LARCH, Leverage, and Long Memory

We consider the long-memory and leverage properties of a modelfor the conditional variance of an observable stationary sequence X_t, where is the square of an inhomogeneous linear combination of X_s, s < t, withsquare summable weights b_j. This model, which we call linearautoregressive conditionally heteroskedastic (LARCH), specializes,when depends only on X_t–1, to theasymmetric ARCH model of Engle (1990, Review of Financial Studies3, 103–106), and, when depends only on finitely many X_s, to a version of the quadratic ARCH modelof Sentana (1995, Review of Economic Studies 62, 639–661),these authors having discussed leverage potential in such models.The model that we consider was suggested by Robinson (1991,Journal of Econometrics 47, 67–84), for use as a possiblylong-memory conditionally heteroskedastic alternative to i.i.d.behavior, and further studied by Giraitis, Robinson and Surgailis(2000, Annals of Applied Probability 10, 1002–1004), whoshowed that integer powers , =" BORDER="0">2 can have long-memory autocorrelations. We establish conditionsunder which the cross-autocovariance function between volatilityand levels, , decays in the manner of moving average weights of long-memory processes on suitable choiceof the b_j. We also establish the leverage property that h_t <0 for 0 < t k, where the value of k (which may be infinite)again depends on the b_j. Conditions for finiteness of thirdand higher moments of X_t are also established.     

Spin-offs, Divestitures, and Conglomerate Investment

We examine whether spin-offs or divestitures cause improvementsin conglomerate investment efficiency. At issue are endogeneityof these restructuring decisions and correct measurement ofinvestment efficiency. Endogeneity is a problem because thefactors that induce firms to spin off or divest divisions mayalso improve investment efficiency; measurement error is a problembecause efficiency measures employ Tobin’s q as a noisyproxy for investment opportunities. We find important differencesbetween firms that divest or spin off and a control sample.After accounting for these differences and for measurement errorin q, we find no evidence of improvements in investment efficiency.(JEL G31, G34)     

Strategic Trading, Liquidity, and Information Acquisition

We study endogenous liquidity trading in a market with long-livedasymmetric information. We distinguish between public information,tractable information that can be acquired, and intractableinformation that cannot be acquired. Besides information asymmetryand noise, the adverse-selection spread depends on the diffusionof intractable information and on the interest rate. With endogenousliquidity trading, efficiency is lower than that implied bynoise-trading models. Liquidity traders benefit from the informationreleased through the insider's trades in spite of their monetarylosses. We study factors that affect the insider's informationacquisition decision, including the amount of intractable information,observability, and information acquisition costs.     

Good Stewards, Cheap Talkers, or Family Men? The Impact of Mutual Fund Closures on Fund Managers, Flows, Fees, and Performance

We examine a sample of 125 equity mutual funds that closed tonew investment between 1993 and 2004. We find that funds closefollowing a period of superior performance and abnormal fundinflows. Fund managers raise their fees when they close to compensatemanagers for losses in income due to the restrictions in sizeimposed by the fund closure decision. Managers reopen when fundsize declines. However, they do not earn superior returns afterreopening, suggesting that the fund closure decision does notprovide information about superior fund managers. (JEL G14,G23)     

The Book-to-Market and Size Effects in a General Asset Pricing Model: Evidence from Seven National Markets

The positive relation of returns with Book-to-Market ratio (BE/ME)and their negative relation withMarket Value(MVE) remains strongunder a general stochastic discount function (SDF) that doesnot depend on a specific asset pricing model and avoids potentiallyserious simultaneity biases inherent in the Fama and Frenchthree-factor model. However, we find that SDF_s that includethe equivalent of the HML portfolio do not span all asset sub-spaces,even with additional conditioning information. Finally, macroand financial variables we introduce to the pricing functionsdo not offer an alternative explanation of the BE/ME effect.JEL Classification codes: G10, G12, G15, G30.     

