The Effect of Illegal Insider Trading on Takeover Premia

This paper empirically investigates whether illegal insidertrading increases the premium a bidder pays for a target. Illegalinsider trading is trading by traditional corporate insiders,as well as others in a position of trust and confidence (e.g.investment bankers, lawyers), based on material, non-publicinformation (‘inside information’). The paper examinesthe premia of takeovers with known illegal insider trading andcompares them to a control sample of takeovers matched by industry,time period, and size that do not have detected illegal insidertrading. After controlling for differences in merger characteristics,such as number of bidders, type of offer, form of payment, etc.,we find that takeovers with detected illegal insider tradinghave takeover premia which are approximately 10 percentage points,or almost one-third, higher than the control sample. We conductadditional tests in an attempt to determine the direction ofcausality between illegal insider trading and takeover premiasize and explore the effect of potential detection bias. Theresults suggest both that illegal inside traders base theirtrades on factors other than premia size, and that illegal insidertrading in takeovers with large premia is not necessarily morelikely to be detected. Our findings are consistent with thehypothesis that the illegal insider trading itself tends tocreate larger takeover premia.     

The Market for Corporate Control and the Agency Paradigm

The paper analyzes the role of agency driven takeover activity. The analysis shows that takeovers can play an important role in reducing agency costs even though the gains from the corporate restructuring that follows the takeovers are zero, which counters existing models of agency driven takeover activity. The model can therefore form the basis for deriving empirical predictions which discriminate between the agency paradigm and the corporate restructuring paradigm of takeover activity. Negative post-merger performance (Agrawal et al., 1992), which is inconsistent with corporate restructuring is consistent with this model, and that takeover targets' investment levels are below or at the average (Servaes 1994), which is inconsistent with the free cash flow theory is also consistent with this model.     

Decomposition of Japanese Yen Interest Rate Data Through Local Regression

Seven different Japanese Yen interest rates recorded on a daily basisfor the period from 1986 to 1992 are simultaneously analyzed. Byintroducing a new concept of short term trend, we decomposeeach interest rate series into three components, long termtrend, short term trend and irregular. It is obtained by atwo step lowess smoothing technique. After that, amultivariate autoregressive model (MAR) is fitted to the vectorvalued time series obtained by combining those seven irregularcomponents. The decomposition and MAR model fitting were quitesatisfactory. It enables us to understand well various aspects ofinterest rate series from the trends, the MAR (2) coefficientsand its residuals. The result is compared with the decompositionthrough sabl and the advantages of our procedure will bedemonstrated in relations to other parametric model fitting likeARCH or GARCH. Based on the decomposition we can have betterdaily prediction and more stable long term forecasting.     

Information Monopoly and Commitment in Intermediary-Firm Relationships

A bank may use the private information that it acquires through monitoring to hold up borrowers. This information monopoly of the bank may inefficiently distort the borrowers investment decisions in environments where moral hazard is prevalent. The paper analyses how this problem is resolved within bank-firm relationships. In the benchmark case when the bank can contractually commit to future actions, the optimal contract turns out to be ambiguous in nature. When commitment contracts cannot be written, firms have an incentive to develop multiple banking relationships in order to decrease the inside banks bargaining power. However, with costly monitoring, this may defeat the initial purpose for contracting with a financial intermediary, namely information production. The paper argues that when contractual commitment is not feasible, bank size may serve as an alternative commitment device that prevents the bank from holding up borrowers in the future.     

