The Journal of Finance

Is the Real Interest Rate Stable?

Published: 12/01/1988   |   DOI: 10.1111/j.1540-6261.1988.tb03958.x

ANDREW K. ROSE

Univariate time‐series models for consumption, nominal interest rates, and prices each appear to have a single unit root before 1979. If nominal interest rates have a unit root but inflation and inflation forecast errors do not, then ex ante real interest rates have a unit root and are therefore nonstationary. This deduction does not depend on the properties of the unobservable ex post observed real return, which combines the ex ante real interest rate and inflation‐forecasting errors. The unit‐root characteristic of real interest rates is puzzling from at least two perspectives: many models imply that the growth rate of consumption and the real interest rate should have similar time‐series characteristics; also, nominal returns for other assets (e.g., stocks and bonds) appear to have different times‐series properties from those of treasury bills.

Optimal Debt and Profitability in the Trade‐Off Theory

Published: 10/10/2017   |   DOI: 10.1111/jofi.12590

ANDREW B. ABEL

I develop a dynamic model of leverage with tax deductible interest and an endogenous cost of default. The interest rate includes a premium to compensate lenders for expected losses in default. A borrowing constraint is generated by lenders' unwillingness to lend an amount that would trigger immediate default. When the borrowing constraint is not binding, the trade‐off theory of debt holds: optimal debt equates the marginal interest tax shield and the marginal expected cost of default. Contrary to conventional interpretation, but consistent with empirical findings, increases in current or future profitability reduce the optimal leverage ratio when the trade‐off theory holds.

Incentives and Endogenous Risk Taking: A Structural View on Hedge Fund Alphas

Published: 04/08/2014   |   DOI: 10.1111/jofi.12167

ANDREA BURASCHI, ROBERT KOSOWSKI, WORRAWAT SRITRAKUL

Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and prime broker contracts allowing for forced deleverage (put). The interaction of these option‐like incentives affects optimal leverage ex ante, depending on the distance of fund‐value from the high‐water mark. We study how these endogenous effects influence performance measures used in the literature. We show that reduced‐form measures that do not account for these features are subject to economically significant false discovery biases. The result is stronger for low‐quality funds. We propose an alternative structural methodology for conducting performance attribution in hedge funds.

Asset Market Participation and Portfolio Choice over the Life‐Cycle

Published: 01/20/2017   |   DOI: 10.1111/jofi.12484

ANDREAS FAGERENG, CHARLES GOTTLIEB, LUIGI GUISO

Using error‐free data on life‐cycle portfolio allocations of a large sample of Norwegian households, we document a double adjustment as households age: a rebalancing of the portfolio composition away from stocks as they approach retirement and stock market exit after retirement. When structurally estimating an extended life‐cycle model, the parameter combination that best fits the data is one with a relatively large risk aversion, a small per‐period participation cost, and a yearly probability of a large stock market loss in line with the frequency of stock market crashes in Norway.

Model‐Free International Stochastic Discount Factors

Published: 07/31/2020   |   DOI: 10.1111/jofi.12970

MIRELA SANDULESCU, FABIO TROJANI, ANDREA VEDOLIN

We provide a theoretical framework to uncover in a model‐free way the relationships among international stochastic discount factors (SDFs), stochastic wedges, and financial market structures. Exchange rates are in general different from the ratio of international SDFs in incomplete markets, as captured by a stochastic wedge. We show theoretically that this wedge can be zero in incomplete and integrated markets. Market segmentation breaks the strong link between exchange rates and international SDFs, which helps address salient features of international asset returns while keeping the volatility and cross‐country correlation of SDFs at moderate levels.

Incomplete‐Market Equilibria Solved Recursively on an Event Tree

Published: 09/12/2012   |   DOI: 10.1111/j.1540-6261.2012.01775.x

BERNARD DUMAS, ANDREW LYASOFF

Because of non‐traded human capital, real‐world financial markets are massively incomplete, while the modeling of imperfect, dynamic financial markets remains a wide‐open and difficult field. Some 30 years after Cox, Ross, and Rubinstein (1979) taught us how to calculate the prices of derivative securities on an event tree by simple backward induction, we show how a similar formulation can be used in computing heterogeneous‐agents incomplete‐market equilibrium prices of primitive securities. Extant methods work forward and backward, requiring a guess of the way investors forecast the future. In our method, the future is part of the current solution of each backward time step.

Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies

Published: 05/13/2013   |   DOI: 10.1111/jofi.12057

ANDREW ELLUL, VIJAY YERRAMILLI

We construct a risk management index (RMI) to measure the strength and independence of the risk management function at bank holding companies (BHCs). The U.S. BHCs with higher RMI before the onset of the financial crisis have lower tail risk, lower nonperforming loans, and better operating and stock return performance during the financial crisis years. Over the period 1995 to 2010, BHCs with a higher lagged RMI have lower tail risk and higher return on assets, all else equal. Overall, these results suggest that a strong and independent risk management function can curtail tail risk exposures at banks.

Subsidizing Liquidity: The Impact of Make/Take Fees on Market Quality

Published: 12/02/2014   |   DOI: 10.1111/jofi.12230

KATYA MALINOVA, ANDREAS PARK

Facing increased competition over the last decade, many stock exchanges changed their trading fees to maker‐taker pricing, an incentive scheme that rewards liquidity suppliers and charges liquidity demanders. Using a change in trading fees on the Toronto Stock Exchange, we study whether and why the breakdown of trading fees between liquidity demanders and suppliers matters. Posted quotes adjust after the change in fee composition, but the transaction costs for liquidity demanders remain unaffected once fees are taken into account. However, as posted bid‐ask spreads decline, traders (particularly retail) use aggressive orders more frequently, and adverse selection costs decrease.

The Effects of Market Segmentation and Investor Recognition on Asset Prices: Evidence from Foreign Stocks Listing in the United States

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00134

Stephen R. Foerster, G. Andrew Karolyi

Non‐U.S. firms cross‐listing shares on U.S. exchanges as American Depositary Receipts earn cumulative abnormal returns of 19 percent during the year before listing, and an additional 1.20 percent during the listing week, but incur a loss of 14 percent during the year following listing. We show how these unusual share price changes are robust to changing market risk exposures and are related to an expansion of the shareholder base and to the amount of capital raised at the time of listing. Our tests provide support for the market segmentation hypothesis and Merton's (1987) investor recognition hypothesis.

Why Do Managers Diversify Their Firms? Agency Reconsidered

Published: 02/12/2003   |   DOI: 10.1111/1540-6261.00519

Rajesh K. Aggarwal, Andrew A. Samwick

We develop a contracting model between shareholders and managers in which managers diversify their firms for two reasons: to reduce idiosyncratic risk and to capture private benefits. We test the comparative static predictions of our model. In contrast to previous work, we find that diversification is positively related to managerial incentives. Further, the link between firm performance and managerial incentives is weaker for firms that experience changes in diversification than it is for firms that do not. Our findings suggest that managers diversify their firms in response to changes in private benefits rather than to reduce their exposure to risk.

Optimal Hedging in Futures Markets with Multiple Delivery Specifications

Published: 09/01/1987   |   DOI: 10.1111/j.1540-6261.1987.tb03924.x

AVRAHAM KAMARA, ANDREW F. SIEGEL

Nearly all futures contracts allow delivery of any of several qualities of the underlying asset. Consequently, the price of the futures contract is associated more with the price of the expected cheapest deliverable variety than with the price of the par‐delivery variety. The delivery specifications introduce a delivery risk for every hedger in the market. We derive the optimal hedging strategies in these markets. Their hedging effectiveness is evaluated for wheat futures contracts in Chicago. Hedging optimally would have significantly reduced the variance of the rates of return on hedges while yielding similar mean returns.

