Analyst forecast,accounting conservatism and the related valuation implications

This study investigates whether financial analysts incorporate accounting conservatism into their earnings forecasts and whether it is more difficult for them to forecast earnings for less conservative firms, and then examines the impact of the findings on the return predictability of the value‐to‐price (V/P) ratio. After controlling for the other factors affecting forecast accuracy, such as earnings predictability and information uncertainty, I find that analysts incorporate accounting conservatism into their earnings forecasts and that forecasting earnings is more difficult for less conservative firms. Consequently, the return predictability of the V/P ratio is stronger for more conservative firms, and previously reported return predictability of the V/P ratio is an average across firms with differing levels of conservatism.     

Options trading activity and firm valuation

Options may have an effect on firm value because they help complete markets and stimulate informed trades. However, these benefits are likely to manifest themselves in active, rather than inactive, options markets. Supporting this observation, we find that firms with more options trading have higher values of Tobin's q, after accounting for other determinants of value. Corporate investment in firms with greater options trading is more sensitive to stock prices. Options trading affects firm valuation more strongly in stocks with greater information asymmetry. These results indicate that options trading is positively associated with firm values as well as information production.     

Economic valuation of liquidity timing

This paper conducts a horse-race of different liquidity proxies using dynamic asset allocation strategies to evaluate the short-horizon predictive ability of liquidity on monthly stock returns. We assess the economic value of the out-of-sample power of empirical models based on different liquidity measures and find three key results: liquidity timing leads to tangible economic gains; a risk-averse investor will pay a high performance fee to switch from a dynamic portfolio strategy based on various liquidity measures to one that conditions on the Zeros measure (Lesmond et al., 1999); the Zeros measure outperforms other liquidity measures because of its robustness in extreme market conditions. These findings are stable over time and robust to controlling for existing market return predictors or considering risk-adjusted returns.     

Liquidity and valuation in an uncertain world

During the 2007–2009 financial crisis there was little or no trading in a variety of financial assets, even though bid and ask prices existed for many of these assets. We develop a model in which this illiquidity arises from uncertainty, and we argue that this new form of illiquidity makes bid and ask prices unsuitable as metrics for establishing “fair value” for these assets. We show how the extreme uncertainty that traders face can be characterized by incomplete preferences over portfolios, and we use Bewley's (2002) model of decision making under uncertainty to derive equilibrium quotes and the nonexistence of trading at these quotes. We then suggest alternatives for valuing assets in illiquid markets.     

How important is asymmetric covariance for the risk premium of international assets?

This paper empirically investigates the importance of asymmetric conditional covariance when computing the risk premium of international assets. Conditional second moment asymmetry of equity indices is significant and varies over time. The risk premia estimated allowing for asymmetry are statistically and economically different from risk premia estimated without allowing for asymmetry. In particular, an international investor who ignores covariance asymmetry overestimates required returns for equities of the G4 countries and for the world market, on average.     

VIX option pricing and CBOE VIX Term Structure: A new methodology for volatility derivatives valuation

This study integrates CBOE VIX Term Structure and VIX futures to simplify VIX option pricing in multifactor models. Exponential and hump volatility functions with one- to three-factor models of the VIX evolution are used to examine their pricing for VIX options across strikes and maturities. The results show that using exponential volatility functions presents an effective choice as pricing models for VIX calls, whereas hump volatility functions provide efficient out-of-sample valuation for most VIX puts, in particular with deep in-the-money and deep out-of-the-money. Pricing errors for calls can be further reduced with a two-factor model.     

Liquidity dynamics across public and private markets

In this paper we investigate cross-asset liquidity between equity markets and REITs and between REITs and private real estate markets. While many studies have investigated REIT liquidity, and there is an emerging interest in liquidity in the private real estate markets, there appears to be little knowledge of the dynamics of cross-market liquidity. We find lower levels of liquidity for REITs compared to a set of control firms matched on size and book-to-market ratios. Commonality in liquidity is also lower for REITs than the controls and the overall market. However, we do find an important difference in share turnover for REITs, which appears to have a higher level of commonality than found in other studies. We suggest that this may be due to the financial crisis. Additionally we find evidence of similar time-series variation in liquidity for public and private real estate markets. We also find significant directional causality for most liquidity proxies from the public to private real estate markets. Finally our results show that there is strong contemporaneous correlation between both public and private real estate market liquidity and the term spread and real investment and consumption spending. REIT liquidity measures based on intraday data also appear to contain important information not found in measures constructed from daily returns.     

