The Journal of Finance

Term Structure Movements and Pricing Interest Rate Contingent Claims

Published: 12/01/1986   |   DOI: 10.1111/j.1540-6261.1986.tb02528.x

THOMAS S. Y. HO, SANG‐BIN LEE

This paper derives an arbitrage‐free interest rate movements model (AR model). This model takes the complete term structure as given and derives the subsequent stochastic movement of the term structure such that the movement is arbitrage free. We then show that the AR model can be used to price interest rate contingent claims relative to the observed complete term structure of interest rates. This paper also studies the behavior and the economics of the model. Our approach can be used to price a broad range of interest rate contingent claims, including bond options and callable bonds.

Portfolio Analysis Using Single Index, Multi‐Index, and Constant Correlation Models: A Unified Treatment

Published: 12/01/1984   |   DOI: 10.1111/j.1540-6261.1984.tb04918.x

CLARENCE C. Y. KWAN

In this study a simple common algorithm which is applicable to seven models is proposed for optimal portfolio selection disallowing short sales of risky securities. The models considered in the analysis consist of a single index model, four multi‐index models, and two constant correlation models. Unlike the previous approach, the proposed algorithm does not require explicit ranking of securities. Therefore, it is particularly useful for two multi‐index models with orthogonal indices which do not provide any ranking criterion. Also, because of its algorithmic efficiency as demonstrated in a simulation study on models with multiple groups, the approach here can enhance their usefulness in portfolio analysis.

Lazy Investors, Discretionary Consumption, and the Cross‐Section of Stock Returns

Published: 08/14/2007   |   DOI: 10.1111/j.1540-6261.2007.01253.x

RAVI JAGANNATHAN, YONG WANG

When consumption betas of stocks are computed using year‐over‐year consumption growth based upon the fourth quarter, the consumption‐based asset pricing model (CCAPM) explains the cross‐section of stock returns as well as the Fama and French (1993) three‐factor model. The CCAPM's performance deteriorates substantially when consumption growth is measured based upon other quarters. For the CCAPM to hold at any given point in time, investors must make their consumption and investment decisions simultaneously at that point in time. We suspect that this is more likely to happen during the fourth quarter, given investors' tax year ends in December.

Intertemporal Commodity Futures Hedging and the Production Decision

Published: 06/01/1984   |   DOI: 10.1111/j.1540-6261.1984.tb02314.x

THOMAS S. Y. HO

This paper deals with the producer's optimal use of commodity futures in hedging. The framework for analysis is an intertemporal consumption and investment model. The producer makes his production decisions at the beginning of the period and realizes his return at the end of the time interval. During the period, he faces both price and output uncertainties. In applying stochastic dynamic programming methods, this paper shows the effect of these risks on his consumption behavior. Further, the paper investigates his optimal hedging positions in the futures market over time and his optimal production decisions. Finally, implications of these results on the futures markets are discussed.

Nonfundamental Speculation Revisited

Published: 08/01/2017   |   DOI: 10.1111/jofi.12548

LIYAN YANG, HAOXIANG ZHU

We show that a linear pure strategy equilibrium may not exist in the model of Madrigal (1996), contrary to the claim of the original paper. This is because Madrigal's characterization of a pure strategy equilibrium omits a second‐order condition. If the nonfundamental speculator's information about noise trading is sufficiently precise, a linear pure strategy equilibrium fails to exist. In parameter regions where a pure strategy equilibrium does exist, we identify a few calculation errors in Madrigal (1996) that result in misleading implications.

Credit Granting: A Comparative Analysis of Classification Procedures

Published: 07/01/1987   |   DOI: 10.1111/j.1540-6261.1987.tb04576.x

VENKAT SRINIVASAN, YONG H. KIM

Financial classification issues, and particularly the financial distress problem, continue to be subject to vigorous investigation. The corporate credit granting process has not received as much attention in the literature. This paper examines the relative effectiveness of parametric, nonparametric and judgemental classification procedures on a sample of corporate credit data. The judgemental model is based on the Analytic Hierarchy Process. Evidence indicates that (nonparametric) recursive partitioning methods provide greater information than simultaneous partitioning procedures. The judgemental model is found to perform as well as statistical models. A complementary relationship is proposed between the statistical and the judgemental models as an effective paradigm for granting credit.

