The Journal of Finance

Risky Debt, Investment Incentives, and Reputation in a Sequential Equilibrium

Published: 07/01/1985   |   DOI: 10.1111/j.1540-6261.1985.tb05012.x

KOSE JOHN, DAVID C. NACHMAN

The agency relationship of corporate insiders and bondholders is modeled as a dynamic game with asymmetric information. The incentive effect of risky debt on the investment policy of a levered firm is studied in this context. In a sequential equilibrium of the model, a concept of reputation arises endogenously resulting in a partial resolution of the classic agency problem of underinvestment. The incentive of the firm to underinvest is curtailed by anticipation of favorable rating of its bonds by the market. This anticipated pricing of debt is consistent with rational expectations pricing by a competitive bond market and is realized in equilibrium. Some empirical implications of the model for bond rating, debt covenants, and bond price response to investment announcements are explored.

Industry Concentration and Average Stock Returns

Published: 08/03/2006   |   DOI: 10.1111/j.1540-6261.2006.00893.x

KEWEI HOU, DAVID T. ROBINSON

Firms in more concentrated industries earn lower returns, even after controlling for size, book‐to‐market, momentum, and other return determinants. Explanations based on chance, measurement error, capital structure, and persistent in‐sample cash flow shocks do not explain this finding. Drawing on work in industrial organization, we posit that either barriers to entry in highly concentrated industries insulate firms from undiversifiable distress risk, or firms in highly concentrated industries are less risky because they engage in less innovation, and thereby command lower expected returns. Additional time‐series tests support these risk‐based interpretations.

Does Academic Research Destroy Stock Return Predictability?

Published: 10/13/2015   |   DOI: 10.1111/jofi.12365

R. DAVID MCLEAN, JEFFREY PONTIFF

We study the out‐of‐sample and post‐publication return predictability of 97 variables shown to predict cross‐sectional stock returns. Portfolio returns are 26% lower out‐of‐sample and 58% lower post‐publication. The out‐of‐sample decline is an upper bound estimate of data mining effects. We estimate a 32% (58%–26%) lower return from publication‐informed trading. Post‐publication declines are greater for predictors with higher in‐sample returns, and returns are higher for portfolios concentrated in stocks with high idiosyncratic risk and low liquidity. Predictor portfolios exhibit post‐publication increases in correlations with other published‐predictor portfolios. Our findings suggest that investors learn about mispricing from academic publications.

Equilibrium Interest Rates and Multiperiod Bonds in a Partially Observable Economy

Published: 06/01/1986   |   DOI: 10.1111/j.1540-6261.1986.tb05042.x

MICHAEL U. DOTHAN, DAVID FELDMAN

This paper analyzes the market for financial assets in a production and exchange economy with several realized outputs and a single unobservable source of nondiversifiable risk. The paper demonstrates that, for a large class of diffusion outputs and preferences, optimizing consumers first estimate the realizations of the unobservable factor and then use these estimates to determine portfolio and consumption rules. Moreover, the explicit consideration of this unobservable productivity factor affects equilibrium demands and prices. The equilibrium spot rate of interest emerges as the “best estimate” of the unobservable factor, and multiperiod default‐free bonds arise as the optimal hedge for the unobservable changes of the stochastic investment opportunity set.

First‐Order Risk Aversion, Heterogeneity, and Asset Market Outcomes

Published: 07/16/2009   |   DOI: 10.1111/j.1540-6261.2009.01482.x

DAVID A. CHAPMAN, VALERY POLKOVNICHENKO

We examine a wide range of two‐date economies populated by heterogeneous agents with the most common forms of nonexpected utility preferences used in finance and macroeconomics. We demonstrate that the risk premium and the risk‐free rate in these models are sensitive to ignoring heterogeneity. This follows because of endogenous withdrawal by nonexpected utility agents from the market for the risky asset. This finding is important precisely because these alternative preferences have frequently been proposed as possible resolutions to various asset pricing puzzles, and they have all been examined exclusively in a representative agent framework.

The Pre‐FOMC Announcement Drift

Published: 08/06/2014   |   DOI: 10.1111/jofi.12196

DAVID O. LUCCA, EMANUEL MOENCH

We document large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the Federal Open Market Committee (FOMC) in the past few decades. These pre‐FOMC returns have increased over time and account for sizable fractions of total annual realized stock returns. While other major international equity indices experienced similar pre‐FOMC returns, we find no such effect in U.S. Treasury securities and money market futures. Other major U.S. macroeconomic news announcements also do not give rise to preannouncement excess equity returns. We discuss challenges in explaining these returns with standard asset pricing theory.

