The Journal of Finance

Regulatory Arbitrage and International Bank Flows

Published: 09/12/2012   |   DOI: 10.1111/j.1540-6261.2012.01774.x

JOEL F. HOUSTON, CHEN LIN, YUE MA

We study whether cross‐country differences in regulations have affected international bank flows. We find strong evidence that banks have transferred funds to markets with fewer regulations. This form of regulatory arbitrage suggests there may be a destructive “race to the bottom” in global regulations, which restricts domestic regulators’ ability to limit bank risk‐taking. However, we also find that the links between regulation differences and bank flows are significantly stronger if the recipient country is a developed country with strong property rights and creditor rights. This suggests that, while differences in regulations have important influences, without a strong institutional environment, lax regulations are not enough to encourage massive capital flows.

Portfolio Manager Compensation in the U.S. Mutual Fund Industry

Published: 12/12/2018   |   DOI: 10.1111/jofi.12749

LINLIN MA, YUEHUA TANG, JUAN‐PEDRO GÓMEZ

We study compensation contracts of individual portfolio managers using hand‐collected data of over 4,500 U.S. mutual funds. Variations in the compensation structures are broadly consistent with an optimal contracting equilibrium. The likelihood of explicit performance‐based incentives is positively correlated with the intensity of agency conflicts, as proxied by the advisor's clientele dispersion, its affiliations in the financial industry, and its ownership structure. Investor sophistication and the threat of dismissal in outsourced funds serve as substitutes for explicit performance‐based incentives. Finally, we find little evidence of differences in future performance associated with any particular compensation arrangement.

Why Option Prices Lag Stock Prices: A Trading‐based Explanation

Published: 12/01/1993   |   DOI: 10.1111/j.1540-6261.1993.tb05136.x

KALOK CHAN, Y. PETER CHUNG, HERB JOHNSON

While many studies find that option prices lead stock prices, Stephan and Whaley (1990) find that stocks lead options. We find no evidence that options, even deep out‐of‐the‐money options, lead stocks. After confirming Stephan and Whaley's results, we show their results can be explained as spurious leads induced by infrequent trading of options. We show that the stock lead disappears when the average of the bid and ask prices is used instead of transaction prices. Hence, we find no evidence of arbitrage opportunities associated with the stock lead.

Simple Forecasts and Paradigm Shifts

Published: 05/08/2007   |   DOI: 10.1111/j.1540-6261.2007.01234.x

HARRISON HONG, JEREMY C. STEIN, JIALIN YU

We study the asset pricing implications of learning in an environment in which the true model of the world is a multivariate one, but agents update only over the class of simple univariate models. Thus, if a particular simple model does a poor job of forecasting over a period of time, it is discarded in favor of an alternative simple model. The theory yields a number of distinctive predictions for stock returns, generating forecastable variation in the magnitude of the value‐glamour return differential, in volatility, and in the skewness of returns. We validate several of these predictions empirically.

Sensation Seeking and Hedge Funds

Published: 09/17/2018   |   DOI: 10.1111/jofi.12723

STEPHEN BROWN, YAN LU, SUGATA RAY, MELVYN TEO

We show that, motivated by sensation seeking, hedge fund managers who own powerful sports cars take on more investment risk but do not deliver higher returns, resulting in lower Sharpe ratios, information ratios, and alphas. Moreover, sensation‐seeking managers trade more frequently, actively, and unconventionally, and prefer lottery‐like stocks. We show further that some investors are themselves susceptible to sensation seeking and that sensation‐seeking investors fuel the demand for sensation‐seeking managers. While investors perceive sensation seekers to be less competent, they do not fully appreciate the superior investment skills of sensation‐avoiding fund managers.

The Two‐Pillar Policy for the RMB

Published: 09/18/2022   |   DOI: 10.1111/jofi.13178

URBAN J. JERMANN, BIN WEI, VIVIAN Z. YUE

This paper studies China's recent exchange rate policy for the renminbi (RMB). We demonstrate empirically that a two‐pillar policy is in place, aiming to balance exchange rate flexibility and RMB index stability via market and basket pillars. We further extend and validate the formulation that incorporates the so‐called countercyclical factor. Theoretically, we develop a flexible‐price monetary model for the RMB in which the two‐pillar policy arises endogenously as an optimal response of the government. We estimate the model by generalized method of moments and quantitatively assess various policy trade‐offs.

