The Journal of Finance

Are Overconfident CEOs Better Innovators?

Published: 07/19/2012   |   DOI: 10.1111/j.1540-6261.2012.01753.x

DAVID HIRSHLEIFER, ANGIE LOW, SIEW HONG TEOH

Previous empirical work on adverse consequences of CEO overconfidence raises the question of why firms hire overconfident managers. Theoretical research suggests a reason: overconfidence can benefit shareholders by increasing investment in risky projects. Using options‐ and press‐based proxies for CEO overconfidence, we find that over the 1993–2003 period, firms with overconfident CEOs have greater return volatility, invest more in innovation, obtain more patents and patent citations, and achieve greater innovative success for given research and development expenditures. However, overconfident managers achieve greater innovation only in innovative industries. Our findings suggest that overconfidence helps CEOs exploit innovative growth opportunities.

Corporate Yield Spreads and Bond Liquidity

Published: 01/11/2007   |   DOI: 10.1111/j.1540-6261.2007.01203.x

LONG CHEN, DAVID A. LESMOND, JASON WEI

We find that liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4,000 corporate bonds and spanning both investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads, and an improvement in liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond‐specific, firm‐specific, and macroeconomic variables, and are robust to issuers' fixed effect and potential endogeneity bias. Our findings justify the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants.

Managerial Entrenchment and Capital Structure Decisions

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb01115.x

PHILIP G. BERGER, ELI OFEK, DAVID L. YERMACK

We study associations between managerial entrenchment and firms' capital structures, with results generally suggesting that entrenched CEOs seek to avoid debt. In a cross‐sectional analysis, we find that leverage levels are lower when CEOs do not face pressure from either ownership and compensation incentives or active monitoring. In an analysis of leverage changes, we find that leverage increases in the aftermath of entrenchment‐reducing shocks to managerial security, including unsuccessful tender offers, involuntary CEO replacements, and the addition to the board of major stockholders.

Why Does the Law Matter? Investor Protection and Its Effects on Investment, Finance, and Growth

Published: 01/17/2012   |   DOI: 10.1111/j.1540-6261.2011.01713.x

R. DAVID MCLEAN, TIANYU ZHANG, MENGXIN ZHAO

Investor protection is associated with greater investment sensitivity to q and lower investment sensitivity to cash flow. Finance plays a role in causing these effects; in countries with strong investor protection, external finance increases more strongly with q, and declines more strongly with cash flow. We further find that q and cash flow sensitivities are associated with ex post investment efficiency; investment predicts growth and profits more strongly in countries with greater q sensitivities and lower cash flow sensitivities. The paper's findings are broadly consistent with investor protection promoting accurate share prices, reducing financial constraints, and encouraging efficient investment.

Anomalies and News

Published: 08/09/2018   |   DOI: 10.1111/jofi.12718

JOSEPH ENGELBERG, R. DAVID MCLEAN, JEFFREY PONTIFF

Using a sample of 97 stock return anomalies, we find that anomaly returns are 50% higher on corporate news days and six times higher on earnings announcement days. These results could be explained by dynamic risk, mispricing due to biased expectations, or data mining. We develop and conduct several unique tests to differentiate between these three explanations. Our results are most consistent with the idea that anomaly returns are driven by biased expectations, which are at least partly corrected upon news arrival.

Overconfidence, Arbitrage, and Equilibrium Asset Pricing

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00350

Kent D. Daniel, David Hirshleifer, Avanidhar Subrahmanyam

This paper offers a model in which asset prices reflect both covariance risk and misperceptions of firms' prospects, and in which arbitrageurs trade against mispricing. In equilibrium, expected returns are linearly related to both risk and mispricing measures (e.g., fundamental/price ratios). With many securities, mispricing of idiosyncratic value components diminishes but systematic mispricing does not. The theory offers untested empirical implications about volume, volatility, fundamental/price ratios, and mean returns, and is consistent with several empirical findings. These include the ability of fundamental/price ratios and market value to forecast returns, and the domination of beta by these variables in some studies.

Do Hedge Funds Manipulate Stock Prices?

Published: 05/13/2013   |   DOI: 10.1111/jofi.12062

ITZHAK BEN‐DAVID, FRANCESCO FRANZONI, AUGUSTIN LANDIER, RABIH MOUSSAWI

We provide evidence suggesting that some hedge funds manipulate stock prices on critical reporting dates. Stocks in the top quartile of hedge fund holdings exhibit abnormal returns of 0.30% on the last day of the quarter and a reversal of 0.25% on the following day. A significant part of the return is earned during the last minutes of trading. Analysis of intraday volume and order imbalance provides further evidence consistent with manipulation. These patterns are stronger for funds that have higher incentives to improve their ranking relative to their peers.

