Stock Returns and Volatility: Pricing the Short‐Run and Long‐Run Components of Market Risk

We explore the cross‐sectional pricing of volatility risk by decomposing equity market volatility into short‐ and long‐run components. Our finding that prices of risk are negative and significant for both volatility components implies that investors pay for insurance against increases in volatility, even if those increases have little persistence. The short‐run component captures market skewness risk, which we interpret as a measure of the tightness of financial constraints. The long‐run component relates to business cycle risk. Furthermore, a three‐factor pricing model with the market return and the two volatility components compares favorably to benchmark models.     

Long‐Run Stockholder Consumption Risk and Asset Returns

We provide new evidence on the success of long‐run risks in asset pricing by focusing on the risks borne by stockholders. Exploiting microlevel household consumption data, we show that long‐run stockholder consumption risk better captures cross‐sectional variation in average asset returns than aggregate or nonstockholder consumption risk, and implies more plausible risk aversion estimates. We find that risk aversion around 10 can match observed risk premia for the wealthiest stockholders across sets of test assets that include the 25 Fama and French portfolios, the market portfolio, bond portfolios, and the entire cross‐section of stocks.     

The Impact of a Rating Agency's Private Information and Disclosed Causes of Rating Downgrades on Insurer Stock Returns

Existing studies document that bond and insurer rating downgrades are associated with negative abnormal returns but generally do not consider the reasons for the downgrade disclosed or implied in the downgrade announcement. Using hand-collected press releases (downgrade announcements) of A.M. Best Company (Best) for a sample of publicly traded insurance firms during the period 1996–2012, we classify and analyze downgrades based on the disclosed causes of the downgrades and whether the rating agency has implied reliance upon unfavorable private information or opinion. We find that during the three-day event window (?1, +1), rating downgrades overall generate a statistically significant cumulative average abnormal return (CAAR) of negative 7.76%. A significantly more negative CAAR of negative 11.46% is found for “financial-prospects-deterioration” downgrades with the perceived presence of Best's private information or opinion. For downgrades without any indication of Best's private information or opinion, the CAAR is negative 3.35%, which is significantly different from zero but significantly less negative than the CAAR of downgrades where private information or opinion is indicated. Downgrades with reported causes other than deterioration of a firm's fundamental financial performance or condition, such as increases in financial leverage and increased business risk taking, produced statistically significant CAAR of negative 3.19% during the (?1, +1) three-day event window, which is also significantly less negative than the CAAR of downgrades where private information or opinion is indicated. Our results provide evidence that downgrades where private information or opinion is likely and downgrades due to a decline in fundamental financial profiles contain more value-relevant information than other types of downgrades.     

Preferred Stock Returns, CreditWatch, and Preferred Stock Rating Changes

This paper examines the announcement effects of CreditWatch placement and reratings upon a sample of preferred stock issues that were placed on CreditWatch and later rerated or affirmed by Standard & Poor's. Results indicate that CreditWatch provides information to market participants and may have reduced the surprise associated with subsequent reratings. CreditWatch placement may be an erroneous signal, however, since nearly 50 percent of the issues placed for negative reasons were not downgraded, but affirmed, upon removal from Credit Watch.     

Common Stock Returns and Rating Changes: A Methodological Comparison

This paper examines the adjustments in a firm's common stock price during the eleven months before and during the month of announcement of a bond rating change. Based on several different measures of abnormal security return, the findings are consistent with the proposition that bond downgradings convey information to common stockholders. For bond upgradings, the price adjustments were statistically insignificant in the month of announcement, although in the eleven preceding months, upgraded firms exhibited positive abnormal returns. While the results do not fully support earlier research, we stress that the main contribution of this article lies in the scrutiny it gives to issues of methodology in assessing the possible price effects of bond reclassifications.     

Distinguishing Between Rationales for Short‐Horizon Predictability of Stock Returns

In this paper, we shed light on short‐horizon return reversals. We show theoretically that a risk‐based rationale for reversals implies a relation between returns and past order flow, whereas a reversion in beliefs of biased agents does not do so. The empirical results indicate that returns are more strongly related to own‐return lags than to lagged order imbalances. Thus, the evidence suggests that monthly reversals are not completely captured by inventory effects and may be driven, in part, by belief reversion. We do find that returns are cross‐sectionally related to lagged imbalance innovations at horizons longer than a month.     

Agency Costs and the Short‐Run Stock Price Response to Capital Expenditures

We estimate the short‐run stock price response to unanticipated capital expenditures. We use association study methodology to avoid the self‐selection bias in event studies and to facilitate construction of a large sample of firm‐years likely to exhibit agency problems. We find that the average price response to routine capital expenditures is negative, and that commonly used agency cost measures explain fully the negative response. Subsample results support the conclusion that the market is skeptical of cash flow financed spending by low‐q firms and even capital spending by high‐q firms when the firm is large and q is only marginally high.     

