Change in market assessments of deposit-institution riskiness

Using the Goldfeld and Quandt switching regression method, this article investigates variability over 1975–1985 in the risk components of bank and saving and loan stock. We develop evidence that the market-beta, interest-sensitivity, and residual risk of deposit-institution stock vary significantly during this period. Reassessing previous event studies in light of these findings suggests that event-study methods tend to overreach their data. The Ohio State University University of Maryland     

The Use of Debt to Prevent Short-Term Managerial Exploitation

This paper emphasizes the versatility of debt by presenting a setting in which debt is used to assuage a manager. Our result is driven by the option-like feature of shareholder ownership in the presence of debt and the detrimental effect of diversification (reduced volatility) on option value. The diversification effect is introduced in our model when the shareholders use a “portfolio of managers” over the firm’s life. In contrast, retaining the existing manager is a riskier strategy. Debt makes this risky strategy desirable for the shareholders and, thus, serves to commit them to be more patient in firing decisions. Viewed broadly, the paper stresses the interaction between capital structure, information system design, and control systemsWe thank C.D. Aliprantis (Editor), Tim Baldenius, Joel Demski, Ron Dye, John Fellingham, Hans Frimor, Ronen Israel, Chandra Kanodia, Brian Mittendorf, James Peck, Doug Schroeder, Lixin Ye, workshop participants at Carnegie Mellon, Columbia University, Ohio State University, and the European Summer Symposium in Financial Markets, and two anonymous referees for helpful comments. Anil Arya gratefully acknowledges assistance from the John J. Gerlach Chair     

Unraveling a puzzle: the case of value line timeliness rank upgrades

We examine a sample of Value Line’s timeliness rank upgrades that occur immediately following earnings announcements and find that pre-event price momentum has significant incremental explanatory power for post-event drift, after controlling for the level of earnings surprise. Therefore, the stock price drift following Value Line’s timeliness upgrades cannot be viewed as driven only by the post-earnings announcement drift phenomenon. Instead, these findings indicate that, among other factors, Value Line has been exploiting the price momentum effect for decades. Black (Financ. Anal. J. 29:10–14, 1973) clearly stated that it does indeed do this, but his assertion has not yet been verified as an explanation of the puzzling drift that follows Value Line rank upgrades.     

Market Sentiments,Winner’s Curse and Bidding Outcome in Land Auctions

This paper empirically tests auction theory by examining how the stock market evaluates the outcome of open-bid English auctions of rights to develop residential real estate projects in Hong Kong. To do so, we deconstruct the complexity surrounding actual auction events, and empirically isolate the influence of conflicting auction theory predictions using data from expert opinion around auction events, actual auction event and outcome data, and stock market data. The empirical findings include (1) with increasing uncertainty bidders reduce bids, thus confirming predictions following the winner’s curse thesis; (2) joint bidding does not lead to increased bids based on pooled (“better”) information, but instead leads to reduced competition; while increased competition leads to increased prices at auction, as expected; (3) the market interprets auction outcomes as information events which function to signal developers’ expectations about future market prospects; but if the winning bid is considered too high, this interpretation is revised to that of the winner’s curse; (4) with joint bidding and winning, the market’s response to joint winners is better explained by concern for winner’s curse (despite supposed better informed bids) than the acquisition of a below cost development project following reduced competition at auction; and (5) the market interprets increased competition at auction as indicator of the future direction of property price movements in the secondary market—the more intense the competition, the more positive the future prospect of the property market are seen to be.     

The effect of earnings quality and country-level institutions on the value relevance of earnings

This study investigates the relationship between the value relevance of earnings and earnings quality across countries. We find that there is a stronger relationship between earnings quality and the value relevance of earnings in countries with high investor protection than in countries with weak investor protection. We also find that the association between the value relevance of earnings and earnings quality is higher when a country’s information environment is less opaque. Overall, our study documents evidence on international differences in the ability of stock prices to capture useful accounting information, consistent with the notion that the returns-earnings association reflects not only the quality of accounting earnings but also the informativeness of stock prices.     

New evidence on the effect of belief heterogeneity on stock returns

We develop a new measure to examine the effect of the heterogeneity of beliefs among investors on stock returns. Our initial results do not support the information asymmetry hypothesis or the sidelined investor hypothesis (and thus are consistent with the unbiased prices hypothesis). However, since the first two hypotheses make opposite predictions regarding stock returns, they may both have merit but offset one another. Further analysis suggests that this is indeed the case. Overall, our results support both the information asymmetry and sidelined investor hypotheses and thus occupy middle ground in the debate on the effect of disagreement on stock returns.     

