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Volume 59: Issue 5 (October 2004)

Forecast Dispersion and the Cross Section of Expected Returns

Pages: 1957-1978  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00688.x  |  Cited by: 362


Recent work by Diether, Malloy, and Scherbina (2002) has established a negative relationship between stock returns and the dispersion of analysts' earnings forecasts. I offer a simple explanation for this phenomenon based on the interpretation of dispersion as a proxy for unpriced information risk arising when asset values are unobservable. The relationship then follows from a general options‐pricing result: For a levered firm, expected returns should always decrease with the level of idiosyncratic asset risk. This story is formalized with a straightforward model. Reasonable parameter values produce large effects, and the theory's main empirical prediction is supported in cross‐sectional tests.

Predictable Investment Horizons and Wealth Transfers among Mutual Fund Shareholders

Pages: 1979-2012  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00689.x  |  Cited by: 56


This study analyzes the distribution of investment horizons in a large, proprietary panel of all shareholders in one no‐load mutual fund family. A proportional hazards model shows that there are observable shareholder characteristics that enable the fund to predict reliably on the day each account is opened whether the account will be short term or long term. Simulations show that the liquidity costs imposed on the fund by the expected short‐term shareholders are significantly greater than those imposed by the expected long‐term shareholders. Combining these results, the analysis argues that mutual funds do not provide equitable liquidity‐risk insurance.

Hedge Funds and the Technology Bubble

Pages: 2013-2040  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00690.x  |  Cited by: 702


This paper documents that hedge funds did not exert a correcting force on stock prices during the technology bubble. Instead, they were heavily invested in technology stocks. This does not seem to be the result of unawareness of the bubble: Hedge funds captured the upturn, but, by reducing their positions in stocks that were about to decline, avoided much of the downturn. Our findings question the efficient markets notion that rational speculators always stabilize prices. They are consistent with models in which rational investors may prefer to ride bubbles because of predictable investor sentiment and limits to arbitrage.

Cash and Corporate Control

Pages: 2041-2060  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00691.x  |  Cited by: 129


The takeover market is often suggested as appropriate for containing the agency problems of excessive corporate cash holdings. However, recent studies report contradictory evidence. I focus on the takeover‐deterrence effects of corporate liquidity and suggest the proxy contest as an effective alternative control mechanism. I find that proxy fight targets hold 23% more cash than comparable firms, and that the probability of a contest is significantly increasing in excess cash holdings. Proxy fight announcement return also is positively related to excess cash. Following a contest, executive turnover and special cash distributions to shareholders increase, while cash holdings significantly decline.

Investment–Cash Flow Sensitivities: Constrained versus Unconstrained Firms

Pages: 2061-2092  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00692.x  |  Cited by: 817


From the existing literature, it is not clear what effect financing constraints have on the sensitivities of firms' investment to their cash flow. I propose an explanation that reconciles the conflicting empirical evidence. I present two models: the unconstrained model, in which firms can raise external funds, and the constrained model, in which firms cannot do so. Using low dividends to identify financing constraints in my generated panel of data produces results consistent with those of Fazzari, Hubbard, and Petersen; using the constrained model produces results consistent with those of Kaplan and Zingales.

Dividend Changes and the Persistence of Past Earnings Changes

Pages: 2093-2116  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00693.x  |  Cited by: 79


We examine whether the market interprets changes in dividends as a signal about the persistence of past earnings changes. Prior to observing this signal, investors may believe that past earnings changes are not necessarily indicative of future earnings levels. We empirically investigate whether a change in dividends alters investors' assessments about the valuation implications of past earnings. Results confirm the hypothesis that changes in dividends cause investors to revise their expectations about the persistence of past earnings changes. This effect varies predictably with the magnitude of the dividend change and the sign of the past earnings change.

Correlated Trading and Location

Pages: 2117-2144  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00694.x  |  Cited by: 228


This paper analyzes the trading behavior of stock market investors. Purchases and sales are highly correlated when we divide investors geographically. Investors who live near a firm's headquarters react in a similar manner to releases of public information. We are able to make this identification by exploiting a unique feature of individual brokerage accounts in the People's Republic of China. The data allow us to pinpoint an investor's location at the time he or she places a trade. Our results are consistent with a simple, rational expectations model of heterogeneously informed investors.

The 52‐Week High and Momentum Investing

Pages: 2145-2176  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00695.x  |  Cited by: 542


When coupled with a stock's current price, a readily available piece of information—the 52‐week high price–explains a large portion of the profits from momentum investing. Nearness to the 52‐week high dominates and improves upon the forecasting power of past returns (both individual and industry returns) for future returns. Future returns forecast using the 52‐week high do not reverse in the long run. These results indicate that short‐term momentum and long‐term reversals are largely separate phenomena, which presents a challenge to current theory that models these aspects of security returns as integrated components of the market's response to news.

Characteristics, Contracts, and Actions: Evidence from Venture Capitalist Analyses

Pages: 2177-2210  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00696.x  |  Cited by: 668


We study the investment analyses of 67 portfolio investments by 11 venture capital (VC) firms. VCs describe the strengths and risks of the investments as well as expected postinvestment actions. We classify the risks into three categories and relate them to the allocation of cash flow rights, contingencies, control rights, and liquidation rights between VCs and entrepreneurs. The risk results suggest that agency and hold‐up problems are important to contract design and monitoring, but that risk sharing is not. Greater VC control is associated with increased management intervention, while greater VC equity incentives are associated with increased value‐added support.