Probability and Statistics Applied to the Practice of Financial Risk Management: The Case of J.P. Morgan's RiskMetrics™

This work describes applications of probability and statistics in RiskMetrics, J.P. Morgan's methodology for quantifying market risk. The methodology implements an analytical approach to financial risk in trading, arbitrage, and investment based on the statistics of market moves in equities, bonds, currencies and commodities. The public unveiling of RiskMetrics in October of 1994 attracted widespread interest among regulators, competing financial institutions, investment managers, and corporate treasurers, while the available technical documentation offers us a unique opportunity for informed statistical research on the theory and practice of financial risk management. For the purpose of identifying problems for further research, this discussion focuses on five applications of statistics in RiskMetrics, which range from data analysis of daily returns and locally Gaussian processes to stochastic volatility models and Itô processes for the term structure of interest rates. Another important theme of this discussion, however, is devoted to attracting statisticians to the study of financial risk management and developing the foundations for collaborative work with financial economists and practicing risk managers. For this reason, this is also an expository document that touches several areas of active statistical research with applications to problems of risk management.     

Pension Plan Investment Management Mandates: An Empirical Analysis of Manager Selection

We examine the impact of several factors on the selection of portfolio managers for Australian pension plan mandates. Performance measures do not affect the probability of a mandate allocation. Pension sponsors tend to choose managers with top-quartile five-year performance who have recently beaten a market benchmark. Management expenses have a negative impact on a managers chances. A surprising result is sponsors tolerance for high portfolio trading costs. Mandates are spread across manager investment styles. The style and institutional attributes of preferred managers suggest trustees reputation and prudential concerns matter, particularly for the aggregate annual mandate allocations.     

Nonparametric prediction for the time-dependent volatility of the security price

In this paper we consider a continuous time model for the security price with the time-dependent volatility. It is shown that the non-normality and non-linear dependency of the short-term return, the major characteristics observed on many financial assets, can be incorporated into our model. In order to evaluate the option price formula on the model we propose a nonparametric predictor for the volatility function without reference to a specific functional form. We examine the so-called continuous record asymptotics and show that the proposed predictor is asymptotically minimax for a wide class of the volatility functions. One of the most important results is that the application of the Black-Scholes method can be justified by plugging the proposed predictor in the standard Black-Scholes formula even if the volatility changes over time.     

Horizontal Inequity and Vertical Redistribution

Inequality of post-tax income among pre-tax equals is evaluated andaggregated to form a global index of horizontal inequity in the income tax.The vertical action of the tax is captured by its inequality effect on averagebetween groups of pre-tax equals. Putting the two together, horizontalinequity measures loss of vertical performance. The identification problem,which has previously been thought insuperable, is addressed by a procedurevalidating the banding of income units into close equals groups. Thehorizontal and vertical effects of a major Spanish income tax reform areevaluated. Lines for future investigation are suggested.     

Environmental Taxes, International Capital Mobility and Inefficient Tax Systems: Tax Burden vs. Tax Shifting

This paper deals with the so-called double dividend of an environmental tax reform. In a model with only labor and a polluting input as factors of production, we find that society faces a trade-off between internalizing environmental externalities and raising revenues in the least distortionary way. However, if capital enters the production structure, an ecological tax reform may render the tax structure more efficient from a non-environmental point of view, thereby raising not only environmental quality but also private incomes.     

The Information Content of Bank Examinations

We identify three types of information from bank examinations—auditing information from verifying the honesty and accuracy of the bank's books, regulatory discipline information about the treatment of the bank by regulators, and private information about bank condition. We estimate these information effects by comparing the cumulative abnormal market returns associated with examinations in which the CAMEL rating remained unchanged, improved, and worsened. All three information effects are found to be greater for banks entering the examination process with unsatisfactory ratings from prior examinations. The only consistently strong effect found is that examination downgrades appear to reveal unfavorable private information about bank condition. The evidence also suggests that the information may reach the market in part through loan quality data released in quarterly financial statements.     

Modeling Spatial and Temporal House Price Patterns: A Comparison of Four Models

This research reports results from a competition on modeling spatial and temporal components of house prices. A large, well-documented database was prepared and made available to anyone wishing to join the competition. To prevent data snooping, out-of-sample observations were withheld; they were deposited with one individual who did not enter the competition, but had the responsibility of calculating out-of-sample statistics for results submitted by the others. The competition turned into a cooperative effort, resulting in enhancements to previous methods including: a localized version of Dubins kriging model, a kriging version of Clapps local regression model, and a local application of Cases earlier work on dividing a geographic housing market into districts. The results indicate the importance of nearest neighbor transactions for out-of-sample predictions: spatial trend analysis and census tract variables do not perform nearly as well as neighboring residuals.     