The Legal Origins of Financial Development: Evidence from the Shanghai Concessions

Published: 10/03/2023   |   DOI: 10.1111/jofi.13284

ROSS LEVINE, CHEN LIN, CHICHENG MA, YUCHEN XU

The primary challenge to assessing the legal origins view of comparative financial development is identifying exogenous changes in legal systems. We assemble new data on Shanghai's British and French concessions between 1845 and 1936. Two regime changes altered British and French legal jurisdiction over their respective concessions. By examining the changing application of different legal traditions to adjacent neighborhoods within the same city and controlling for military, economic, and political characteristics, we offer new evidence consistent with the legal origins view: the financial development advantage in the British concession widened after Western legal jurisdiction intensified and narrowed after it abated.

The Cross‐Section of Volatility and Expected Returns

Published: 01/20/2006   |   DOI: 10.1111/j.1540-6261.2006.00836.x

ANDREW ANG, ROBERT J. HODRICK, YUHANG XING, XIAOYAN ZHANG

We examine the pricing of aggregate volatility risk in the cross‐section of stock returns. Consistent with theory, we find that stocks with high sensitivities to innovations in aggregate volatility have low average returns. Stocks with high idiosyncratic volatility relative to the Fama and French (1993, Journal of Financial Economics 25, 2349) model have abysmally low average returns. This phenomenon cannot be explained by exposure to aggregate volatility risk. Size, book‐to‐market, momentum, and liquidity effects cannot account for either the low average returns earned by stocks with high exposure to systematic volatility risk or for the low average returns of stocks with high idiosyncratic volatility.

The Effect of Risk on the Firm's Optimal Capital Stock: A Note

Published: 09/01/1983   |   DOI: 10.1111/j.1540-6261.1983.tb02296.x

KEVIN J. MALONEY, WILLIAM J. MARSHALL, JESS B. YAWITZ

Taxes, Default Risk, and Yield Spreads

Published: 09/01/1985   |   DOI: 10.1111/j.1540-6261.1985.tb02367.x

JESS B. YAWITZ, KEVIN J. MALONEY, LOUIS H. EDERINGTON

This paper develops a model of bond prices and yield spreads that incorporates the effect of both taxes and differences in default probabilities. The tax loss consequences of default are recognized. Traditionally, tax‐free (municipal) bond yields have been viewed as linearly related to taxable yields with a slope coefficient equal to one minus the tax rate and the intercept representing differences in default risk. While our model supports the linearity assumption, it implies that the slope and intercept are both functions of both the break‐even tax rate and the default probability(ies). Clientele effects among both municipal and taxable bonds are demonstrated. Finally, the implied marginal tax rates and the implied default probabilities are estimated for different categories of municipal bonds.

THE USE OF AVERAGE MATURITY AS A RISK PROXY IN INVESTMENT PORTFOLIOS

Published: 05/01/1975   |   DOI: 10.1111/j.1540-6261.1975.tb01814.x

Jess B. Yawitz, George H. Hempel, William J. Marshall

Attention Spillover in Asset Pricing

Published: 09/25/2023   |   DOI: 10.1111/jofi.13281

XIN CHEN, LI AN, ZHENGWEI WANG, JIANFENG YU

Exploiting a screen display feature whereby the order of stock display is determined by the stock's listing code, we lever a novel identification strategy and study how the interaction between overconfidence and limited attention affect asset pricing. We find that stocks displayed next to those with higher returns in the past two weeks are associated with higher returns in the future week, which are reverted in the long run. This is consistent with our conjectures that investors tend to trade more after positive investment experience and are more likely to pay attention to neighboring stocks, both confirmed using trading data.

Anomalies and the Expected Market Return

Published: 12/06/2021   |   DOI: 10.1111/jofi.13099

XI DONG, YAN LI, DAVID E. RAPACH, GUOFU ZHOU

We provide the first systematic evidence on the link between long‐short anomaly portfolio returns—a cornerstone of the cross‐sectional literature—and the time‐series predictability of the aggregate market excess return. Using 100 representative anomalies from the literature, we employ a variety of shrinkage techniques (including machine learning, forecast combination, and dimension reduction) to efficiently extract predictive signals in a high‐dimensional setting. We find that long‐short anomaly portfolio returns evince statistically and economically significant out‐of‐sample predictive ability for the market excess return. The predictive ability of anomaly portfolio returns appears to stem from asymmetric limits of arbitrage and overpricing correction persistence.

Global Currency Hedging

Published: 01/13/2010   |   DOI: 10.1111/j.1540-6261.2009.01524.x

JOHN Y. CAMPBELL, KARINE SERFATY‐DE MEDEIROS, LUIS M. VICEIRA

Over the period 1975 to 2005, the U.S. dollar (particularly in relation to the Canadian dollar), the euro, and the Swiss franc (particularly in the second half of the period) moved against world equity markets. Thus, these currencies should be attractive to risk‐minimizing global equity investors despite their low average returns. The risk‐minimizing currency strategy for a global bond investor is close to a full currency hedge, with a modest long position in the U.S. dollar. There is little evidence that risk‐minimizing investors should adjust their currency positions in response to movements in interest differentials.