Looking for Someone to Blame: Delegation, Cognitive Dissonance, and the Disposition Effect

Published: 08/06/2015   |   DOI: 10.1111/jofi.12311

TOM Y. CHANG, DAVID H. SOLOMON, MARK M. WESTERFIELD

We analyze brokerage data and an experiment to test a cognitive dissonance based theory of trading: investors avoid realizing losses because they dislike admitting that past purchases were mistakes, but delegation reverses this effect by allowing the investor to blame the manager instead. Using individual trading data, we show that the disposition effect—the propensity to realize past gains more than past losses—applies only to nondelegated assets like individual stocks; delegated assets, like mutual funds, exhibit a robust reverse‐disposition effect. In an experiment, we show that increasing investors' cognitive dissonance results in both a larger disposition effect in stocks and a larger reverse‐disposition effect in funds. Additionally, increasing the salience of delegation increases the reverse‐disposition effect in funds. Cognitive dissonance provides a unified explanation for apparently contradictory investor behavior across asset classes and has implications for personal investment decisions, mutual fund management, and intermediation.

Sticky Expectations and the Profitability Anomaly

Published: 10/07/2018   |   DOI: 10.1111/jofi.12734

JEAN‐PHILIPPE BOUCHAUD, PHILIPP KRÜGER, AUGUSTIN LANDIER, DAVID THESMAR

We propose a theory of the “profitability” anomaly. In our model, investors forecast future profits using a signal and sticky belief dynamics. In this model, past profits forecast future returns (the profitability anomaly). Using analyst forecast data, we measure expectation stickiness at the firm level and find strong support for three additional model predictions: (1) analysts are on average too pessimistic regarding the future profits of high‐profit firms, (2) the profitability anomaly is stronger for stocks that are followed by stickier analysts, and (3) the profitability anomaly is stronger for stocks with more persistent profits.

Resource Allocation in Bank Supervision: Trade‐Offs and Outcomes

Published: 03/29/2022   |   DOI: 10.1111/jofi.13127

THOMAS M. EISENBACH, DAVID O. LUCCA, ROBERT M. TOWNSEND

We estimate a structural model of resource allocation on work hours of Federal Reserve bank supervisors to disentangle how supervisory technology, preferences, and resource constraints impact bank outcomes. We find a significant effect of supervision on bank risk and large technological scale economies with respect to bank size. Consistent with macroprudential objectives, revealed supervisory preferences disproportionately weight larger banks, especially post‐2008 when a resource reallocation to larger banks increased risk on average across all banks. Shadow cost estimates show tight resources around the financial crisis and counterfactuals indicate that binding constraints have large effects on the distribution of bank outcomes.

Market Maker Quotation Behavior and Pretrade Transparency

Published: 05/06/2003   |   DOI: 10.1111/1540-6261.00565

Yusif Simaan, Daniel G. Weaver, David K. Whitcomb

We examine the impact of differing levels of pretrade transparency on the quotation behavior of Nasdaq market makers. We find that market makers are more likely to quote on odd ticks, and to actively narrow the spread, when they can do so anonymously by posting limit orders on Electronic Communication Networks (ECNs). From a public policy perspective, our findings suggest that making the level of pretrade transparency on Nasdaq more opaque by allowing anonymous quotes could improve price competition and narrow spreads further.

Family‐Controlled Firms and Informed Trading: Evidence from Short Sales

Published: 01/17/2012   |   DOI: 10.1111/j.1540-6261.2011.01714.x

RONALD C. ANDERSON, DAVID M. REEB, WANLI ZHAO

We investigate the relation between organization structure and the information content of short sales, focusing on founder‐ and heir‐controlled firms. Our analysis indicates that family‐controlled firms experience substantially higher abnormal short sales prior to negative earnings shocks than nonfamily firms. Supplementary testing indicates that family control characteristics intensify informed short selling. Further analysis suggests that daily short‐sale interest in family firms contains useful information in forecasting stock returns; however, we find no discernable effect for nonfamily firms. This analysis provides compelling evidence that informed trading via short sales occurs more readily in family firms than in nonfamily firms.

