Are Incentive Contracts Rigged by Powerful CEOs?

We argue that some powerful CEOs induce boards to shift the weight on performance measures toward the better performing measures, thereby rigging incentive pay. A simple model formalizes this intuition and gives an explicit structural form on the rigged incentive portion of CEO wage function. Using U.S. data, we find support for the model's predictions: rigging accounts for at least 10% of the compensation to performance sensitivity and it increases with CEO human capital and firm volatility. Moreover, a firm with rigged incentive pay that is one standard deviation above the mean faces a subsequent decrease of 4.8% in firm value and 7.5% in operating return on assets.     

Information asymmetry and investment–cash flow sensitivity

Models of capital market imperfections predict that information asymmetry decreases firm investment and increases the sensitivity of investment expenditures to fluctuations in internal funds. Previous empirical tests of the link between investment and financing decisions have relied on indirect measures of financial constraint due to market frictions. In contrast, we use more direct measures derived from the market microstructure literature. Consistent with the theoretical predictions, our analysis shows that scaled investment expenditures are on average lower and the investment–cash flow sensitivity is greater when the probability of informed trading is high. Our results are robust to alternative measures of informed trading and liquidity, but they are not pervasive in our sample.     

Catering through Nominal Share Prices

We propose and test a catering theory of nominal stock prices. The theory predicts that when investors place higher valuations on low‐price firms, managers respond by supplying shares at lower price levels, and vice versa. We confirm these predictions in time‐series and firm‐level data using several measures of time‐varying catering incentives. More generally, the results provide unusually clean evidence that catering influences corporate decisions, because the process of targeting nominal share prices is not well explained by alternative theories.     

Structural models of credit risk are useful: Evidence from hedge ratios on corporate bonds

Structural models of credit risk provide poor predictions of bond prices. We show that, despite this, they provide quite accurate predictions of the sensitivity of corporate bond returns to changes in the value of equity (hedge ratios). This is important since it suggests that the poor performance of structural models may have more to do with the influence of non-credit factors rather than their failure to capture the credit exposure of corporate debt. The main result of this paper is that even the simplest of the structural models [Merton, R., 1974. On the pricing of corporate debt: the risk structure of interest rates. Journal of Finance 29, 449–470] produces hedge ratios that are not rejected in time-series tests. However, we find that the Merton model (with or without stochastic interest rates) does not capture the interest rate sensitivity of corporate debt, which is substantially lower than would be expected from conventional duration measures. The paper also shows that corporate bond prices are related to a number of market-wide factors such as the Fama-French SMB (small minus big) factor in a way that is not predicted by structural models.     

Sales and consumer inventory

Temporary price reductions (sales) are common for many goods and naturally result in a large increase in the quantity sold. We explore whether the data support the hypothesis that these increases are, at least partly, due to demand anticipation: at low prices, consumers store for future consumption. This effect, if present, has broad economic implications. We test the predictions of an inventory model using scanner data with two years of household purchases. The results are consistent with an inventory model and suggest that static demand estimates may overestimate price sensitivity.     

Crude oil price volatility and equity return predictability: A comparative out-of-sample study

We evaluate the predictive power afforded by crude oil price volatility relative to widely used variables in the financial literature, such as the dividend yield, earnings-to-price ratio, the default yield spread as well several crude oil price-based variables. From a statistical viewpoint, predictions employing the suggested crude oil price volatility-based measures display a similar pattern as predictions using dividend ratios and interest rates, namely, they have relatively weak out-of-sample power. However, we find that gains in utility for an investor that uses predictions produced under the model employing crude oil price log-realized semivolatilities are statistically significant higher than an investor relying on predictions produced under the competitors as well as the historical average benchmark. We discuss and explain the reasons for our results. Overall, we argue that it is hard not to justify more attention to crude oil price semivolatilities relative to widely used financial and macroeconomic variables.     

THE EFFECT OF MONETARY POLICY ON CREDIT SPREADS

We analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions.     

Balancing difficulty of performance targets: theory and evidence

We examine how firms balance difficulty of performance targets in their annual bonus plans. We present an analytical model showing that managerial allocation of effort is a function of not only relative incentive weights but also the difficulty of performance targets. We find that relative incentive weights and target difficulty can either be complements or substitutes in motivating effort depending on the extent to which managers have alternative employment opportunities. To test the predictions of our model, we use survey data on performance targets in annual bonus plans. Our sample of 877 survey respondents consists primarily of financial executives in small- and medium-size private companies where annual bonuses are important both for motivation and retention. Consistent with our model, we find that relative incentive weights are negatively (positively) associated with perceived target difficulty when concerns about managerial retention are high (low). It follows that performance measures included in annual bonus plans have sometimes easy and other times challenging targets depending on their relative incentive weights and retention concerns.     