On the microstructure of price determination and information aggregation with sequential and asymmetric information arrival in an experimental asset market

Summary. Experiments were conducted on an asset with the structure of an option. The information of any individual is limited, as if only the direction of movement of the option value known for a single period without information of the value from when movement was initiated. However, if all information of all insiders were pooled, the value of the option would be known with certainty. The results are the following: (1) Information becomes aggregated in the prices as if fully informative rational expectations operated; and (2) The mechanism through which information gets into the market is captured by a path dependent process that we term The Fundamental Coordination Principle of Information Transfer in Competitive Markets. The early contracts tend to be initiated by insiders who tender limit orders. The emergence of bubbles and mirages in the markets are coincident with failures and circumstances that prevent the operation of the Fundamental Principle.The financial support of the national science foundation and the Caltech Laboratory for Experimental Economics and Political Science are gratefully acknowledged. The authors have benefited from helpful comments of David Grether, Kerry Back, Ivana Komunjer and Pete Kyle.     

Edokko Options: A New Framework of Barrier Options

In this paper, we will give a new framework of barrier options to generalize`Parisian Option' and `Delayed Barrier Option'. Take a stopping time asthe caution time. When occurs, derivatives are given `Caution'. After, if K.O. time =() occurs, derivative contractsvanish. We simply say that first `Caution' second `K.O.'. Using thisframework, designs of barrier options become more flexible than before and newrisk management will be possible. New barrier options in this category arecalled Edokko Options or Tokyo Options.     

Balance Sheets, the Transfer Problem, and Financial Crises

In a world of high capital mobility, the threat of speculative attack becomes a central issue of macroeconomicpolicy. While first-generation and second-generation models of speculative attacks both have considerablerelevance to particular financial crises of the 1990s, a third-generation model is needed to make sense of thenumber and nature of the emerging market crises of 1997-98. Most of the recent attempts to produce such amodel have argued that the core of the problem lies in the banking system. This paper sketches another candidatefor third-generation crisis modeling—one that emphasizes two facts that have been omitted from formal modelsto date: the role of companies' balance sheets in determining their ability to invest, and that of capital flows inaffecting the real exchange rate.     

Financial Distress and Bank Restructuring of Small to Medium Size UK Companies

We use a unique data set to study how U.K. banks deal with financially distressed small and medium-sized companies under a contractualist bankruptcy system. Unlike in the U.S., these procedures limit the discretion of courts to strict enforcement of debt contracts, without any dilution of creditors claims. We show that lenders and borrowers select a debt structure that avoids some of the market failures often attributed to a contractualist system. Collateral and liquidation rights are highly concentrated in the hands of the main bank, giving it a dominant position in restructuring or liquidating a defaulting firm. There is little litigation, and no evidence of co-ordination failures or creditors runs. However, there is some evidence that the banks dominance makes it lazy in monitoring, relying heavily on the value of its collateral in timing the bankruptcy decision.     

A Fundamental Approach to Estimating Economies of Scale and Scope of Financial Products: The Case of Mutual Funds

We propose a Fundamental approach to estimate the economies of scale and scope for financial institutions offering multi-product lines. We first estimate pure economies of scale from its fundamental definition, which is the marginal cost reduction that is to be achieved by single product firms of increasing size that offer the same product. Similarly, we estimate the economies of scope from its fundamental definition, as the marginal cost reduction achieved by the addition of a new product line. Operationally, we compare the cost of operating a say, 3 product-line financial institution with the cost of operating a portfolios of companies that are synthetically created from a control sample of financial institutions offering fewer, such as 2 and 1 similar product lines. When this approach is applied to mutual funds data, we find economies of scale for some fund type. The evidence on marginal cost economies due to increasing scope is rather weak. The results have practical implications for potential organizers and current management of investment companies.     