Dividends, Taxes, and Signaling: Evidence from Germany

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb03822.x

YAKOV AMIHUD, MAURIZIO MURGIA

The higher taxation of dividends in the United States gave rise to theories that explain why companies pay dividends. Tax‐based signaling models propose that the higher tax on dividends is a necessary condition to make them informative about companies' values. In Germany, where dividends are not tax‐disadvantaged and in fact are taxed lower for most investor classes, these models predict that dividends are not informative. However, we find that the stock price reaction to dividend news in Germany is similar to that found in the United States. This suggests other reasons, beyond taxation, that make dividends informative.

Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00670.x

Ravi Bansal, Amir Yaron

We model consumption and dividend growth rates as containing (1) a small long‐run predictable component, and (2) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin's (1989) preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better long‐run growth prospects raise equity prices. The model can justify the equity premium, the risk‐free rate, and the volatility of the market return, risk‐free rate, and the price–dividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time‐varying.

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.

Liquidity Supply in the Corporate Bond Market

Published: 11/10/2020   |   DOI: 10.1111/jofi.12991

JONATHAN GOLDBERG, YOSHIO NOZAWA

This paper examines dealer inventory capacity, or liquidity supply, as a driver of liquidity and expected returns in the corporate bond market. We identify shocks to aggregate liquidity supply using data on corporate bond yields and dealer positions. Liquidity supply shocks lead to persistent changes in market liquidity, are correlated with proxies for dealer financial constraints, and have significant explanatory power for cross‐sectional and time‐series variation in expected returns, beyond standard risk factors. Our findings point to liquidity supply by financially constrained intermediaries as a main driver of market liquidity and asset prices.

Model Secrecy and Stress Tests

Published: 02/04/2023   |   DOI: 10.1111/jofi.13207

YARON LEITNER, BASIL WILLIAMS

Should regulators reveal the models they use to stress‐test banks? In our setting, revealing leads to gaming, but secrecy can induce banks to underinvest in socially desirable assets for fear of failing the test. We show that although the regulator can solve this underinvestment problem by making the test easier, some disclosure may still be optimal (e.g., if banks have high appetite for risk or if capital shortfalls are not very costly). Cutoff rules are optimal within monotone disclosure rules, but more generally optimal disclosure is single‐peaked. We discuss policy implications and offer applications beyond stress tests.

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.

ORDERING UNCERTAIN OPTIONS WITH BORROWING AND LENDING

Published: 05/01/1978   |   DOI: 10.1111/j.1540-6261.1978.tb04867.x

Haim Levy, Yoram Kroll

Information Diversity and Complementarities in Trading and Information Acquisition

Published: 12/02/2014   |   DOI: 10.1111/jofi.12226

ITAY GOLDSTEIN, LIYAN YANG

We analyze a model in which different traders are informed of different fundamentals that affect the security value. We identify a source for strategic complementarities in trading and information acquisition: aggressive trading on information about one fundamental reduces uncertainty in trading on information about the other fundamental, encouraging more trading and information acquisition on that fundamental. This tends to amplify the effect of exogenous changes in the underlying information environment. Due to complementarities, greater diversity of information in the economy improves price informativeness. We discuss the relation between our model and recent financial phenomena and derive testable empirical implications.

Increasing Enrollment in Income‐Driven Student Loan Repayment Plans: Evidence from the Navient Field Experiment

Published: 10/28/2021   |   DOI: 10.1111/jofi.13088

HOLGER MUELLER, CONSTANTINE YANNELIS

We report evidence from a randomized field experiment conducted by a major student loan servicer, Navient, in which student loan borrowers received prepopulated applications for income‐driven repayment (IDR) plans. Treatment increased IDR enrollment by 34 percentage points relative to the control group. Using the random treatment assignment as an instrument for IDR enrollment, we furthermore provide local average treatment effect (LATE) estimates of the effects of IDR enrollment on new delinquencies, monthly student loan payments, and consumer spending. Our study is the first field‐experimental evaluation of a U.S. government program designed to address the soaring debt burdens of U.S. households.