Trading volume: definitions, data analysis, and implications of portfolio theory

We examine the implications of portfolio theory for the cross-sectionalbehavior of equity trading volume. Two-fund separation theoremssuggest a natural definition for trading activity: share turnover.If two-fund separation holds, share turnover must be identicalfor all securities. If (K + 1)-fund separation holds, we showthat turnover satisfies an approximately linear K-factor structure.These implications are examined empirically using individualweekly turnover data for NYSE and AMEX securities from 1962to 1996. We find strong evidence against two-fund separation,and a principal-components decomposition suggests that turnoveris well approximated by a two-factor linear model.     

Market Responses to Buy Recommendations Issued by Personal Finance Magazines: Effects of Information, Price-Pressure, and Company Characteristics

This paper analyzes explicit buy recommendations for stockspublished by German Personal Finance Magazines from 1995 to2003. These recommendations earn significant abnormal returnsof 2.58% within the five days around the publication day. Boththe price-pressure hypothesis and the information hypothesiscan be confirmed by our data. The price-pressure effect is mostevident for small stocks and glamour stocks. However, whereasthe initial price reaction to small stocks is additionally drivenby permanent information value, this does not hold true forglamour stocks. In contrast, value stocks are associated withhigh cumulative abnormal returns that are solely driven by informationvalue.     

Household Portfolio Diversification: A Case for Rank-Dependent Preferences

The proliferation of novel preference theories in financialeconomics is hampered by a lack of non-experimental evidenceand by the theories’ additional complexity which has notbeen shown to be critical in applications. In this article Ipresent arguments in support of preferences with rank dependency.Using the Survey of Consumer Finances data, I document two widespreadpatterns inconsistent with expected utility: (i) many householdssimultaneously invest in well-deversified funds and in poorly-diversifiedportfolios of stocks; and (ii) some households with substantialsavings do not invest anything in equities. I show that portfoliochoice models with rank-dependent preferences, plausibly parameterizedand under fully rational assumptions, are quantitatively consistentwith the observed diversification. These results call for furtherefforts to integrate the models of rank-dependent preferencesin portfolio theory and asset pricing.     

Macroeconomic Factors Do Influence Aggregate Stock Returns

Stock market returns are significantly correlated with inflationand money growth. The impact of real macroeconomic variableson aggregate equity returns has been difficult to establish,perhaps because their effects are neither linear nor time invariant.We estimate a GARCH model of daily equity returns, where realizedreturns and their conditional volatility depend on 17 macroseries' announcements. We find six candidates for priced factors:three nominal (CPI, PPI, and a Monetary Aggregate) and threereal (Balance of Trade, Employment Report, and Housing Starts).Popular measures of overall economic activity, such as IndustrialProduction or GNP are not represented.     

Inequality Constraints in the Fractionally Integrated GARCH Model

In this article we derive necessary and sufficient conditionsfor the nonnegativity of the conditional variance in the fractionallyintegrated generalized autoregressive conditional heteroskedastic(p, d, q) (FIGARCH) model of the order p 2 and sufficient conditionsfor the general model. These conditions can be seen as beinganalogous to those derived by Nelson and Cao (1992, Journalof Business & Economic Statistics 10, 229–235) forthe GARCH(p, q) model. However, the inequality constraints whichwe derive for the FIGARCH model illustrate two remarkable propertiesof the FIGARCH model which are in contrast to the GARCH model:(i) even if all parameters are nonnegative, the conditionalvariance can become negative and (ii) even if all parametersare negative (apart from d), the conditional variance can benonnegative almost surely. In particular, the conditions forthe (1, d, 1) model substantially enlarge the sufficient parameterset provided by Bollerslev and Mikkelsen (1996, Journal of Econometrics73, 151–184). The importance of the result is illustratedin an empirical application of the FIGARCH(1, d, 1) model toJapanese yen versus U.S. dollar exchange rate data.     

