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Volume 59: Issue 3 (June 2004)

Are Judgment Errors Reflected in Market Prices and Allocations? Experimental Evidence Based on the Monty Hall Problem

Pages: 969-997  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00654.x  |  Cited by: 39

Brian D. Kluger, Steve B. Wyatt

The question of whether individual judgment errors survive in market equilibrium is an issue that naturally lends itself to experimental analysis. Here, the Monty Hall problem is used to detect probability judgment errors both in a cohort of individuals and in a market setting. When all subjects in a cohort made probability judgment errors, market prices also reflected the error. However, competition among two bias‐free subjects was sufficient to drive prices to error‐free levels. Thus, heterogeneity in behavior can be an important factor in asset pricing, and further, it may take few bias‐free traders to make asset prices bias‐free.

Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing

Pages: 999-1037  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00655.x  |  Cited by: 128

Robert M. Dammon, Chester S. Spatt, Harold H. Zhang

We investigate optimal intertemporal asset allocation and location decisions for investors making taxable and tax‐deferred investments. We show a strong preference for holding taxable bonds in the tax‐deferred account and equity in the taxable account, reflecting the higher tax burden on taxable bonds relative to equity. For most investors, the optimal asset location policy is robust to the introduction of tax‐exempt bonds and liquidity shocks. Numerical results illustrate optimal portfolio decisions as a function of age and tax‐deferred wealth. Interestingly, the proportion of total wealth allocated to equity is inversely related to the fraction of total wealth in tax‐deferred accounts.

Are Momentum Profits Robust to Trading Costs?

Pages: 1039-1082  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00656.x  |  Cited by: 291

Robert A. Korajczyk, Ronnie Sadka

We test whether momentum strategies remain profitable after considering market frictions induced by trading. Intraday data are used to estimate alternative measures of proportional and non‐proportional (price impact) trading costs. The price impact models imply that abnormal returns to portfolio strategies decline with portfolio size. We calculate break‐even fund sizes that lead to zero abnormal returns. In addition to equal‐ and value‐weighted momentum strategies, we derive a liquidity‐weighted strategy designed to reduce the cost of trades. Equal‐weighted strategies perform the best before trading costs and the worst after trading costs. Liquidity‐weighted and hybrid liquidity/value‐weighted strategies have the largest break‐even fund sizes: $5 billion or more (relative to December 1999 market capitalization) may be invested in these momentum strategies before the apparent profit opportunities vanish.

Analyzing the Analysts: When Do Recommendations Add Value?

Pages: 1083-1124  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00657.x  |  Cited by: 387

Narasimhan Jegadeesh, Joonghyuk Kim, Susan D. Krische, Charles M. C. Lee

We show that analysts from sell‐side firms generally recommend “glamour” (i.e., positive momentum, high growth, high volume, and relatively expensive) stocks. Naïve adherence to these recommendations can be costly, because the level of the consensus recommendation adds value only among stocks with favorable quantitative characteristics (i.e., value stocks and positive momentum stocks). In fact, among stocks with unfavorable quantitative characteristics, higher consensus recommendations are associated with worse subsequent returns. In contrast, we find that the quarterly change in consensus recommendations is a robust return predictor that appears to contain information orthogonal to a large range of other predictive variables.

A Catering Theory of Dividends

Pages: 1125-1165  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00658.x  |  Cited by: 439

Malcolm Baker, Jeffrey Wurgler

We propose that the decision to pay dividends is driven by prevailing investor demand for dividend payers. Managers cater to investors by paying dividends when investors put a stock price premium on payers, and by not paying when investors prefer nonpayers. To test this prediction, we construct four stock price‐based measures of investor demand for dividend payers. By each measure, nonpayers tend to initiate dividends when demand is high. By some measures, payers tend to omit dividends when demand is low. Further analysis confirms that these results are better explained by catering than other theories of dividends.

Executive Option Repricing, Incentives, and Retention

Pages: 1167-1199  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00659.x  |  Cited by: 53

Mark A. Chen

While many firms grant executive stock options that can be repriced, other firms systematically restrict or prohibit repricing. This article investigates the determinants of firms' repricing policies and the consequences of such policies for executive turnover and retention. Firms that have better internal governance, that use more powerful stock‐based incentives, or that face less shareholder scrutiny are more likely to maintain repricing flexibility. Firms that restrict repricing are more vulnerable to voluntary executive turnover following stock price declines. When share price declines are severe, restricting firms appear to award unusually large numbers of new options.

Economic News and the Impact of Trading on Bond Prices

Pages: 1201-1233  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00660.x  |  Cited by: 197

T. Clifton Green

This paper studies the impact of trading on government bond prices surrounding the release of macroeconomic news. The results show a significant increase in the informational role of trading following economic announcements, which suggests the release of public information increases the level of information asymmetry in the government bond market. The informational role of trading is greater after announcements with a larger initial price impact, and the relation is associated with the surprise component of the announcement and the precision of the public information. The results provide evidence that government bond order flow reveals fundamental information about riskless rates.