Boarding a Sinking Ship? An Investigation of Job Applications to Distressed Firms

Published: 10/13/2015   |   DOI: 10.1111/jofi.12367

JENNIFER BROWN, DAVID A. MATSA

We use novel data from a leading online job search platform to examine the impact of corporate distress on firms’ ability to attract job applicants. Survey responses suggest that job seekers accurately perceive firms’ financial condition, as measured by companies’ credit default swap prices and accounting data. Analyzing responses to job postings by major financial firms during the Great Recession, we find that an increase in an employer's distress results in fewer and lower quality applicants. These effects are particularly evident when the social safety net provides workers with weak protection against unemployment and for positions requiring a college education.

Speculative Betas

Published: 05/27/2016   |   DOI: 10.1111/jofi.12431

HARRISON HONG, DAVID A. SRAER

The risk and return trade‐off, the cornerstone of modern asset pricing theory, is often of the wrong sign. Our explanation is that high‐beta assets are prone to speculative overpricing. When investors disagree about the stock market's prospects, high‐beta assets are more sensitive to this aggregate disagreement, experience greater divergence of opinion about their payoffs, and are overpriced due to short‐sales constraints. When aggregate disagreement is low, the Security Market Line is upward‐sloping due to risk‐sharing. When it is high, expected returns can actually decrease with beta. We confirm our theory using a measure of disagreement about stock market earnings.

Investor Psychology and Security Market Under‐ and Overreactions

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00077

Kent Daniel, David Hirshleifer, Avanidhar Subrahmanyam

We propose a theory of securities market under‐ and overreactions based on two well‐known psychological biases: investor overconfidence about the precision of private information; and biased self‐attribution, which causes asymmetric shifts in investors' confidence as a function of their investment outcomes. We show that overconfidence implies negative long‐lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public‐event‐based return predictability. Biased self‐attribution adds positive short‐lag autocorrelations (“momentum”), short‐run earnings “drift,” but negative correlation between future returns and long‐term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy.

Can Costs of Consumption Adjustment Explain Asset Pricing Puzzles?

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00119

David A. Marshall, Nayan G. Parekh

We investigate Grossman and Laroque's (1990) conjecture that costs of adjusting consumption can account, in part, for the empirical failure of the consumption‐based capital asset pricing model (CCAPM). We incorporate small fixed costs of consumption adjustment into a CCAPM with heterogeneous agents. We find that undetectably small consumption adjustment costs can account for much of the discrepancy between the observed variance of nondurable aggregate consumption growth and the predictions of the CCAPM, and can partially reconcile nondurable consumption data with the observed equity premium. We conclude that the CCAPM's implications are nonrobust to extremely small adjustment costs.

Is the Short Rate Drift Actually Nonlinear?

Published: 03/31/2007   |   DOI: 10.1111/0022-1082.00208

David A. Chapman, Neil D. Pearson

Aït‐Sahalia (1996) and Stanton (1997) use nonparametric estimators applied to short‐term interest rate data to conclude that the drift function contains important nonlinearities. We study the finite‐sample properties of their estimators by applying them to simulated sample paths of a square‐root diffusion. Although the drift function is linear, both estimators suggest nonlinearities of the type and magnitude reported in Aït‐Sahalia (1996) and Stanton (1997). Combined with the results of a weighted least squares estimator, this evidence implies that nonlinearity of the short rate drift is not a robust stylized fact.

Is Information Risk a Determinant of Asset Returns?

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00493

David Easley, Soeren Hvidkjaer, Maureen O'Hara

We investigate the role of information‐based trading in affecting asset returns. We show in a rational expectation example how private information affects equilibrium asset returns. Using a market microstructure model, we derive a measure of the probability of information‐based trading, and we estimate this measure using data for individual NYSE‐listed stocks for 1983 to 1998. We then incorporate our estimates into a Fama and French (1992) asset‐pricing framework. Our main result is that information does affect asset prices. A difference of 10 percentage points in the probability of information‐based trading between two stocks leads to a difference in their expected returns of 2.5 percent per year.