Practitioners' Corner

The first 150 words of the full text of this article appear below. In our discussion in the last issue of Journal of FinancialEconometrics (JFEC) of the nonparametric methods developed byBarndorff-Nielsen and Shephard (2006) to detect jumps in thelocal behavior of the continuous time path of a price process,we observed these tests were not designed to detect major pricediscontinuity events such as the 1987 crash, since the testingmethodology precludes jumps in adjacent time intervals. Indeed,a major event such as Black Monday is characterized by a sequenceof jumps in consecutive time intervals throughout the day. Inthe interest of thematic continuity, let’s pursue thematter of jumps further. The first article in the current issue by Hossein Asgharianand Chistoffer Bengtsson addresses directly the detection ofbig events in stock prices. More particularly, the authors analyzethe spillover of jumps across international stock markets. Tomeasure jumps, the authors formulate a parametric model in . . . [Full Text of this Article]     

Imperfect Competition, Information Heterogeneity, and Financial Contagion

This study examines how heterogeneity of private informationmay induce financial contagion. Using a model of multi-assettrading in which the three main channels of contagion throughfinancial linkages in the literature (correlated information,correlated liquidity, and portfolio rebalancing) are ruled outby construction, I show that financial contagion can still bean equilibrium outcome when speculators receive heterogeneousfundamental information. Risk-neutral speculators trade strategicallyacross many assets to mask their information advantage aboutone asset. Asymmetric sharing of information among them preventsrational market makers from learning about their individualsignals and trades with sufficient accuracy. Incorrect cross-inferenceabout terminal payoffs and contagion ensue. When used to analyzethe transmission of shocks across countries, my model suggeststhat the process of generation and disclosure of informationin emerging markets may explain their vulnerability to financialcontagion (JEL D82, G14, G15).     

Capital Controls, Liberalizations, and Foreign Direct Investment

This article evaluates the impact of capital controls and theirliberalization on the activities of US multinational firms.These firms attempt to circumvent capital controls by reducingreported local profitability and increasing the frequency ofdividend repatriations. As a result, the reported profit impactof local capital controls is comparable with the effect of 27%higher corporate tax rates, and affiliates located in countriesimposing capital controls are 9.8% more likely than other affiliatesto remit dividends to parent companies. Multinational affiliateslocated in countries with capital controls face 5.25% higherinterest rates on local borrowing than do affiliates of thesame parent borrowing locally in countries without capital controls.Capital control liberalizations are associated with significantincreases in multinational activity—property, plant, andequipment grow at 6.9% faster annual rates following liberalizations.The combination of the costliness of avoidance and higher interestrates discourages investment in countries with capital controls,and this effect is reversed upon liberalization of controls.(JEL F21, F23, F36, F42, G15, G32, G34)     

Reputation, renegotiation, and the choice between bank loans and publicly traded debt

We model firms' choice between bank loans and publicly tradeddebt, allowing for debt renegotiation in the event of financialdistress. Entrepreneurs, with private information about theirprobability of financial distress, borrow from banks (multiperiodplayers) or issue bonds to implement projects. If a firm isin financial distress, lenders devote a certain amount of resources(unobservable to entrepreneurs) to evaluate whether to liquidatethe firm or to renegotiate its debt. We demonstrate that banks'desire to acquire a reputation for making the 'right' renegotiationversus liquidation decision provides them an endogenous incentiveto devote a larger amount of resources than bondholders towardsuch evaluations. In equilibrium, bank loans dominate bondsfrom the point of view of minimizing inefficient liquidation,.however, firms with a lower probability of financial distresschoose bonds over bank loans.     

Termination Risk, Multiple Managers and Mutual Fund Tournaments

This study analyzes the risk-taking behavior of mutual fundsin response to their relative performance over the 1992 to 1999period. Our results show that managers of funds whose performanceis closer to that of the top performing funds have greater incentivesto increase their portfolios' risk than managers at the topwho exhibit a tendency to lock in their positions. The evidencesuggests that termination risk imposes a constraint on the risktaking behavior of underperforming fund managers and the winnertakes all phenomenon generates a strong incentive for the fundmanagers to be the top manager. We also analyze the differencein the risk taking behavior of funds managed by multiple managersand single managers. JEL Classification codes: G2 L2     

Pricing Interest Rate Derivatives: A General Approach

The relationship between affine stochastic processes and bondpricing equations in exponential term structure models has beenwell established. We connect this result to the pricing of interestrate derivatives. If the term structure model is exponentialaffine, then there is a linkage between the bond pricing solutionand the prices of many widely traded interest rate derivativesecurities. Our results apply to m-factor processes with n diffusionsand l jump processes. The pricing solutions require at mosta single numerical integral, making the model easy to implement.We discuss many options that yield solutions using the methodsof the article.     