Can Taxes Shape an Industry? Evidence from the Implementation of the “Amazon Tax”

Published: 04/20/2018   |   DOI: 10.1111/jofi.12687

BRIAN BAUGH, ITZHAK BEN‐DAVID, HOONSUK PARK

For years, online retailers have maintained a price advantage over brick‐and‐mortar retailers by not collecting sales tax at the time of sale. Recently, several states have required that online retailer Amazon collect sales tax during checkout. Using transaction‐level data, we document that households living in these states reduced their Amazon purchases by 9.4% following the implementation of the sales tax laws, implying elasticities of –1.2 to –1.4. The effect is stronger for large purchases, where purchases declined by 29.1%, corresponding to an elasticity of –3.9. Studying competitors in the electronics field, we find some evidence of substitution toward competing retailers.

Do ETFs Increase Volatility?

Published: 09/22/2018   |   DOI: 10.1111/jofi.12727

ITZHAK BEN‐DAVID, FRANCESCO FRANZONI, RABIH MOUSSAWI

Due to their low trading costs, exchange‐traded funds (ETFs) are a potential catalyst for short‐horizon liquidity traders. The liquidity shocks can propagate to the underlying securities through the arbitrage channel, and ETFs may increase the nonfundamental volatility of the securities in their baskets. We exploit exogenous changes in index membership and find that stocks with higher ETF ownership display significantly higher volatility. ETF ownership increases the negative autocorrelation in stock prices. The increase in volatility appears to introduce undiversifiable risk in prices because stocks with high ETF ownership earn a significant risk premium of up to 56 basis points monthly.

Affine Term Structure Models and the Forward Premium Anomaly

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00325

David K. Backus, Silverio Foresi, Chris I. Telmer

One of the most puzzling features of currency prices is the forward premium anomaly: the tendency for high interest rate currencies to appreciate. We characterize the anomaly in the context of affine models of the term structure of interest rates. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that nominal interest rates take on negative values with positive probability. We find the quantitative properties of either alternative to have important shortcomings.

Driven to Distraction: Extraneous Events and Underreaction to Earnings News

Published: 09/28/2009   |   DOI: 10.1111/j.1540-6261.2009.01501.x

DAVID HIRSHLEIFER, SONYA SEONGYEON LIM, SIEW HONG TEOH

Recent studies propose that limited investor attention causes market underreactions. This paper directly tests this explanation by measuring the information load faced by investors. The investor distraction hypothesis holds that extraneous news inhibits market reactions to relevant news. We find that the immediate price and volume reaction to a firm's earnings surprise is much weaker, and post‐announcement drift much stronger, when a greater number of same‐day earnings announcements are made by other firms. We evaluate the economic importance of distraction effects through a trading strategy, which yields substantial alphas. Industry‐unrelated news and large earnings surprises have a stronger distracting effect.

Market Timing Strategies in Convertible Debt Financing

Published: 03/01/1979   |   DOI: 10.1111/j.1540-6261.1979.tb02076.x

GORDON J. ALEXANDER, ROGER D. STOVER, DAVID B. KUHNAU

VALUATION OF FINANCIAL LEASE CONTRACTS

Published: 06/01/1976   |   DOI: 10.1111/j.1540-6261.1976.tb01924.x

Stewart C. Myers, David A. Dill, Alberto J. Bautista

On the Relation between the Expected Value and the Volatility of the Nominal Excess Return on Stocks

Published: 12/01/1993   |   DOI: 10.1111/j.1540-6261.1993.tb05128.x

LAWRENCE R. GLOSTEN, RAVI JAGANNATHAN, DAVID E. RUNKLE

We find support for a negative relation between conditional expected monthly return and conditional variance of monthly return, using a GARCH‐M model modified by allowing (1) seasonal patterns in volatility, (2) positive and negative innovations to returns having different impacts on conditional volatility, and (3) nominal interest rates to predict conditional variance. Using the modified GARCH‐M model, we also show that monthly conditional volatility may not be as persistent as was thought. Positive unanticipated returns appear to result in a downward revision of the conditional volatility whereas negative unanticipated returns result in an upward revision of conditional volatility.

INFORMATIONAL ASYMMETRIES, FINANCIAL STRUCTURE, AND FINANCIAL INTERMEDIATION

Published: 05/01/1977   |   DOI: 10.1111/j.1540-6261.1977.tb03277.x

Richard Brealey, Hayne E. Leland, David H. Pyle