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Volume 66: Issue 3 (June 2011)


Front Matter

Pages: i-iii  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01678.x  |  Cited by: 0


FELLOW OF THE AMERICAN FINANCE ASSOCIATION FOR 2011

Pages: iv-v  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01676.x  |  Cited by: 0

Milton Harris


The Internal Governance of Firms

Pages: 689-720  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01649.x  |  Cited by: 77

VIRAL V. ACHARYA, STEWART C. MYERS, RAGHURAM G. RAJAN

We develop a model of internal governance where the self‐serving actions of top management are limited by the potential reaction of subordinates. Internal governance can mitigate agency problems and ensure that firms have substantial value, even with little or no external governance by investors. External governance, even if crude and uninformed, can complement internal governance and improve efficiency. This leads to a theory of investment and dividend policy, in which dividends are paid by self‐interested CEOs to maintain a balance between internal and external control.


Municipal Debt and Marginal Tax Rates: Is There a Tax Premium in Asset Prices?

Pages: 721-751  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01650.x  |  Cited by: 19

FRANCIS A. LONGSTAFF

We study the marginal tax rate incorporated into short‐term municipal rates using municipal swap market data. Using an affine model, we identify the marginal tax rate and the credit/liquidity spread in 1‐week tax‐exempt rates, as well as their associated risk premia. The marginal tax rate averages 38.0% and is related to stock, bond, and commodity returns. The tax risk premium is negative, consistent with the strong countercyclical nature of after‐tax fixed‐income cash flows. These results demonstrate that tax risk is a systematic asset pricing factor and help resolve the muni‐bond puzzle.


Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act

Pages: 753-787  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01651.x  |  Cited by: 69

DHAMMIKA DHARMAPALA, C. FRITZ FOLEY, KRISTIN J. FORBES

The Homeland Investment Act provided a tax holiday for the repatriation of foreign earnings. Advocates argued the Act would alleviate financial constraints by reducing the cost to U.S. multinationals of accessing internal capital. This paper shows that repatriations did not increase domestic investment, employment, or R&D—even for firms that appeared to be financially constrained or lobbied for the holiday. Instead, a $1 increase in repatriations was associated with a $0.60 to $0.92 increase in shareholder payouts. Regulations intended to restrict such payouts were undermined by the fungibility of money. Results indicate that U.S. multinationals were not financially constrained and were well‐governed.


Financial Distress and the Cross-section of Equity Returns

Pages: 789-822  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01652.x  |  Cited by: 117

LORENZO GARLAPPI, HONG YAN

We explicitly consider financial leverage in a simple equity valuation model and study the cross‐sectional implications of potential shareholder recovery upon resolution of financial distress. Our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book‐to‐market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump‐shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.


Are All Inside Directors the Same? Evidence from the External Directorship Market

Pages: 823-872  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01653.x  |  Cited by: 116

RONALD W. MASULIS, SHAWN MOBBS

Agency theory and optimal contracting theory posit opposing roles and shareholder wealth effects for corporate inside directors. We evaluate these theories using the market for outside directorships to differentiate among inside directors. Firms with inside directors holding outside directorships have better operating performance and market‐to‐book ratios, especially when monitoring is more difficult. These firms make better acquisition decisions, have greater cash holdings, and overstate earnings less often. Announcements of outside board appointments improve shareholder wealth, while departure announcements reduce it, consistent with these inside directors improving board performance and outside directorships being an important source of inside director incentives.


Estimation and Evaluation of Conditional Asset Pricing Models

Pages: 873-909  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01654.x  |  Cited by: 49

STEFAN NAGEL, KENNETH J. SINGLETON

We find that several recently proposed consumption‐based models of stock returns, when evaluated using an optimal set of managed portfolios and the associated model‐implied conditional moment restrictions, fail to capture key features of risk premiums in equity markets. To arrive at these conclusions, we construct an optimal Generalized Method of Moments (GMM) estimator for models in which the stochastic discount factor (SDF) is a conditionally affine function of a set of priced risk factors, and we show that there is an optimal choice of managed portfolios to use in testing a null model against a proposed alternative generalized SDF.


The Illiquidity of Corporate Bonds

Pages: 911-946  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01655.x  |  Cited by: 304

JACK BAO, JUN PAN, JIANG WANG

This paper examines the illiquidity of corporate bonds and its asset‐pricing implications. Using transactions data from 2003 to 2009, we show that the illiquidity in corporate bonds is substantial, significantly greater than what can be explained by bid–ask spreads. We establish a strong link between bond illiquidity and bond prices. In aggregate, changes in market‐level illiquidity explain a substantial part of the time variation in yield spreads of high‐rated (AAA through A) bonds, overshadowing the credit risk component. In the cross‐section, the bond‐level illiquidity measure explains individual bond yield spreads with large economic significance.


Intermediated Investment Management

Pages: 947-980  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01656.x  |  Cited by: 42

NEAL M. STOUGHTON, YOUCHANG WU, JOSEF ZECHNER

Intermediaries such as financial advisers serve as an interface between portfolio managers and investors. A large fraction of their compensation is often provided through kickbacks from the portfolio manager. We provide an explanation for the widespread use of intermediaries and kickbacks. Depending on the degree of investor sophistication, kickbacks are used either for price discrimination or aggressive marketing. We explore the effects of these arrangements on fund size, flows, performance, and investor welfare. Kickbacks allow higher management fees to be charged, thereby lowering net returns. Competition among active portfolio managers reduces kickbacks and increases the independence of advisory services.


Employee Stock Options and Investment

Pages: 981-1009  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01657.x  |  Cited by: 25

ILONA BABENKO, MICHAEL LEMMON, YURI TSERLUKEVICH

Exercises of employee stock options generate substantial cash inflows to the firm. These cash inflows substitute for costly external finance in those states of the world in which the demand for investment is high. Using the fact that the proceeds from option exercises exhibit a distinct nonlinearity around the point where options fall out of the money, we estimate that firms increase investment by $0.34 for each dollar received from the exercise of stock options. Firms that face higher external financing costs allocate more of the proceeds from option exercises to investment.


Do Individual Investors Have Asymmetric Information Based on Work Experience?

Pages: 1011-1041  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01658.x  |  Cited by: 43

TROND M. DØSKELAND, HANS K. HVIDE

Using a novel data set covering all individual investors' stock market transactions in Norway over 10 years, we analyze whether individual investors have a preference for professionally close stocks, and whether they make excess returns on such investments. After excluding own‐company stock holdings, investors hold 11% of their portfolio in stocks within their two‐digit industry of employment. Given the poor hedging properties of such investments, one would expect abnormally high returns. In contrast, all estimates of abnormal returns are negative, in many cases statistically significant. Overconfidence seems the most likely explanation for the excessive trading in professionally close stocks.


MISCELLANEA

Pages: 1043-1044  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01659.x  |  Cited by: 0


Back Matter

Pages: 1045-1049  |  Published: 5/2011  |  DOI: 10.1111/j.1540-6261.2011.01677.x  |  Cited by: 0