Financial Leverage,CEO Compensation,and Corporate Hedging: Evidence from Real Estate Investment Trusts

This paper studies the determinants of corporate hedging practices in the REIT industry between 1999 and 2001. We find a positive significant relation between hedging and financial leverage, indicating the financial distress costs motive for using derivatives in the REIT industry. Using estimates of the Black–Scholes sensitivity of CEO’s stock option portfolios to stock return volatility and the sensitivity of CEO’s stock and stock option portfolios to stock price, we find evidence to support managerial risk aversion motive for corporate hedging in the REIT industry. Our results indicate that CEO’s cash compensation and the CEO’s wealth sensitivity to stock return volatility are significant determinants of derivative use in REITs. We also document a significant positive relation between institutional ownership and hedging activity. Further, we find that probability of hedging is related to economies of scale in hedging costs.

When Less (Potential Demand) Is More (Revenue): Asymmetric Bidding Capacities in Divisible Good Auctions

We show that asymmetry in bidders’ capacity constraints plays an important role in inhibiting collusion and promoting competitive outcomes in multi-unit auctions in which the final value of the good is common knowledge. This effect appears to be related to the increased difficulty of coordination when there are significant differences between bidders. Due to its impact on collusive outcomes, asymmetry in bidding capacities has a more powerful impact on the seller’s revenue than does the auction type. Consistent with the finding in Sade et al. (2006) that the discriminatory auction is more susceptible to collusion than the uniform-price auction, asymmetry in capacity constraints has a greater impact in discriminatory auctions.We thank Emmanuel Morales-Camargo, Ira Luria and Yelena Larkin for their excellent research assistance. We have benefited from comments by Yishay Yafeh, Eugene Kandel, Dan Levin, David Genesove, Eric Hughson, Steve Rock, Peter Bossaerts, David McAdams two anonymous referees, participants at the 2005 International Meeting of the Economic Science Association in Montreal, the 2006 winter meeting of the Econometric Society in Boston, and seminar participants at the University of Cincinnati, Hebrew University, Federal Reserve Bank of Atlanta, Tel-Aviv University, the University of Notre Dame, and Ben-Gurion University. Sade thanks the Israel Science Foundation (ISF 480/05) and the Krueger Center for Finance at the Hebrew University of Jerusalem for partial financial support.     

Competition in Lending: Theory and Experiments*

A variation of the Rothschild-Stiglitz’ equilibrium is examined in the context of competitive lending under adverse selection. The predictions of the model are tested in an experimental market setting. If equilibrium exists, the loan contracts offered and taken should separate projects by quality. When equilibrium exists, the experiments confirm the theory. The entrepreneurs with high-risk projects take bigger loans and pay higher credit spreads than those with low-risk projects. When equilibrium does not exist, which happens exactly when the candidate equilibrium does not provide a Pareto-optimal allocation, in half of the sessions loan trading stabilizes around the candidate equilibrium pair. In the other half, however, markets never settle down. This finding has important implications. When lenders can offer menus of contracts, as is usually the case in reality, the outcome may not be the zero-profit separating contracts of the standard model. Worse, fitting the standard model to field data may lead to serious biases in estimated parameters while falsely accepting the model’s main restriction (separation). *The financial support of the Division of Humanities and Social Sciences at Caltech is gratefully acknowledged. I would like to thank Charles Plott, Thomas Palfrey, Bill Zame, Mike Lemmon, as well as the seminar participants at Caltech, UCSD, Duke, Berkeley, Stanford, University of Utah, Columbia, Georgia State University, Tulane, University of Houston, and Arizona State University for helpful comments, and the staff of EEPS, SSEL, and CASSEL for their help in running the experiments. I am especially grateful to my advisor and mentor Peter Bossaerts for his guidance and encouragement. All errors are my own.     