EQUITY VALUATION EFFECTS OF FORCED WARRANT EXERCISE

We examine stock price reactions to announced calls of in-the-money warrants and find a significant average devaluation in excess of 4 percent, consistent with the recent literature. We test theoretical predictions based on asymmetric information, agency costs, and corporate control in a cross-sectional model of announcement-period returns and find support for voting rights and ownership dilution as an explanation. We find evidence of some price recovery after the call announcement; however, further evidence of a liquidity-based explanation is mixed.     

Performance-measurement system design and functional strategic decision influence: The role of performance-measure properties

Although conceptual research in the accounting literature suggests that the use of performance-measurement systems affects the influence of organizational actors, empirical evidence for this suggestion is largely limited to anecdotal evidence and a few qualitative case studies. Drawing on institutional theory, we develop predictions that link the use of performance measures to the influence of functional subunits in strategic decision making. Our research model tests the effects of two types of performance-measure use on functional strategic decision influence: (1) decision-facilitating use and (2) use for accountability. Moreover, we propose that the effects of using performance measures for these two purposes depend on the reliability and functional specificity of the measures the functional subunits use. We empirically test our hypotheses and a research question with survey data from 192 marketing directors of German firms. We find that the effect of performance-measure use on functional strategic decision influence depends on the two properties of the performance measures. We find no significant effects when these properties are not considered. However, decision-facilitating use of performance measures has a positive effect on functional strategic decision influence when the measures are specific to the functional subunit. With respect to the use of performance measures for accountability we find countervailing effects, as the effect on functional strategic decision influence is positive when the measures are more reliable but negative when they are more specific to the functional subunit. We discuss these findings in light of existing evidence and theory.     

Impact of Segment‐level Natural Resource Operational Risk Reporting on Earnings Predictions

Non‐financial reports alert investors to operational risks associated with issues such as insufficient access to natural resource inputs and related costly interruptions to production, while segment‐level reports alert investors to operational risk distribution across a firm. An important issue, to date unexplored, is how segment‐level non‐financial reporting has an impact on earnings predictions. We report the results of an experiment used to examine how mining company segment‐level water reports affect investors' earnings predictions, where water reports indicate whether the firm and its segments will have access to sufficient water to meet production needs. We find that investors do not change their earnings predictions when firm and segment‐level reports indicate low water risk but they do revise down their earnings predictions when firm and segment‐level water reports indicate high water risk. This is consistent with investors responding to the additional information provided in segment‐level reports confirming that water risk is high across the firm. Regardless of whether firm‐level water reports indicate high or low water risk, when segment‐level reports indicate that one segment is low water risk and another is high water risk, investors revise down their earnings predictions. This is consistent with investors recognizing that natural resource operational risk concentration in one segment can affect earnings more than evenly‐distributed risk. Overall, our findings suggest that belief‐adjustment theory explains how investors react to prospective operational risk information contained in segment‐level water reports according to the similarity of the segment‐level risks, and that this information is factored into earnings predictions.     

Performance measures,consensus on strategy implementation,and performance: Evidence from the operational-level of organizations

In this article, we examine how consensus between operational-level managers and employees on strategy implementation affects the effectiveness of performance measures and employee performance. We use field-based surveys and proprietary archival data from a Taiwanese financial services company to answer our research questions. Consistent with the predictions of person–organization fit theory, we find that consensus on the implementation of the customer-oriented strategy is positively associated with frontline employees’ performance. Our results also indicate that the incentive effect of using performance measures in performance evaluation and promotion is stronger for employees with a higher level of consensus. Our findings suggest that consensus is critical to the success of an organization’s strategy implementation and the effectiveness of performance measures.     

STOCK MARKET SIGNALS OF CHANGES IN EXPECTED INFLATION

This paper examines the relationship between stock returns and several measures of expected inflation. The proxies include the inflation forecasts extracted from U.S. Treasury bill yields, the mean forecast of surveys conducted by the Institute for Social Research, and the predictions from a rolling time-series model. Unlike recent studies, there does not appear to be a significant negative relationship between stock returns and expected inflation at the beginning of the period. The results are consistent with the hypothesis that stock returns signal changes in expected inflation.     

A unified model of entrepreneurship dynamics

We develop an incomplete-markets q-theoretic model to study entrepreneurship dynamics. Precautionary motive, borrowing constraints, and capital illiquidity lead to underinvestment, conservative debt use, under-consumption, and less risky portfolio allocation. The endogenous liquid wealth-illiquid capital ratio w measures time-varying financial constraint. The option to accumulate wealth before entry is critical for entrepreneurship. Flexible exit option is important for risk management purposes. Investment increases and the private marginal value of liquidity decreases as w decreases and exit becomes more likely, contrary to predictions of standard financial constraint models. We show that the idiosyncratic risk premium is quantitatively significant, especially for low w.     

