Explaining Returns with Cash-Flow Proxies

Stock returns are correlated with contemporaneous earnings growth,dividend growth, future real activity, and other cash-flow proxies.The correlation between cash-flow proxies and stock returnsmay arise from association of cash-flow proxies with one-periodexpected returns, cash-flow news, and/or expected-return news.We use Campbell’s (1991) return decomposition to measurethe relative importance of these three effects in regressionsof returns on cash-flow proxies. In some of the popular specifications,variables that are motivated as proxies for cash-flow news alsotrack a nontrivial proportion of one-period expected returnsand expected-return news. As a result, the R² from a regressionof returns on cash-flow proxies may overstate or understatethe importance of cash-flow news as a source of return variance.     

Price Informativeness and Investment Sensitivity to Stock Price

The article shows that two measures of the amount of privateinformation in stock price—price nonsynchronicity andprobability of informed trading (PIN)—have a strong positiveeffect on the sensitivity of corporate investment to stock price.Moreover, the effect is robust to the inclusion of controlsfor managerial information and for other information-relatedvariables. The results suggest that firm managers learn fromthe private information in stock price about their own firms’fundamentals and incorporate this information in the corporateinvestment decisions. We relate our findings to an alternativeexplanation for the investment-to-price sensitivity, namelythat it is generated by capital constraints, and show that boththe learning channel and the alternative channel contributeto this sensitivity. (JEL G14, G31)     

Model-free versus Model-based Volatility Prediction

The well-known ARCH/GARCH models for financial time series havebeen criticized of late for their poor performance in volatilityprediction, that is, prediction of squared returns.¹ Focusingon three representative data series, namely a foreign exchangeseries (Yen vs. Dollar), a stock index series (the S&P500index), and a stock price series (IBM), the case is made thatfinancial returns may not possess a finite fourth moment. Takingthis into account, we show how and why ARCH/GARCH models—whenproperly applied and evaluated—actually do have nontrivialpredictive validity for volatility. Furthermore, we show howa simple model-free variation on the ARCH theme can performeven better in that respect. The model-free approach is basedon a novel normalizing and variance–stabilizing transformation(NoVaS, for short) that can be seen as an alternative to parametricmodeling. Properties of this transformation are discussed, andpractical algorithms for optimizing it are given.     

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]     

Agency and Optimal Investment Dynamics

Agency problems limit firms’ access to capital markets,curbing investment. Firms and investors seek contractual waysto mitigate these problems. What are the implications for investment?We present a theory of a firm’s investment dynamics inthe presence of agency problems and optimal long-term financialcontracts. We derive results relating firms’ investmentdecisions, current and past cash flows, firm size, capital structure,and dividends. Among the results, optimal investment is increasingin current and past cash flow; and optimal investment is positivelyserially correlated over time (after controlling for investmentopportunities). These results hold for a range of agency problems.(JEL G30, G31, G32, G35, D82, D86, D92)     

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)     

Top Management Compensation and the Structure of the Board of Directors in Commercial Banks

We examine the relationship between top management compensationand the structure of the board of directors for a sample ofcommercial banks. We find that boards with more reputable outsidedirectors compensate managers more heavily with long-term incentives(stock and stock options) than with cash (salary and bonus).We also find a significant positive correlation between thefuture performance of our sample banks and the proportion oftheir managers’ compensation in the form of long-termincentives. Taken together, these results suggest that boardswith highly reputed outside directors are more effective inproviding managers with the appropriate incentives and thusensuring better future firm performance. Another indicationof the effectiveness of these boards is our finding that theycompensate managers more heavily with long-term incentives (insteadof cash) when these managers are more entrenched. We also findvery little evidence of mutually beneficial back-scratchingor collusion between outside directors and senior managers whensetting management compensation. But boards with long-servingoutside directors are less effective in creating appropriatemanagement incentives.     

Theory and Evidence on the Resolution of Financial Distress

We analyze a financially distressed owner-managed project. Themain results of the model are: (1) borrower default is an endogenousresponse to the anticipated restructuring–foreclosureoutcome; (2) the lender’s restructuring–foreclosuredecision depends critically on the interaction between projectvalue and industry liquidity; and (3) the lender waits for theindustry to recapitalize before selling assets obtained throughforeclosure. Empirical analysis of a large sample of defaultedcommercial real estate loans supports many of the model predictions,including restructuring–foreclosure outcomes that areconsistent with endogenous borrower default and firesale discountsthat vary depending on industry market conditions at the timeof foreclosure. (JEL G33)     

Takeover Contests with Asymmetric Bidders

Target firms often face bidders that are not equally well informed,which reduces competition, because bidders with less informationfear the winner’s curse more. We analyze how targets shouldbe sold in this situation. We show that a sequential procedurecan extract the highest possible transaction price. The targetfirst offers an exclusive deal to a better-informed bidder,without considering a less well-informed bidder. If rejected,the target offers either an exclusive deal to the less well-informedbidder, or a modified first-price auction. Deal protection devicescan be used to enhance a target’s commitment to the procedure.(JEL G34, K22, D44)     

Tipping

We investigate the trading of institutions immediately beforethe release of analysts’ initial buy recommendations.We document abnormally high institutional trading volume andbuying beginning five days before recommendations are publiclyreleased. Abnormal buying is related to initiation characteristicsthat would require knowledge of the content of the report—suchas the identity of the analyst and brokerage firm, and whetherthe recommendation is a strong buy. We confirm that institutionsbuying before the recommendation release earn abnormal profits.Our results are consistent with institutional traders receivingtips regarding the contents of forthcoming analysts’ reports.(JEL G14, G18, G24)     

State Dependence Can Explain the Risk Aversion Puzzle

Risk aversion functions extracted from observed stock and optionprices can be negative, as shown by Aït-Sahalia and Lo(2000), Journal of Econometrics 94: 9–51; and Jackwerth(2000), The Review of Financial Studies 13(2), 433–51.We rationalize this puzzle by a lack of conditioning on latentstate variables. Once properly conditioned, risk aversion functionsand pricing kernels are consistent with economic theory. Todifferentiate between the various theoretical explanations interms of heterogeneity of beliefs or preferences, market sentiment,state-dependent utility, or regimes in fundamentals, we calibrateseveral consumption-based asset pricing models to match theempirical pricing kernel and risk aversion functions at differentdates and over several years.     