Optimal Sequential Selling Mechanism and Deal Protections in Mergers and Acquisitions

Published: 05/05/2023   |   DOI: 10.1111/jofi.13235

YI CHEN, ZHE WANG

We study the dynamic profit‐maximizing selling mechanism in a merger and acquisitions (M&A) environment with costly bidder entry and without entry fees. Depending on the parameters, the optimal mechanism is implemented by a standard auction or by a two‐stage procedure with exclusive offers to one bidder followed by an auction potentially favoring that bidder. The optimal mechanism may involve common deal protections like termination fees, asset lockups, or stock option lockups. Our proposed procedures resemble sales of targets filing Chapter 11 bankruptcy or M&A involving public targets, and they shed light on how to use deal protections in practice.

How Do Crises Spread? Evidence from Accessible and Inaccessible Stock Indices

Published: 03/09/2006   |   DOI: 10.1111/j.1540-6261.2006.00860.x

BRIAN H. BOYER, TOMOMI KUMAGAI, KATHY YUAN

We provide empirical evidence that stock market crises are spread globally through asset holdings of international investors. By separating emerging market stocks into two categories, namely, those that are eligible for purchase by foreigners (accessible) and those that are not (inaccessible), we estimate and compare the degree to which accessible and inaccessible stock index returns co‐move with crisis country index returns. Our results show greater co‐movement during high volatility periods, especially for accessible stock index returns, suggesting that crises spread through the asset holdings of international investors rather than through changes in fundamentals.

Participation Costs and the Sensitivity of Fund Flows to Past Performance

Published: 05/08/2007   |   DOI: 10.1111/j.1540-6261.2007.01236.x

JENNIFER HUANG, KELSEY D. WEI, HONG YAN

We present a simple rational model to highlight the effect of investors' participation costs on the response of mutual fund flows to past fund performance. By incorporating participation costs into a model in which investors learn about managers' ability from past returns, we show that mutual funds with lower participation costs have a higher flow sensitivity to medium performance and a lower flow sensitivity to high performance than their higher‐cost peers. Using various fund characteristics as proxies for the reduction in participation costs, we provide empirical evidence supporting the model's implications for the asymmetric flow‐performance relationship.

Information Asymmetry and Asset Prices: Evidence from the China Foreign Share Discount

Published: 01/10/2008   |   DOI: 10.1111/j.1540-6261.2008.01313.x

KALOK CHAN, ALBERT J. MENKVELD, ZHISHU YANG

We examine the effect of information asymmetry on equity prices in the local A‐ and foreign B‐share market in China. We construct measures of information asymmetry based on market microstructure models, and find that they explain a significant portion of cross‐sectional variation in B‐share discounts, even after controlling for other factors. On a univariate basis, the price impact measure and the adverse selection component of the bid‐ask spread in the A‐ and B‐share markets explains 44% and 46% of the variation in B‐share discounts. On a multivariate basis, both measures are far more statistically significant than any of the control variables.

CEO Connectedness and Corporate Fraud

Published: 01/27/2015   |   DOI: 10.1111/jofi.12243

VIKRAMADITYA KHANNA, E. HAN KIM, YAO LU

We find that connections CEOs develop with top executives and directors through their appointment decisions increase the risk of corporate fraud. Appointment‐based CEO connectedness in executive suites and boardrooms increases the likelihood of committing fraud and decreases the likelihood of detection. Additionally, it decreases the expected costs of fraud by helping conceal fraudulent activity, making CEO dismissal less likely upon discovery, and lowering the coordination costs of carrying out illegal activity. Connections based on network ties through past employment, education, or social organization memberships have insignificant effects on fraud. Appointment‐based CEO connectedness warrants attention from regulators, investors, and corporate governance specialists.