AN ALTERNATE ESTIMATION OF THE “NEUTRALIZED MONEY STOCK”

Published: 03/01/1972   |   DOI: 10.1111/j.1540-6261.1972.tb00619.x

David A. Bowers, Lorraine E. Duro

Trading and Liquidity on the Tokyo Stock Exchange: A Bird's Eye View

Published: 07/01/1994   |   DOI: 10.1111/j.1540-6261.1994.tb00084.x

BRUCE N. LEHMANN, DAVID M. MODEST

The trading mechanism for equities on the Tokyo Stock Exchange (TSE) stands in sharp contrast to the primary mechanisms used to trade stocks in the United States. In the United States, exchange‐designated specialists have affirmative obligations to provide continuous liquidity to the market. Specialists offer simultaneous and tight quotes to both buy and sell and supply sufficient liquidity to limit the magnitude of price changes between consecutive transactions. In contradistinction, the TSE has no exchange‐designated liquidity suppliers. Instead, liquidity is provided through a public limit order book, and liquidity is organized through restrictions on maximum price changes between trades that serve to slow down trading. In this article, we examine the efficacy of the TSE's trading mechanisms at providing liquidity. Our analysis is based on a complete record of transactions and best‐bid and best‐offer quotes for most stocks in the First Section of the TSE over a period of 26 months. We study the size of the bid‐ask spread and its cross‐sectional and intertemporal stability; intertemporal patterns in returns, volatility, volume, trade size, and the frequency of trades; and market depth based on the response of quotes to trades and the frequency of trading halts and warning quotes.

Market Structure, Internal Capital Markets, and the Boundaries of the Firm

Published: 11/11/2008   |   DOI: 10.1111/j.1540-6261.2008.01395.x

RICHMOND D. MATHEWS, DAVID T. ROBINSON

We study how the creation of an internal capital market (ICM) can invite strategic responses in product markets that, in turn, shape firm boundaries. ICMs provide ex post resource flexibility, but come with ex ante commitment costs. Alternatively, stand‐alones possess commitment ability but lack flexibility. By creating flexibility, integration can sometimes deter a rival's entry, but commitment problems can also invite predatory capital raising. These forces drive different organizational equilibria depending on the integrator's relation to the product market. Hybrid organizational forms like strategic alliances can sometimes dominate integration by offering some of its benefits with fewer strategic costs.

A Theory of Corporate Scope and Financial Structure

Published: 06/01/1996   |   DOI: 10.1111/j.1540-6261.1996.tb02699.x

DAVID D. LI, SHAN LI

We simultaneously address three basic issues regarding the corporation: the optimal scope of operation, the optimal financial structure, and the relationship between these two. The starting point is that financial structure serves as a bonding device on the managers' self‐interest behavior. The effectiveness of this bonding depends on the distribution of the firm's future cash flow, which in turn depends on the firm's scope. Our theory also links the firm's investment decisions to its operation scope. As empirical implications, the theory reconciles the failure of the 1960s U.S. conglomerates with the success of the Japanese Keiretsu.

The Conditional Performance of Insider Trades

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.205263

B. Espen Eckbo, David C. Smith

This paper estimates the performance of insider trades on the closely held Oslo Stock Exchange (OSE) during a period of lax enforcement of insider trading regulations. Our data permit construction of a portfolio that tracks all movements of insiders in and out of the OSE firms. Using three alternative performance estimators in a time‐varying expected return setting, we document zero or negative abnormal performance by insiders. The results are robust to a variety of trade characteristics. Applying the performance measures to mutual funds on the OSE, we also document some evidence that the average mutual fund outperforms the insider portfolio.

Learning about Internal Capital Markets from Corporate Spin‐offs

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00503

Robert Gertner, Eric Powers, David Scharfstein

We examine the investment behavior of firms before and after being spun off from their parent companies. Their investment after the spin‐off is significantly more sensitive to measures of investment opportunities (e.g., industry Tobin's Q or industry investment) than it is before the spin‐off. Spin‐offs tend to cut investment in low Q industries and increase investment in high Q industries. These changes are observed primarily in spin‐offs of firms in industries unrelated to the parents' industries and in spin‐offs where the stock market reacts favorably to the spin‐off announcement. Our findings suggest that spin‐offs may improve the allocation of capital.

DISCUSSION

Published: 05/01/1977   |   DOI: 10.1111/j.1540-6261.1977.tb03283.x

David K. Whitcomb, Enrique R. Arzac

Return, Risk, and Yield: Evidence from Ex Ante Data

Published: 06/01/1985   |   DOI: 10.1111/j.1540-6261.1985.tb04971.x

JAMES S. ANG, DAVID R. PETERSON

The purpose of this study is to investigate the relationship between return and yield in the context of ex ante data from The Value Line Investment Survey and by examining the role of dividends as a proxy for risk. The use of ex ante data should substantially reduce the confounding of tax and information effects that has affected earlier studies. Heteroscedasticity is detected in the after‐tax CAPM and found to be negatively related to yield and positively related to beta. Maximum likelihood methods are used to correct for heteroscedasticity and generate efficient coefficient estimates. Using data for each of the years 1973 through 1983, there is an overall positive relationship between expected return and yield. However, coefficient estimates of yield are highly variable from year to year.