Option Coskewness and Capital Asset Pricing

This article shows how the market coskewness model of Rubinstein(1973) and Kraus and Litzenberger (1976) is altered when a nonredundantcall option is optimally traded. Owing to the option’snonredundancy, the economy’s stochastic discount factor(SDF) depends not only on the market return and the square ofthe market return but also on the option return, the squareof the option return, and the product of the market and optionreturns. This leads to an asset pricing model in which the expectedreturn on any risky asset depends explicitly on the asset’scoskewness with option returns. The empirical results show thatthe option coskewness model outperforms several competing benchmarkmodels. Furthermore, option coskewness captures some of thesame risks as the Fama–French factors small minus big(SMB) and high minus low (HML). These results suggest that thefactors that drive the pricing of nonredundant options are alsoimportant for pricing risky equities.(JEL G11, G12, D61)     

Practitioners' Corner

The first 150 words of the full text of this article appear below. This issue of the Journal of Financial Econometrics containspapers that were presented at the (EC)² conference Econometricsof Financial and Insurance Risks held in Istanbul on December15–17, 2005. Launched in 1990, (EC)² is an annual seriesof international conferences on research in quantitative economicsand econometrics. The acronym stands for European Conferencesof the Econom[etr]ics Community. Its primary aim is to providea vibrant forum where both senior and junior European researchersin quantitative economics and econometrics can discuss the resultsand progress of their research. (EC)² conferences are of relativelysmall scale (less than 200 participants) and quite intensive.Each year a different topic is selected as the major theme ofthe conference. A few leading quantitative economists or econometriciansare invited as keynote speakers, such as Eric Ghysels, who alsoacts as co-Guest editor of this issue; the other speakers areselected . . . [Full Text of this Article]     

Financial Intermediation and the Costs of Trading in an Opaque Market

Municipal bonds trade in opaque, decentralized broker-dealermarkets in which price information is costly to gather. We analyzea database of trades between broker-dealers and customers inmunicipal bonds. These data were only released to the publicwith a lag; the market was opaque. Dealers earn lower averagemarkups on larger trades, even though dealers bear a higherrisk of losses with larger trades. We estimate a bargainingmodel and compute measures of dealer’s bargaining power.Dealers exercise substantial market power. Our measures of marketpower decrease in trade size and increase in the complexityof the trade for the dealer. (JEL G0, G24)     

Beauty Contests and Iterated Expectations in Asset Markets

In a financial market where traders are risk averse and shortlived and prices are noisy, asset prices today depend on theaverage expectation today of tomorrow’s price. Thus (iteratingthis relationship) the date 1 price equals the date 1 averageexpectation of the date 2 average expectation of the date 3price. This will not, in general, equal the date 1 average expectationof the date 3 price. We show how this failure of the law ofiterated expectations for average belief can help understandthe role of higher-order beliefs in a fully rational asset pricingmodel.     

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.     

Transmission of Information across International Equity Markets

This article provides evidence of information transmission fromthe United States and Japan to Korean and Thai equity markets.Information is defined as important macroeconomic announcementsin the United States, Japan, Korea, and Thailand. Using high-frequencyintraday data, I find a large and significant association betweendeveloped-economy macroeconomic announcements and emerging-economyequity volatility and trading volume at short time horizons.Previous studies’ findings of at most weak evidence oftransmission from developed to emerging economies may be dueto their use of lower frequency data and their focus on developed-economyfinancial market innovations as a proxy for information. (JELE44, G14, G15)     

Transactions Accounts and Loan Monitoring

We show that transactions accounts, by providing ongoing dataon borrowers’ activities, help financial intermediariesmonitor borrowers. This information is most readily availableto commercial banks, which offer these accounts and lendingtogether. We find that (1) monthly changes in accounts receivableare reflected in transactions accounts; (2) borrowings in excessof collateral predict credit downgrades and loan write-downs;and (3) the lender intensifies monitoring in response. Thisis evidence on a key issue in financial intermediation—thereis an advantage to providing deposit-taking and lending jointly.But this advantage may have fallen as the cost of communicationhas declined. (JEL G10, G20, G21)     

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.     

A parametric nonlinear model of term structure dynamics

Recent nonparametric estimation studies pioneered by Ait-Sahaliadocument that the diffusion of the short rate is similar tothe parametric function, r^1.5, estimated by Chan et al., whereasthe drift is substantially nonlinear in the short rate. Theseempirical properties call into question the efficacy of theexisting affine term structure models and beg for alternativemodels which admit the observed behavior. This article presentssuch a model. Our model delivers closed-form solutions for bondprices and a concave relationship between the interest rateand the yields. We show that in empirical analyses, our modeloutperforms the one-factor affine models in both time-seriesas well as cross-sectional tests.