Informed Trading in Stock and Option Markets

Pages: 1235-1257  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00661.x  |  Cited by: 336

Sugato Chakravarty, Huseyin Gulen, Stewart Mayhew

We investigate the contribution of option markets to price discovery, using a modification of Hasbrouck's (1995) “information share” approach. Based on five years of stock and options data for 60 firms, we estimate the option market's contribution to price discovery to be about 17% on average. Option market price discovery is related to trading volume and spreads in both markets, and stock volatility. Price discovery across option strike prices is related to leverage, trading volume, and spreads. Our results are consistent with theoretical arguments that informed investors trade in both stock and option markets, suggesting an important informational role for options.

Is All That Talk Just Noise? The Information Content of Internet Stock Message Boards

Pages: 1259-1294  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00662.x  |  Cited by: 639

Werner Antweiler, Murray Z. Frank

Financial press reports claim that Internet stock message boards can move markets. We study the effect of more than 1.5 million messages posted on Yahoo! Finance and Raging Bull about the 45 companies in the Dow Jones Industrial Average and the Dow Jones Internet Index. Bullishness is measured using computational linguistics methods. Wall Street Journal news stories are used as controls. We find that stock messages help predict market volatility. Their effect on stock returns is statistically significant but economically small. Consistent with Harris and Raviv (1993), disagreement among the posted messages is associated with increased trading volume.

Risk Sharing and Asset Prices: Evidence from a Natural Experiment

Pages: 1295-1324  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00663.x  |  Cited by: 121

Anusha Chari, Peter Blair Henry

When countries liberalize their stock markets, firms that become eligible for foreign purchase (investible), experience an average stock price revaluation of 15.1%. Since the historical covariance of the average investible firm's stock return with the local market is roughly 200 times larger than its historical covariance with the world market, liberalization reduces the systematic risk associated with holding investible securities. Consistent with this fact: (1) the average effect of the reduction in systematic risk is 6.8 percentage points, or roughly two fifths of the total revaluation; and (2) the firm‐specific revaluations are directly proportional to the firm‐specific changes in systematic risk.

The Foundations of Freezeout Laws in Takeovers

Pages: 1325-1344  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00664.x  |  Cited by: 29

Yakov Amihud, Marcel Kahan, Rangarajan K. Sundaram

We provide an economic basis for permitting freezeouts of nontendering shareholders following successful takeovers. We describe a specific freezeout mechanism based on easily verifiable information that induces desirable efficiency and welfare properties in models of both corporations with widely dispersed shareholdings and corporations with large pivotal shareholders. The mechanism dominates previous proposals along some important dimensions. We also examine takeover premia that arise in the presence of competition among raiders. Our mechanism is closely related to the practice of takeover law in the United States; thus, our analysis may be thought of as analyzing the economic foundations of current regulations.

Market States and Momentum

Pages: 1345-1365  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00665.x  |  Cited by: 421

Michael J. Cooper, Roberto C. Gutierrez, Allaudeen Hameed

We test overreaction theories of short‐run momentum and long‐run reversal in the cross section of stock returns. Momentum profits depend on the state of the market, as predicted. From 1929 to 1995, the mean monthly momentum profit following positive market returns is 0.93%, whereas the mean profit following negative market returns is −0.37%. The up‐market momentum reverses in the long‐run. Our results are robust to the conditioning information in macroeconomic factors. Moreover, we find that macroeconomic factors are unable to explain momentum profits after simple methodological adjustments to take account of microstructure concerns.

Do Stock Prices and Volatility Jump? Reconciling Evidence from Spot and Option Prices

Pages: 1367-1403  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00666.x  |  Cited by: 561

Bjørn Eraker

This paper examines the empirical performance of jump diffusion models of stock price dynamics from joint options and stock markets data. The paper introduces a model with discontinuous correlated jumps in stock prices and stock price volatility, and with state‐dependent arrival intensity. We discuss how to perform likelihood‐based inference based upon joint options/returns data and present estimates of risk premiums for jump and volatility risks. The paper finds that while complex jump specifications add little explanatory power in fitting options data, these models fare better in fitting options and returns data simultaneously.

Specification Analysis of Option Pricing Models Based on Time-Changed Lévy Processes

Pages: 1405-1439  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00667.x  |  Cited by: 177

Jing-zhi Huang, Liuren Wu

We analyze the specifications of option pricing models based on time‐changed Lévy processes. We classify option pricing models based on the structure of the jump component in the underlying return process, the source of stochastic volatility, and the specification of the volatility process itself. Our estimation of a variety of model specifications indicates that to better capture the behavior of the S&P 500 index options, we need to incorporate a high frequency jump component in the return process and generate stochastic volatilities from two different sources, the jump component and the diffusion component.


Pages: 1441-1442  |  Published: 6/2004  |  DOI: 10.1111/j.1540-6261.2004.00668.x  |  Cited by: 1