The Journal of Finance

The American Put Option and Its Critical Stock Price

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00289

David S. Bunch, Herb Johnson

We derive an expression for the critical stock price for the American put. We start by expressing the put price as an integral involving first‐passage probabilities. This approach yields intuition for Merton's result for the perpetual put. We then consider the finite‐lived case. Using (1) the fact that the put value ceases to depend on time when the critical stock price is reached and (2) the result that an American put equals a European put plus an early‐exercise premium, we derive the critical stock price. We approximate the critical‐stock‐price function to compute accurate put prices.

Time and the Process of Security Price Adjustment

Published: 06/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04402.x

DAVID EASLEY, MAUREEN O'HARA

This paper delineates the link between the existence of information, the timing of trades, and the stochastic process of prices. We show that time affects prices, with the time between trades affecting spreads. Because the absence of trades is correlated with volume, our model predicts a testable relation between spreads and normal and unexpected volume, and demonstrates how volume affects the speed of price adjustment. Our model also demonstrates how the transaction price series will be a biased representation of the true price process, with the variance being both overstated and heteroskedastic.

The Banking View of Bond Risk Premia

Published: 05/20/2020   |   DOI: 10.1111/jofi.12949

VALENTIN HADDAD, DAVID SRAER

Banks' balance sheet exposure to fluctuations in interest rates strongly forecasts excess Treasury bond returns. This result is consistent with optimal risk management, a banking counterpart to the household Euler equation. In equilibrium, the bond risk premium compensates banks for bearing fluctuations in interest rates. When banks' exposure to interest rate risk increases, the price of this risk simultaneously rises. We present a collection of empirical observations that support this view, but also discuss several challenges to this interpretation.

Taking Stock: Equity‐Based Compensation and the Evolution of Managerial Ownership

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00250

Eli Ofek, David Yermack

We investigate the impact of stock‐based compensation on managerial ownership. We find that equity compensation succeeds in increasing incentives of lower‐ownership managers, but higher‐ownership managers negate much of its impact by selling previously owned shares. When executives exercise options to acquire stock, nearly all of the shares are sold. Our results illuminate dynamic aspects of managerial ownership arising from divergent goals of boards of directors, who use equity compensation for incentives, and managers, who respond by selling shares for diversification. The findings cast doubt on the frequent and important theoretical assumption that managers cannot hedge the risks of these awards.

Bookbuilding and Strategic Allocation

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00407

Francesca Cornelli, David Goldreich

In the bookbuilding procedure, an investment banker solicits bids for shares from institutional investors prior to pricing an equity issue. The banker then prices the issue and allocates shares at his discretion to the investors. We examine the books for 39 international equity issues. We find that the investment banker awards more shares to bidders who provide information in their bids. Regular investors receive favorable allocations, especially when the issue is heavily oversubscribed. The investment banker also favors revised bids and domestic investors.

RESTRICTIONS ON THE RATE OF INTEREST ON DEMAND DEPOSITS AND A THEORY OF COMPENSATING BALANCES

Published: 05/01/1976   |   DOI: 10.1111/j.1540-6261.1976.tb01883.x

David Wiley Mullins

Which Money Is Smart? Mutual Fund Buys and Sells of Individual and Institutional Investors

Published: 01/10/2008   |   DOI: 10.1111/j.1540-6261.2008.01311.x

ANEEL KESWANI, DAVID STOLIN

Gruber (1996) and Zheng (1999) report that investors channel money toward mutual funds that subsequently perform well. Sapp and Tiwari (2004) find that this “smart money” effect no longer holds after controlling for stock return momentum. While prior work uses quarterly U.S. data, we employ a British data set of monthly fund inflows and outflows differentiated between individual and institutional investors. We document a robust smart money effect in the United Kingdom. The effect is caused by buying (but not selling) decisions of both individuals and institutions. Using monthly data available post‐1991 we show that money is comparably smart in the United States.

Microstructure and Ambiguity

Published: 09/21/2010   |   DOI: 10.1111/j.1540-6261.2010.01595.x

DAVID EASLEY, MAUREEN O'HARA

A goal for stock exchanges is to increase participation by firms and investors. We show how specific features of the microstructure can reduce perceived ambiguity, and induce participation by both investors and issuers. We develop a model with sophisticated traders, who we view as expected utility maximizers with rational expectations, and unsophisticated traders, who we view as rational traders facing ambiguity about the payoffs to participating in the market. We show how designing markets to reduce ambiguity can benefit investors through greater liquidity, exchanges through greater volume, and issuing firms through a lower cost of capital.