Fractals in trade duration: capturing long-range dependence and heavy tailedness in modeling trade duration

Several studies that have investigated a few stocks have found that the spacing between consecutive financial transactions (referred to as trade duration) tend to exhibit long-range dependence, heavy tailedness, and clustering. In this study, we empirically investigate whether a larger sample of stocks exhibit those characteristics. We do so by comparing goodness of fit in modeling trade duration data for stable distribution and fractional stable noise based on a procedure applying bootstrap methods developed by the authors with several alternative distributional assumptions in modeling trade duration data. The empirical results suggest that the autoregressive conditional duration model with stable distribution fits better than other combinations, while fractional stable noise itself fits better for the time series of trade duration. Our result is consistent with the general findings in the literature that trade duration is informative and that short trade durations move prices more than long trade duration. In addition, our result confirms the advantage of fractal models in the study of roughness in trade duration and provides some evidence for duration dependence. S. Rachev’s research was supported by grants from the Division of Mathematical, Life and Physical Science, College of Letters and Science, University of California, Santa Barbara, and the Deutschen Forschungsgemeinschaft. W. Sun’s research was supported by grants from the Deutschen Forschungsgemeinschaft. P.S. Kalev’s research was supported with a NCG grant from the Faculty of Business and Economics, Monash University. Data are supplied by Securities Industry Research Center of Asia-Pacific (SIRCA) on behalf of Reuters. The first draft of this paper was presented at the International Conference on High Frequency Finance 2006; the authors would like to thank the conference participants for their valuable comments.     

Do local analysts have an informational advantage in forecasting stock returns? Evidence from the German DAX30

Utilizing data from the German DAX30 stock index, we investigate whether local analysts have an informational advantage in forecasting stock returns. We analyze whether banks’ buy and sell recommendations improve on the out-of-sample predictability of daily stock returns and the market-timing ability of investors who base their decisions on such recommendations. We find that, indeed, in a few cases German banks do have better stock-forecasting ability for daily stock returns than do foreign banks. However, the value added of bank recommendations is generally small and sensitive to the model-selection criterion used by an investor in setting up a forecasting model for stock returns.     

Option market making under inventory risk

We propose a mean-variance framework to analyze the optimal quoting policy of an option market maker. The market maker’s profits come from the bid-ask spreads received over the course of a trading day, while the risk comes from uncertainty in the value of his portfolio, or inventory. Within this framework, we study the impact of liquidity and market incompleteness on the optimal bid and ask prices of the option. First, we consider a market maker in a complete market, where continuous trading in a perfectly liquid underlying stock is allowed. In this setting, the market maker may remove all risk by Delta hedging, and the optimal quotes will depend on the option’s liquidity, but not on the inventory. Second, we model a market maker who may not trade continuously in the underlying stock, but rather sets bid and ask quotes in the option and this illiquid stock. We find that the optimal stock and option quotes depend on the relative liquidity of both instruments as well as on the net Delta of the inventory. Third, we consider an incomplete market with residual risks due to stochastic volatility and large overnight moves in the stock price. In this setting, the optimal quotes depend on the liquidity of the option and on the net Vega and Gamma of the inventory.      

Issuers’ incentives and tests of Baron’s model of IPO underpricing

This paper reexamines the validity of Baron’s (J Financ 37:955–976, 1982) model of IPO underpricing, in which IPO underpricing is caused by asymmetric information between issuers and investment bankers. Muscarella and Vetsuypens (J Financ Econ 24:125–135, 1989) find that lead-manager IPOs are significantly more underpriced than non-self-marketed IPOs and conclude that their empirical results do not support Baron’s model. We compare self-marketed underwriters’ IPOs with non-self-marketed underwriters’ IPOs and with IPOs they lead. Our empirical results show that it is premature to reject Baron’s model of IPO underpricing when we take issuer incentives into account.     

Structuring the Initial Offering: Who to Sell To and How to Do It

We develop a unified model of the issuer’s decisions that takes into account both mechanism design and adverse selection risk. The model enables us to determine the optimal amount of information gathering prior to setting the offer price, and to understand what does and does not cause underpricing. The flexibility to allocate securities between a pool of investors who provide pricingrelevant information and investors who do not provide information is key to controlling underpricing. Policies that guarantee a minimum allocation to investors in the pool result in underpricing; policies that cap the allocations to such investors do not. The optimal number of investors in the pool, and thus the amount of information acquired, generally increases with the riskiness of the issue. However, this relation breaks down if pool members are guaranteed minimum allocations.We are grateful to the referees and the editor, Marco Pagano, for their insightful suggestions. We thank Sugato Bhattacharyya, Jos von Bommel, Zhoahui Chen, Robert Hauswald, Dilip Madan, Kristian Rydqvist, Alex Stomper, Meg Van De Weghe, Ivo Welch and participants at Carnegie Mellon, Indiana University, the University of Maryland, Tulane University and Yale University finance seminars for their helpful comments. This paper has evolved from an earlier paper titled Private versus Public Offerings: Optimal Selling Mechanisms with Adverse Selection, that was presented at the 1999 Western Finance Association meetings.     