The Pooling and Tranching of Securities: A Model of Informed Intermediation

I show that when an issuer has superior information about thevalue of its assets, it is better off selling assets separatelyrather than as a pool due to the information destruction effectof pooling. If, however, the issuer can create a derivativesecurity that is collateralized by the assets, pooling and "tranching"may be optimal. If the residual risk of each asset is not highlycorrelated, tranching allows the issuer to exploit the riskdiversification effect of pooling to create a low-risk and highlyliquid security. In contrast, for an uninformed seller, purepooling reduces underpricing and is preferred to separate assetsales. These results lead to a dynamic model of financial intermediation:originators sell pools of assets, some of which are purchasedby informed intermediaries who then further pool and tranchethem. Pooling and tranching allow intermediaries to leveragetheir capital more efficiently, enhancing the returns to theirprivate information.     

Periodic Stochastic Volatility and Fat Tails

This article provides a comprehensive analysis of the size andstatistical significance of the day of the week, month of theyear, and holiday effects in daily stock index returns and volatility.We employ data from the Dow Jones Industrial Average (DJIA),the S&P 500, the S&P MidCap 400, and the S&P SmallCap600 in order to test whether the seasonal patterns of mediumand small firms are similar to those of large firms. Using formalhypothesis tests based on bootstrapping, we demonstrate thatthere are more significant calendar effects in volatility thanin expected returns, especially for the two large cap indices.More importantly, we introduce the periodic stochastic volatility(PSV) model for characterizing the observed seasonal patternsof daily financial market volatility. We analyze the interactionbetween seasonal heteroskedasticity and fat tails by comparingthe performance of Gaussian PSV and fat-tailed PSVt specificationsto the plain vanilla SV and SVt benchmarks. Consistent withour model-free results, we find strong evidence of seasonalperiodicity in volatility, which essentially eliminates theneed for a fat-tailed conditional distribution, and is robustto the exclusion of the crash of 1987 outliers.     

The Term Structure of Interest Rates: Bounded or Falling?

This short paper resolves an apparent contradiction betweenFeldman's (1989) and Riedel's (2000) equilibrium models of theterm structure of interest rates under incomplete information.Feldman (1989) showed that in an incomplete information versionof Cox, Ingersoll, and Ross (1985), where the stochastic productivityfactors are unobservable, equilibrium term structures are ‘interior’and bounded. Interestingly, Riedel (2000) showed that an incompleteinformation version of Lucas (1978), with an unobservable constantgrowth rate, induces a ‘corner’ unbounded equilibriumterm structure: it decreases to negative infinity. This paperdefines constant and stochastic asymptotic moments, clarifiesthe apparent conflict between Feldman's and Riedel's equilibria,and discusses implications. Because productivity and growthrates are not directly observable in the real world, the questionwe answer is of particular relevance. JEL Classification codes:E43, G12, D92, D80, D51.     

Practitioners' Corner

The first 150 words of the full text of this article appear below. The analysis of volatility remains a preoccupation. In our veryfirst issue, "Practitioners' Corner" offered a brief retrospectiveon volatility modeling, surveying several strategies in thehistory of volatility modeling and locating the contributionsof the first issue within these broad themes. Of course, notall the highlights of this voluminous literature could be visitedor all noteworthy references cited. Nonetheless, we should havereferred to the venerable literature on mixture models introducedby the polymath Simon Newcomb in the late 19th century and subsequentlystudied by Karl Pearson. A neglected reminder was certainlysupplied by Lanne and Saikkonen (2003), who in this same firstissue of JFEC offered the wry understatement that the conditionalheteroskedasticity inherent in mixture autoregressive modelsmay not adequately capture the time-series properties of financialdata. The point is made again in the contribution to this issueby Markus Haas, Stefan Mittnik, and Marc . . . [Full Text of this Article]