Idiosyncratic Consumption Risk and the Cross Section of Asset Returns

Pages: 2211-2252  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00697.x  |  Cited by: 80


This paper investigates the importance of idiosyncratic consumption risk for the cross‐sectional variation in asset returns. We find that besides the rate of aggregate consumption growth, the cross‐sectional variance of consumption growth is also a priced factor. This suggests that consumers are not fully insured against idiosyncratic consumption risk, and that asset returns reflect their attempts to reduce their exposure to this risk. The resulting two‐factor consumption‐based asset pricing model significantly outperforms the CAPM, and its performance compares favorably with that of the Fama–French three‐factor model.

Bond Insurance: What Is Special About Munis?

Pages: 2253-2280  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00698.x  |  Cited by: 71


Close to 50% of municipal bonds are prepackaged with insurance at the time of issue. We offer a tax‐based rationale for the emergence of third‐party insurance of tax‐exempt bonds. We argue that insurance adds value as it allows a third party to become, in a probabilistic sense, an issuer of tax‐exempt securities. Insurance however reduces value by eliminating the possibility of a capital tax loss. While the net benefit from insurance increases with bond maturity, the benefit may not increase monotonically with default risk. We also provide empirical evidence supportive of the model's predictions.

Remuneration, Retention, and Reputation Incentives for Outside Directors

Pages: 2281-2308  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00699.x  |  Cited by: 529


I study incentives received by outside directors in Fortune 500 firms from compensation, replacement, and the opportunity to obtain other directorships. Previous research has only shown these relations to apply under limited circumstances such as financial distress. Together these incentive mechanisms provide directors with wealth increases of approximately 11 cents per $1,000 rise in firm value. Although smaller than the performance sensitivities of CEOs, outside directors' incentives imply a change in wealth of about $285,000 for a 1 standard deviation (SD) change in typical firm performance. Cross‐sectional patterns of director equity awards conform to agency and financial theories.

Bids and Allocations in European IPO Bookbuilding

Pages: 2309-2338  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00700.x  |  Cited by: 141


This paper uses evidence from a data set of 27 European IPOs to analyze how investors bid and the factors that influence their allocations. We also make use of a unique ranking of investor quality, associated with the likelihood of flipping the IPO. We find that investors perceived to be long‐term holders of the stock are consistently favored in allocation and in out‐turn profits. In contrast to Cornelli and Goldreich (2001), we find little evidence that more informative bids receive larger allocations or higher profits. Our results cast doubt upon the extent of information production during the bookbuilding period.

The Development of Secondary Market Liquidity for NYSE‐Listed IPOs

Pages: 2339-2374  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00701.x  |  Cited by: 47


For NYSE‐listed IPOs, limit order submissions and depth relative to volume are unusually low on the first trading day. Initial buy‐side liquidity is higher for IPOs with high‐quality underwriters, large syndicates, low insider sales, and high premarket demand, while sell‐side liquidity is higher for IPOs that represent a large fraction of outstanding shares and have low premarket demand. Our results suggest that uncertainty and offer design affect initial liquidity, though order flow stabilizes quickly. We also find that submission strategies are influenced by expected underwriter stabilization and preopening order flow contains information about both initial prices and subsequent returns.

Risk‐Neutral Parameter Shifts and Derivatives Pricing in Discrete Time

Pages: 2375-2402  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00702.x  |  Cited by: 37


We obtain a large class of discrete‐time risk‐neutral valuation relationships, or “preference‐free” derivatives pricing models, by imposing a simple restriction on the state‐price density process. The risk‐neutral stock‐return and forward‐rate dynamics are obtained by changing only a location parameter, which can be determined independent of the preference and true location parameters. The Gaussian models of Rubinstein (1976), Brennan (1979), and Câmera (2003), and the gamma model of Heston (1993) are all special cases. The model provides simple relationships between expected returns and state‐price density parameters analogous to the diffusion case.

Monitoring as a Motivation for IPO Underpricing

Pages: 2403-2420  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00703.x  |  Cited by: 39


Brennan and Franks (1997) and Stoughton and Zechner (1998) provide contrasting arguments for why monitoring considerations create incentives for managers to underprice their firms' IPOs (initial public offerings). Like Smart and Zutter (2003), we examine these arguments using a sample of U.S. IPOs. However, we find evidence that the determinants of initial returns, institutional shareholdings, and post‐IPO likelihood of acquisition are not consistent with these arguments. Thus, we conclude that monitoring considerations are not important determinants of IPO underpricing.

Competition and Coalition among Underwriters: The Decision to Join a Syndicate

Pages: 2421-2444  |  Published: 10/2004  |  DOI: 10.1111/j.1540-6261.2004.00704.x  |  Cited by: 50


This paper studies the decision of lead investment banks to organize hybrid syndicates (commercial banks participating as co‐managers) versus pure investment bank syndicates. The findings show that hybrid underwriting issues are more challenging to float. Compared to pure investment bank syndicates, hybrid syndicates serve clients that are smaller, have lower common stock rankings and less prior access to the capital markets, rely more on bank loans, and invest less capital but issue larger amounts, which indicates that commercial banks' participation enhances hybrid services. Moreover, lead investment banks tend to invite banks' participation when clients exhibit higher loyalty in reusing their services.