The Impact of Risk-Based Premiums on FDIC-Insured Institutions

This paper examines the effect of a series of announcements leading to the approval of risk-based deposit insurance premiums on returns to stockholders of commercial banks. Utilizing risk-weighted capital ratios and measures of overall risk, we group banks according to one of the nine-tier insurance categories subsequently defined by the FDIC. During the period in which the new insurance system was considered and approved, we found that stockholders of well-capitalized, healthy banks experienced wealth changes significantly different from those experienced by less than well-capitalized, less than healthy banks. Although many argued the premium range in the initial insurance schedule was insufficient, the results show that this initial risk-basing marked an important change in the relative burdens imposed by FDIC insurance.     

The impact of tax on foreign direct investment: Empirical evidence and the implications for tax integration schemes

We estimate the impact of taxation on foreign direct investment (FDI) flows, using data on flows between seven countries for 1984 through 1989, and a sophisticated measure of the cost of capital. We find that the choice between domestic investment and total outward FDI is not significantly affected by taxation but that taxation does affect the location of outward FDI. These results are used to examine the impact of tax integration systems. Giving a tax credit to foreign shareholders may induce a large increase in inward FDI from exemption countries but not from partial-credit countries. For the United States, the total effect would be small.     

Determinants of stock market volatility and risk premia

Summary. We show the dynamics of diverse beliefs is the primary propagation mechanism of volatility in asset markets. Hence, we treat the characteristics of the market beliefs as a primary, primitive, explanation of market volatility. We study an economy with stock and riskless bond markets and formulate a financial equilibrium model with diverse and time varying beliefs. Agents states of belief play a key role in the market, requiring an endogenous expansion of the state space. To forecast prices agents must forecast market states of belief which are beliefs of others hence our equilibrium embodies the Keynes Beauty Contest. A market state of belief is a vector which uniquely identifies the distribution of conditional probabilities of agents. Restricting beliefs to satisfy the rationality principle of Rational Belief (see Kurz, 1994, 1997) our economy replicates well the empirical record of the (i) moments of the price/dividend ratio, risky stock return, riskless interest rate and the equity premium; (ii) Sharpe ratio and the correlation between risky returns and consumption growth; (iii) predictability of stock returns and price/dividend ratio as expressed by: (I) Variance Ratio statistic for long lags, (II) autocorrelation of these variables, and (III) mean reversion of the risky returns and the predictive power of the price/dividend ratio. Also, our model explains the presence of stochastic volatility in asset prices and returns. Two properties of beliefs drive market volatility: (i) rationalizable over confidence implying belief densities with fat tails, and (ii) rationalizable asymmetry in frequencies of bull or bear states.This research was supported by a grant of the Smith Richardson Foundation to the Stanford Institute for Economic Policy Research (SIEPR). We thank Kenneth Judd for constant advice which was crucial at several points in the development of this work. We also thank Kenneth Arrow, Min Fan, Michael Magill, Carsten Nielsen, Manuel Santos, Nicholas Yannelis, Ho-Mou Wu and Woody Brock for comments on earlier drafts. The RBE model developed in this paper and the associated programs used to compute it are available to the public on Mordecai Kurzs web page at http://www.stanford.edu/ mordecai.This revised version was published online in January 2005 with corrections to the Cover date.     

Explaining intercity home price differences

This paper develops and tests an equilibrium model seeking to explain intercity variation in owner-occupied housing prices. Empirical tests with a reduced form equation using aggregated 1980 data on 94 SMSAs suggest explanation for 84% of this intercity home price variation. Intercity housing demand, based upon homeowner quality of life equilibrium, is successfully represented by the non-monetary income determinant of climate mildness in addition to several monetary income determinants that reflect household residual after-tax real income. Intercity housing supply was found to be influenced by intercity variation in construction costs and limitations upon the available supply of undeveloped urban land.