Fan, Anurag Gupta, Peter Ritchken

This paper examines whether higher order multifactor models, with state variables linked solely to underlying LIBOR‐swap rates, are by themselves capable of explaining and hedging interest rate derivatives, or whether models explicitly exhibiting features such as unspanned stochastic volatility are necessary. Our research shows that swaptions and even swaption straddles can be well hedged with LIBOR bonds alone. We examine the potential benefits of looking outside the LIBOR market for factors that might impact swaption prices without impacting swap rates, and find them to be minor, indicating that the swaption market is well integrated with the LIBOR‐swap market.

The Determinants of Underpricing for Seasoned Equity Offers

Pages: 2249-2279  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00604  |  Cited by: 337

Shane A. Corwin

Seasoned offers were underpriced by an average of 2.2 percent during the 1980s and 1990s, with the discount increasing substantially over time. The increase appears to be related to Rule 10b‐21 and to economic changes affecting both IPOs and SEOs. Consistent with temporary price pressure, underpricing is positively related to offer size especially for securities with relatively inelastic demand. Underpricing is also positively related to price uncertainty and, after Rule 10b‐21, to the magnitude of preoffer returns. Additionally, I find that underpricing is significantly related to underwriter pricing conventions such as price rounding and pricing relative to the bid quote.


Pages: 2281-2282  |  Published: 9/2003  |  DOI: 10.1111/1540-6261.00605  |  Cited by: 0


Pages: 2283-2284  |  Published: 10/2003  |  DOI: 10.1111/j.1540-6261.2003.tb00677.x  |  Cited by: 0