Which parametric model for conditional skewness?

This paper addresses an existing gap in the developing literature on conditional skewness. We develop a simple procedure to evaluate parametric conditional skewness models. This procedure is based on regressing the realized skewness measures on model-implied conditional skewness values. We find that an asymmetric generalized autoregressive conditional heteroscedasticity specification on shape parameters with a skewed generalized error distribution provides the best in-sample fit for the data, as well as reasonable predictions of the realized skewness measure. Our empirical findings imply significant asymmetry with respect to positive and negative news in both conditional asymmetry and kurtosis processes.     

Outside monitoring and CEO compensation in the banking industry

We hypothesize that CEO compensation is optimally designed to trade off two types of agency problems: the standard shareholder-management agency problem as well as the risk-shifting problem between shareholders and debtholders. Analyses in this setup produces two predictions: (1) the pay-for-performance sensitivity of CEO compensation decreases with the leverage ratio; and (2) the pay-for-performance sensitivity of CEO compensation increases with the intensity of outside monitoring on the firm's risk choice. We test these two hypotheses for the banking industry where regulators and nondepository (subordinated) debtholders provide outside monitoring on the risk choice. We construct an index of the intensity of outside monitoring based on three variables: subordinated debt rating, non performing loan ratio and examination rating assigned by regulators. We find supporting evidence for both hypotheses.     

Equity‐based incentives and shareholder say‐on‐pay

We study the relationship between CEO pay‐performance sensitivity, pay‐risk sensitivity, and shareholder voting outcomes as part of the “say‐on‐pay” provision of the 2010 US Dodd‐Frank Act. Consistent with our hypothesis, we provide evidence that shareholders tend to approve of compensation packages that are more sensitive to changes in stock price (pay‐performance sensitivity). Our findings are consistent with theoretical predictions that outside owners approve of equity incentives as a means of aligning managers' interests with those of shareholders. We also document that future changes to equity‐based incentives are related to voting outcomes and that shareholders incorporate CFO incentives into their votes. Collectively, these results provide evidence of the importance of equity‐based incentives from the perspective of those most concerned with firm value and of the effectiveness of say‐on‐pay as a governance mechanism.     

Overemployment,executive pay-for-performance sensitivity and economic consequences: Evidence from China

Using a sample of state-owned enterprises (SOEs) listed on the Shanghai and Shenzhen Stock Exchanges during the 1999–2009 period, we investigate the effects of overemployment on executives’ pay-for-performance sensitivity (PPS) and analyze how the behavior of firms with high/low PPS affects the number of surplus employees. We find the existence of a redundant workforce significantly weakens PPS and the role of accounting measures in performance assessment. In contrast to prior literature, we find that higher PPS is associated with a stronger incentive to lay off redundant employees and to limit future employee numbers. We also find that weaker government intervention strengthens managerial control over the future size of the workforce. Finally, our findings suggest that a heavier government policy burden on SOEs leads to lower tax rates and more government gains.     

Trading off accuracy for speed: Hedge funds' decision-making under uncertainty

Active managers operating quick portfolio adjustments, backed only by some rough estimates and loose predictions, might improve their market timing performances to benefit in turbulent times, but oversimplification can lead to an inability to profit in calm markets. By selecting accuracy levels upfront, through different data-filtering techniques, we expose a trade-off between prediction accuracy and reaction speed across different hedge funds' investment styles. Our empirical analysis shows that less accurate predictions can speed up reactions to unexpected changes in a large set of uncertainty and risk measures. We justify and complement these findings with a simulation exercise.     

The second moment matters! Cross-sectional dispersion of firm valuations and expected returns

Behavioral theories predict that firm valuation dispersion in the cross-section (“dispersion”) measures aggregate overpricing caused by investor overconfidence and should be negatively related to expected aggregate returns. This paper develops and tests these hypotheses. Consistent with the model predictions, I find that measures of dispersion are positively related to aggregate valuations, trading volume, idiosyncratic volatility, past market returns, and current and future investor sentiment indexes. Dispersion is a strong negative predictor of subsequent short- and long-term market excess returns. Market beta is positively related to stock returns when the beginning-of-period dispersion is low and this relationship reverses when initial dispersion is high. A simple forecast model based on dispersion significantly outperforms a naive model based on historical equity premium in out-of-sample tests and the predictability is stronger in economic downturns.