Good Day Sunshine: Stock Returns and the Weather

Published: 05/06/2003   |   DOI: 10.1111/1540-6261.00556

David Hirshleifer, Tyler Shumway

Psychological evidence and casual intuition predict that sunny weather is associated with upbeat mood. This paper examines the relationship between morning sunshine in the city of a country's leading stock exchange and daily market index returns across 26 countries from 1982 to 1997. Sunshine is strongly significantly correlated with stock returns. After controlling for sunshine, rain and snow are unrelated to returns. Substantial use of weather‐based strategies was optimal for a trader with very low transactions costs. However, because these strategies involve frequent trades, fairly modest costs eliminate the gains. These findings are difficult to reconcile with fully rational price setting.

Optimal Bank Behavior under Uncertain Inflation

Published: 09/01/1985   |   DOI: 10.1111/j.1540-6261.1985.tb02369.x

YORAM LANDSKRONER, DAVID RUTHENBERG

In this paper, we derive a model of the individual banking firm facing stochastic inflation. The bank is considered as a depository financial intermediary operating in the primary market as a multiproduct price discriminating firm. A secondary market is also considered where liquidity surpluses and deficits are traded. Two types of assets and liabilities are assumed: deposits and loans linked to a general price level and nonlinked instruments. Effects of changes in the parameters such as inflation rate and variability, reserve requirements are analyzed.

Information and the Cost of Capital

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00672.x

David Easley, Maureen O'hara

We investigate the role of information in affecting a firm's cost of capital. We show that differences in the composition of information between public and private information affect the cost of capital, with investors demanding a higher return to hold stocks with greater private information. This higher return arises because informed investors are better able to shift their portfolio to incorporate new information, and uninformed investors are thus disadvantaged. In equilibrium, the quantity and quality of information affect asset prices. We show firms can influence their cost of capital by choosing features like accounting treatments, analyst coverage, and market microstructure.

On the Costs of a Bank‐Centered Financial System: Evidence from the Changing Main Bank Relations in Japan

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.254893

David E. Weinstein, Yishay Yafeh

We examine the effects of bank–firm relationships on firm performance in Japan. When access to capital markets is limited, close bank–firm ties increase the availability of capital to borrowing firms, but do not lead to higher profitability or growth. The cost of capital of firms with close bank ties is higher than that of their peers. This indicates that most of the benefits from these relationships are appropriated by the banks. Finally, the slow growth rates of bank clients suggest that banks discourage firms from investing in risky, profitable projects. However, liberalization of financial markets reduces the banks' market power.

CONSUMER CREDIT AND CONSUMER DEMAND FOR AUTOMOBILES

Published: 03/01/1976   |   DOI: 10.1111/j.1540-6261.1976.tb03201.x

David B. Eastwood, Robert Anderson

Consensus Beliefs Equilibrium and Market Efficiency

Published: 06/01/1983   |   DOI: 10.1111/j.1540-6261.1983.tb02509.x

DAVID EASLEY, ROBERT A. JARROW

This paper presents an analysis of the concept of consensus beliefs and its relation to market efficiency. We show that unless traders have rational expectations, the two published interpretations of consensus beliefs are not useful for considerations of market efficiency. One interpretation (see Verrecchia [6]) has no implication for market efficiency. Under the second interpretation (see Verrecchia [7], [8]) consensus beliefs equilibria are efficient, but they typically do not exist unless traders have rational expectations.

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.

MARKET EFFICIENCY AND THE COST OF CAPITAL: THE STRANGE CASE OF FIRE AND CASUALTY INSURANCE COMPANIES

Published: 05/01/1975   |   DOI: 10.1111/j.1540-6261.1975.tb01820.x

G. David Quirin, William R. Waters

Convertible Debt: Corporate Call Policy and Voluntary Conversion

Published: 09/01/1991   |   DOI: 10.1111/j.1540-6261.1991.tb04618.x

PAUL ASQUITH, DAVID W. MULLINS

This paper examines why, in contrast to the predictions of finance theory, firms do not call convertible debt when the conversion price exceeds the call price. The empirical results suggest that the principal reason is because some firms enjoy an advantage of paying less in after‐tax interest than they would pay in dividends were the bond converted. This cash flow incentive is the inverse of an investor's incentive to convert voluntarily if the converted dividends are greater than the bond's coupon. Because of taxation, however, the decisions by investors and firms are not symmetric, and there exist bonds which the firm may not call and an investor will not convert. The results also find that voluntary conversion is significantly related to both the conversion price and the differential between the coupon and the dividends on the converted stock.

Corporate Dividends and Seasoned Equity Issues: An Empirical Investigation

Published: 03/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb03983.x

CLAUDIO F. LODERER, DAVID C. MAUER

This paper investigates whether managers rely on dividends to obtain a higher price in a stock offering and whether the stock price reaction to dividend and offering announcements justifies such a coordination. The evidence does not support either conjecture. Issuing firms are not more likely to pay or increase dividends than nonissuing forms. Moreover, there is little evidence that firms time stock offering announcements right after dividend declarations to benefit from the attendant information disclosure. The analysis of dividend and stock offering announcement effects suggests few if any benefits from linking dividend and stock offering announcements.