Tests for relative performance evaluation based on assumptions derived from proxy statement disclosures

The main purpose of this paper is to test for relative performance evaluation (RPE) using assumptions derived from an examination of firms’ disclosures about their RPE use. Prior empirical evidence supporting the use of RPE in executive compensation is mixed. This is puzzling since studies of firm disclosures indicate that firms claim to use RPE based on both accounting measures and stock returns. Those few studies that do find empirical support observe it with either an accounting performance measure or stock returns, but not both. The lack of strong consistent empirical support for RPE is due, in part, to the fact that the preponderance of tests for RPE incorporate unsubstantiated assumptions about the way firms apply RPE. This includes the compensation measure to which RPE is applied and the way in which firms use firm-own and peer group performance when determining compensation. Our test results provide support for the use of RPE among 1998 S&P 500 firms with both stock returns and return on equity. To our knowledge, this is the first study to find support for RPE with both stock returns and an accounting performance measure. Through a series of sensitivity analyses, we also provide insight into the amount of detail researchers need to build into their empirical tests in order to find support for RPE.     

Pricing mortgages: An interpretation of the models and results

Mortgages, like all debt securities, can be viewed as risk-free assets plus or minus contingent claims that can be usefully viewed as options. The most important options are: prepayment, which is a call option giving the borrower the right to buy back the mortgage at par; and default, which is a put option giving the borrower the right to sell the house in exchange for the mortgage. This article reviews and interprets the large and growing body of literature that applies recent results of option pricing models to mortgages. We also provide a critique of the models and suggest directions for future research.The Ohio State University and the National Bureau of Economic ResearchThe Urban Institute University of California at Los Angeles     

Volatility Decomposition and Correlation in International Securitized Real Estate Markets

This study contributes to the literature in international securitized real estate market volatility in three ways. Each market’s conditional volatility is decomposed into a “permanent” or long-run component and a “transitory” or short-run component via a component-GARCH model. Even though with the same number of common factors derived from the “permanent” and “transitory” volatility series, their loadings are not similar and consequently the long-run and short-run volatility linkages for some markets are different. Finally there are significant volatility co-movements between real estate and stock markets’ “permanent” and “transitory” components suggesting that real estate markets are at least not segmented from stock markets in international investing.     

The makings of an information leader: the intraday price discovery process for individual stocks in the DJIA

The main purpose of this paper is to construct an intraday arbitrage price series for each stock in the DJIA using information in the Diamond Trust Fund ETF. We then compute the information shares (Hasbrouck in J Finan 50(4):1175–1199, 1995) for the actual versus the arbitrage prices for each stock. While previous literature documents that ETFs lead stock indices in information origination, we find that some firms are “information leaders” in that the information share that comes from the stock price is larger than that which comes from the ETF-related arbitrage price. Further analysis is conducted to uncover the firm-specific factors that are related to a stock’s role in information generation.     

Is the disposition effect in bonds as strong as in stocks? Evidence from an emerging market

Does the disposition effect appear in bond trades as in stocks? We apply Odean's measurement (1998) to a proprietary transaction database with unique investor IDs from an emerging market exchange that holds both stock and bond trading. We find some disposition effect in treasury bonds, but much lower than in stocks, and a positive relation between the two measures by investor. In addition, we find a significant disposition effect for local individuals and family offices, in both markets. In contrast, long-term institutions, brokerage firms, and foreign investors do not exhibit this bias. This is the first study to report evidence of the disposition effect in a fixed-income market.     

IPO underpricing,signaling, and property returns

This paper investigates whether IPO signals reveal proprietary information about the prospects of an issuing firm’s underlying industry. By analyzing a sample of European property company (EPC) IPOs from 1997 to 2007, we take advantage of a heterogeneous set of industry performance measures, i.e., yields and total returns of direct property investments in various European property markets that can be clearly assigned to each individual IPO. The results reveal that the main signal of interest, underpricing, is in fact positively related to average property yields for a 12-month post-IPO period; a result that supports our assumption. Other signals, as proposed in previous research, do not appear to contain any information about the prospects of the IPO firm’s target property investment market. We also show that total returns seem to be a biased measure for direct property performance. Further tests for the signaling model’s preconditioned presence of information asymmetry among EPCs reveal that underpricing levels are a function of company-specific ex ante uncertainty proxies. In contrast, property-specific ex ante uncertainty proxies do not explain underpricing levels.