Capital structure,credit risk,and macroeconomic conditions

This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.     

Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries

Using data on defaulted firms in the United States over the period 1982–1999, we show that creditors of defaulted firms recover significantly lower amounts in present-value terms when the industry of defaulted firms is in distress. We investigate whether this is purely an economic-downturn effect or also a fire-sales effect along the lines of Shleifer and Vishny [1992. Liquidation values and debt capacity: a market equilibrium approach. Journal of Finance 47, 1343–1366]. We find the fire-sales effect to be also at work: Creditors recover less if the industry is in distress and non-defaulted firms in the industry are illiquid, particularly if the industry is characterized by assets that are specific, that is, not easily redeployable by other industries, and if the debt is collateralized by such specific assets. The interaction effect of industry-level distress and asset-specificity is strongest for senior unsecured creditors, is economically significant, and robust to contract-specific, firm-specific, macroeconomic, and bond-market supply effects. We also document that defaulted firms in distressed industries are more likely to emerge as restructured firms than to be acquired or liquidated, and spend longer time in bankruptcy.     

COSTS OF FINANCIAL DISTRESS AND INTEREST COVERAGE RATIOS

Creditors routinely impose on a borrowing firm a minimum interest coverage ratio that the firm has to maintain. I show that nonlinear costs of financial distress provide a possible explanation of why firms find it optimal to have an interest coverage ratio covenant in their debt indenture, even in the absence of information asymmetries or agency costs.     

Financial development and asset valuation: The special case of real estate

This paper studies the impact of financial development on asset valuation. We model the agency theoretic perspective of risk-averse investors and financiers in a general equilibrium setting under the framework of rational expectations (i.e., symmetric information). We focus on real estate, as it constitutes a special case of complete market contracting where adverse selection and moral hazard are easily mitigated. Our results illustrate an increase in pareto-efficiency, as financial architecture advances from: (i) banks to capital markets; and (ii) plain vanilla debt to an innovative one with participation clauses. This is attributed to the reduction in agency costs and cross-sectional risk-sharing, leading to an increase in the value of property. Our results predict that an optimal financial system will orient itself towards efficient financial contracts, irrespective of its source of origination. We also rationalize the co-existence of banks and capital markets, and generalize our results under a set of restrictive conditions.     

The mystery of zero-leverage firms

We present the puzzling evidence that, from 1962 to 2009, an average 10.2% of large public nonfinancial US firms have zero debt and almost 22% have less than 5% book leverage ratio. Zero-leverage behavior is a persistent phenomenon. Dividend-paying zero-leverage firms pay substantially higher dividends, are more profitable, pay higher taxes, issue less equity, and have higher cash balances than control firms chosen by industry and size. Firms with higher Chief Executive Officer (CEO) ownership and longer CEO tenure are more likely to have zero debt, especially if boards are smaller and less independent. Family firms are also more likely to be zero-levered.     

Estimating exponential affine models with correlated measurement errors: Applications to fixed income and commodities

Exponential affine models (EAMs) are factor models popular in financial asset pricing requiring a dynamic term structure, such as for interest rates and commodity futures. When implementing EAMs it is usual to first specify the model in state-space form (SSF) and then to estimate it using the Kalman filter. To specify the SSF, a structure of the measurement error must be provided which is not specified in the EAM itself. Different specifications of the measurement errors will result in different SSFs, leading to different parameter estimates. In this paper we investigate the influence of the measurement error specification on the parameter estimates. Using market data for both fixed income and commodities we provide evidence that measurement errors are cross-sectionally and serially correlated, which is not consistent with the independent identically distributed (iid) assumptions commonly adopted in the literature. Using simulated data we show that measurement error assumptions affect parameter estimates, especially in the presence of serial correlation. We provide a new specification, the augmented state-space form (ASSF), as a solution to these biases and show that the ASSF gives much better estimates than the basic SSF.     

Pricing the US residential asset through the rent flow: A cross-sectional study

The paper explores how the standard consumption-CAPM fares in pricing housing returns and regional rental income streams in a cross-section of regions. In particular, we estimate the Euler equations associated with the gross housing returns inclusive of price appreciations and rents jointly for several metropolitan areas of the US. The representative agent has a Constant Relative Risk Aversion (CRRA) utility. The rent growth is allowed to depend on the business cycle. When biannual data from 1978 to 2007 is used, the parameter estimates are reasonable, and the model is not rejected. Large standard errors indicate uninformative estimates. The implied price rent ratio time series averages are similar to the data; however the model misses the boom-bust pattern in the prices. The model significantly understates the average and the variance of the price appreciations. Results are robust to allowing housing consumption directly in the utility function or using the Epstein–Zin–Weil utility.     