Yes, Discounts on Closed‐End Funds Are a Sentiment Index

Published: 06/01/1993   |   DOI: 10.1111/j.1540-6261.1993.tb04742.x

NAVIN CHOPRA, CHARLES M. C. LEE, ANDREI SHLEIFER, RICHARD H. THALER

DIRECT INVESTMENT AND CORPORATE ADJUSTMENT TECHNIQUES UNDER THE VOLUNTARY U.S. BALANCE OF PAYMENTS PROGRAM

Published: 05/01/1966   |   DOI: 10.1111/j.1540-6261.1966.tb00226.x

Andrew F. Brimmer

Reinvestment Risk and the Equity Term Structure

Published: 04/27/2021   |   DOI: 10.1111/jofi.13035

ANDREI S. GONÇALVES

The equity term structure is downward sloping at long maturities. I estimate an Intertemporal Capital Asset Pricing Model (ICAPM) to show that the trade‐off between market and reinvestment risk explains this pattern. Intuitively, while long‐term dividend claims are highly exposed to market risk, they are good hedges for reinvestment risk because dividend prices rise as expected returns decline, and longer‐term claims are more sensitive to discount rates. In the estimated ICAPM, reinvestment risk dominates at long maturities, inducing relatively low risk premia on long‐term dividend claims. The model is also consistent with the equity term structure cyclicality and the upward‐sloping bond term structure.

When It Pays to Pay Your Investment Banker: New Evidence on the Role of Financial Advisors in M&As

Published: 01/17/2012   |   DOI: 10.1111/j.1540-6261.2011.01712.x

ANDREY GOLUBOV, DIMITRIS PETMEZAS, NICKOLAOS G. TRAVLOS

We provide new evidence on the role of financial advisors in M&As. Contrary to prior studies, top‐tier advisors deliver higher bidder returns than their non‐top‐tier counterparts but in public acquisitions only, where the advisor reputational exposure and required skills set are relatively larger. This translates into a $65.83 million shareholder gain for an average bidder. The improvement comes from top‐tier advisors' ability to identify more synergistic combinations and to get a larger share of synergies to accrue to bidders. Consistent with the premium price–premium quality equilibrium, top‐tier advisors charge premium fees in these transactions.

Change You Can Believe In? Hedge Fund Data Revisions: Erratum

Published: 07/23/2015   |   DOI: 10.1111/jofi.12306

ANDREW J. PATTON, TARUN RAMADORAI, MICHAEL STREATFIELD

The “Market Model” In Investment Management

Published: 05/01/1980   |   DOI: 10.1111/j.1540-6261.1980.tb02192.x

ANDREW RUDD, BARR ROSENBERG

Implementing Option Pricing Models When Asset Returns Are Predictable

Published: 03/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb05168.x

ANDREW W. LO, JIANG WANG

The predictability of an asset's returns will affect the prices of options on that asset, even though predictability is typically induced by the drift, which does not enter the option pricing formula. For discretely‐sampled data, predictability is linked to the parameters that do enter the option pricing formula. We construct an adjustment for predictability to the Black‐Scholes formula and show that this adjustment can be important even for small levels of predictability, especially for longer maturity options. We propose several continuous‐time linear diffusion processes that can capture broader forms of predictability, and provide numerical examples that illustrate their importance for pricing options.

Portfolio Analysis with Factors and Scenarios

Published: 09/01/1981   |   DOI: 10.1111/j.1540-6261.1981.tb04889.x

HARRY M. MARKOWITZ, ANDRÉF. PEROLD

Recently there has been a growing interest in the scenario model of covariance as an alternative to the one‐factor or many‐factor models. We show how the covariance matrix resulting from the scenario model can easily be made diagonal by adding new variables linearly related to the amounts invested; note the meanings of these new variables; note how portfolio variance divides itself into “within scenario” and “between scenario” variances; and extend the results to models in which scenarios and factors both appear where factor distributions and effects may or may not be scenario sensitive.

Personal Bankruptcy and Credit Market Competition

Published: 03/19/2010   |   DOI: 10.1111/j.1540-6261.2009.01547.x

ASTRID A. DICK, ANDREAS LEHNERT

We document a link between U.S. credit supply and rising personal bankruptcy rates. We exploit the exogenous variation in market contestability brought on by banking deregulation—the relaxation of entry restrictions in the 1980s and 1990s—at the state level. We find deregulation explains at least 10% of the rise in bankruptcy rates. We also find that deregulation leads to increased lending, lower loss rates on loans, and higher lending productivity. Our findings indicate that increased competition prompted banks to adopt sophisticated credit rating technology, allowing for new credit extension to existing and previously excluded households.