Are Liquidity and Information Risks Priced in the Treasury Bond Market?

Published: 01/23/2009   |   DOI: 10.1111/j.1540-6261.2008.01439.x

HAITAO LI, JUNBO WANG, CHUNCHI WU, YAN HE

We provide a comprehensive empirical analysis of the effects of liquidity and information risks on expected returns of Treasury bonds. We focus on the systematic liquidity risk of Pastor and Stambaugh as opposed to the traditional microstructure‐based measures of liquidity. Information risk is measured by the probability of information‐based trading (PIN). We document a strong positive relation between expected Treasury returns and liquidity and information risks, controlling for the effects of other systematic risk factors and bond characteristics. This relation is robust to many empirical specifications and a wide variety of traditional liquidity and informed trading proxies.

On the Relative Pricing of Long‐Maturity Index Options and Collateralized Debt Obligations

Published: 11/19/2012   |   DOI: 10.1111/j.1540-6261.2012.01779.x

PIERRE COLLIN‐DUFRESNE, ROBERT S. GOLDSTEIN, FAN YANG

We investigate a structural model of market and firm‐level dynamics in order to jointly price long‐dated S&P 500 index options and CDO tranches of corporate debt. We identify market dynamics from index option prices and idiosyncratic dynamics from the term structure of credit spreads. We find that all tranches can be well priced out‐of‐sample before the crisis. During the crisis, however, our model can capture senior tranche prices only if we allow for the possibility of a catastrophic jump. Thus, senior tranches are nonredundant assets that provide a unique window into the pricing of catastrophic risk.

Global Diversification, Industrial Diversification, and Firm Value

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00485

David J. Denis, Diane K. Denis, Keven Yost

Using a sample of 44,288 firm‐ears between 1984 and 1997, we document an increase in the extent of global diversification over time. This trend does not reflect a substitution of global for industrial diversification. We also find that global diversification results in average valuation discounts of approximately the same magnitude as those for industrial diversification. Analysis of the changes in excess value associated with changes in diversification reveals that increases in global diversification reduce excess value, while reductions in global diversification increase excess value. These findings support the view that the costs of global diversification outweigh the benefits.

Advance Refundings of Municipal Bonds

Published: 03/18/2017   |   DOI: 10.1111/jofi.12506

ANDREW ANG, RICHARD C. GREEN, FRANCIS A. LONGSTAFF, YUHANG XING

The advance refunding of debt is a widespread practice in municipal finance. In an advance refunding, municipalities retire callable bonds early and refund them with bonds with lower coupon rates. We find that 85% of all advance refundings occur at a net present value loss, and that the aggregate losses over the past 20 years exceed $15 billion. We explore why municipalities advance refund their debt at loss. Financially constrained municipalities may face pressure to advance refund since it allows them to reduce short‐term cash outflows. We find strong evidence that financial constraints are a major driver of advance refunding activity.

Managerial Opportunism? Evidence from Directors' and Officers' Insurance Purchases

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00436

John M. R. Chalmers, Larry Y. Dann, Jarrad Harford

We analyze a sample of 72 IPO firms that went public between 1992 and 1996 for which we have detailed proprietary information about the amount and cost of D&O liability insurance. If managers of IPO firms are exploiting superior inside information, we hypothesize that the amount of insurance coverage chosen will be related to the post‐offering performance of the issuing firm's shares. Consistent with the hypothesis, we find a significant negative relation between the three‐year post‐IPO stock price performance and the insurance coverage purchased in conjunction with the IPO. One plausible interpretation is that, like insider securities transactions, D&O insurance decisions reveal opportunistic behavior by managers. This provides some motivation to argue that disclosure of the details of D&O insurance decisions, as is required in some other countries, is valuable.

Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading

Published: 09/04/2015   |   DOI: 10.1111/jofi.12357

ANDREW ELLUL, CHOTIBHAK JOTIKASTHIRA, CHRISTIAN T. LUNDBLAD, YIHUI WANG

Accounting rules, through their interactions with capital regulations, affect financial institutions’ trading behavior. The insurance industry provides a laboratory to explore these interactions: life insurers have greater flexibility than property and casualty insurers to hold speculative‐grade assets at historical cost, and the degree to which life insurers recognize market values differs across U.S. states. During the financial crisis, insurers facing a lesser degree of market value recognition are less likely to sell downgraded asset‐backed securities. To improve their capital positions, these insurers disproportionately resort to gains trading, selectively selling otherwise unrelated bonds with high unrealized gains, transmitting shocks across markets.