Optimal strike prices of stock options for effort-averse executives

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy [Hall, Brian, Murphy, Kevin J., 2000. Optimal exercise prices for executive stock options. American Economic Review 90 (2), 209–214] claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort-averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages, options, and stock grants. We simulate the manager’s effort choice and compensation as well as the value of shareholders’ equity under alternative compensation schemes, and identify schemes that are optimal. Our simulations indicate that, when abstracting from tax considerations, it is optimal to award managers with options that will most likely be highly valuable (i.e., substantially in-the-money) on their expiration date. Prior to 2006, the tax code and financial reporting standards provided incentives to award options that are closer to the money when issued than the options that were optimal in the absence of these considerations. Recent tax and reporting changes voided these incentives and thus we predict that these changes will induce firms to issue options with lower strike prices than those that were issued prior to 2006.     

Profitability and capital structure: Evidence from import penetration

Firms experiencing increases in import competition significantly reduce their leverage ratios by issuing equity and selling assets to repay debt. Using import tariffs and foreign exchange rates as instrumental variables for import penetration, I show that these results are not manifestations of endogenous relations between import competition and leverage. The results are consistent with traditional trade-off models of capital structure that predict a positive relation between book leverage and expected future profitability. Further evidence suggests that import competition affects leverage through changes in the trade-off between the tax benefits of debt and the costs of financial distress.     

Volatility and covariation of financial assets: A high-frequency analysis

Using high frequency data for the price dynamics of equities we measure the impact that market microstructure noise has on estimates of the: (i) volatility of returns; and (ii) variance–covariance matrix of n assets. We propose a Kalman-filter-based methodology that allows us to deconstruct price series into the true efficient price and the microstructure noise. This approach allows us to employ volatility estimators that achieve very low Root Mean Squared Errors (RMSEs) compared to other estimators that have been proposed to deal with market microstructure noise at high frequencies. Furthermore, this price series decomposition allows us to estimate the variance covariance matrix of n assets in a more efficient way than the methods so far proposed in the literature. We illustrate our results by calculating how microstructure noise affects portfolio decisions and calculations of the equity beta in a CAPM setting.     

Valuation in US Commercial Real Estate

We consider a log‐linearized version of a discounted rents model to price commercial real estate as an alternative to traditional hedonic models. First, we verify a key implication of the model, namely, that cap rates forecast commercial real estate returns. We do this using two different methodologies: time series regressions of 21 US metropolitan areas and mixed data sampling (MIDAS) regressions with aggregate REIT returns. Both approaches confirm that the cap rate is related to fluctuations in future returns. We also investigate the provenance of the predictability. Based on the model, we decompose fluctuations in the cap rate into three parts: (i) local state variables (demographic and local economic variables); (ii) growth in rents; and (iii) an orthogonal part. About 30% of the fluctuation in the cap rate is explained by the local state variables and the growth in rents. We use the cap rate decomposition into our predictive regression and find a positive relation between fluctuations in economic conditions and future returns. However, a larger and significant part of the cap rate predictability is due to the orthogonal part, which is unrelated to fundamentals. This implies that economic conditions, which are also used in hedonic pricing of real estate, cannot fully account for future movements in returns. We conclude that commercial real estate prices are better modelled as financial assets and that the discounted rent model might be more suitable than traditional hedonic models, at least at an aggregate level.     

Spot price modeling and the valuation of electricity forward contracts: The role of demand and capacity

We propose a model where wholesale electricity prices are explained by two state variables: demand and capacity. We derive analytical expressions to price forward contracts and to calculate the forward premium. We apply our model to the PJM, England and Wales, and Nord Pool markets. Our empirical findings indicate that volatility of demand is seasonal and that the market price of demand risk is also seasonal and positive, both of which exert an upward (seasonal) pressure on the price of forward contracts. We assume that both volatility of capacity and the market price of capacity risk are constant and find that, depending on the market and period under study, it could either exert an upward or downward pressure on forward prices. In all markets we find that the forward premium exhibits a seasonal pattern. During the months of high volatility of demand, forward contracts trade at a premium. During months of low volatility of demand, forwards can either trade at a relatively small premium or, even in some cases, at a discount, i.e. they exhibit a negative forward premium.