Long‐Run Stock Performance and Its Determinants for Asset Buyers

This paper examines the long‐term stock performance of asset purchasers and the determinants of cross‐sectional differences in performance. Our findings show that buyers’ stocks, on average, underperform following purchases. Buy‐and‐hold abnormal returns of buyers acquiring related assets are significantly higher than those acquiring unrelated assets, consistent with the focus hypothesis. Asset buyers with superior prior stock performance experience poorer long‐run performance than buyers with inferior prior stock performance, consistent with the prior performance hypothesis. Asset buyers that manage earnings upward, experience poorer long‐term abnormal stock performance than acquirers with downward earnings management, consistent with the earnings management hypothesis. The long‐term return evidence is to some degree consistent with the governance hypothesis but we find little support for the free cash flow hypothesis.     

The Effect of Bond Rating Changes and New Ratings on UK Stock Returns

This is the first study to use daily data from a major capital market outside of the US to examine the role of corporate bond and commercial paper rating changes on common stock returns. Using data published by Standard and Poors' credit rating agency between 1984 and 1992, we examine the impact of new credit ratings, credit rating changes and Credit Watch announcements on UK common stock returns. We find significant negative excess returns around the date of a downgrade and positive returns close to the date of a positive CreditWatch announcement. Hence, the financial markets would appear to place some importance on rating agency pronouncements in the UK. New ratings, whether short or long-term, have no significant impact on returns. We also attempt to quantify the impact of a new credit rating upon firm cost of capital through measures of conditional volatility and systematic risk. However, we find only weak evidence to suggest that a stock's cost of capital is reduced after a long-term credit rating is awarded for the first time.     

Short‐ and Long‐Term Effects of Multimarket Trading

We analyze short‐ and long‐term effects of multimarket trading by examining the entries of multiple markets into transacting three ETFs, DIA, QQQ, and SPY. We find that large‐scale entries improve overall market quality, while small‐scale entries have ambiguous effects. Our results show that the competition effect dominates the fragmentation effect over a long horizon and that market fragmentation leads to a decline in trading costs. Further, we find that the order handling rules help mitigate the fragmentation effect and facilitate the competition effect. We do not find that multimarket trading harms price efficiency or increases price volatility.     

Trading Mechanisms and Stock Returns: An Empirical Investigation

This paper examines the effects of the mechanism by which securities are traded on their price behavior. We compare the behavior of open-to-open and close-to-close returns on NYSE stocks, given the differences in execution methods applied in the opening and closing transactions. Opening returns are found to exhibit greater dispersion, greater deviations from normality and a more negative and significant autocorrelation pattern than closing returns. We study the effects of the bid-ask spread and the price-adjustment process on the estimated return variances and covariances and discuss the associated biases. We conclude that the trading mechanism has a significant effect on stock price behavior.     

Effects of Analysts’ Ratings on Insurer Stock Returns: Evidence of Asymmetric Responses

We examine the information value contained in insurer rating changes. Using a contemporary event study approach, we document an asymmetric reaction of stock prices to rating changes: downgrades cut share prices by approximately 7 percent but upgrades have little significant effect. This result varies across agencies as share prices react more strongly to A.M. Best and Standard & Poor's downgrades than to Moody's. We observe a similar asymmetric reaction to rating changes subject to a common rating benchmark. Finally, we find that prices fall most dramatically when a rating downgrade from one rating agency follows a downgrade from another agency.     

Market Risk,Interest Rate Risk,and Interdependencies in Insurer Stock Returns: A System‐GARCH Model

We examine market risk, interest rate risk, and interdependencies in returns and return volatilities across three insurer segments within a System‐GARCH framework. Three main results are obtained: market risk is greatest for accident and health (A&H) insurers, followed by life (Life) and property and casualty (P&C) insurers; interest rate sensitivity is negative and greatest for Life insurers; and interdependencies in returns are significant with the magnitude being strongest between P&C and A&H insurers. The implication is that greatest diversification benefits arise between Life and the other segments of the insurance industry. Market risk and interest rate risk for diversified firms are smaller than those for nondiversified firms for both product and geographic diversification.     

Underwriter Quality and Long‐Run IPO Performance

We analyze the relationship between the quality of underwriters and the long‐run performance of initial public offerings (IPOs) in light of underwriter marketing, certification and screening, and information production. We find that higher underwriter quality (measured by the number of managing underwriters, underwriter reputation, and absolute price adjustment) predicts better long‐run performance, even when returns are value weighted. We compare underwriter quality measures and find that the effects of the number of managing underwriters and underwriter reputation are mutually complementary and are especially strong among IPOs with high uncertainty, while absolute price adjustment, which is more likely to be associated with information production than marketing or certification/screening, loses significance. Our findings are consistent with the marketing and certification and screening roles of investment banks but lend little support for the information production role of underwriters.     

Understanding the Distributional Impact of Long‐Run Inflation

The impact of fully anticipated inflation is systematically studied in heterogeneous agent economies with an endogenous labor supply and portfolio choices. In stationary equilibrium, inflation nonlinearly alters the endogenous distributions of income, wealth, and consumption. Small departures from zero inflation have the strongest impact. Three features determine how inflation impacts distributions and welfare: financial structure, shock persistence, and labor supply elasticity. When agents can self‐insure only with money, inflation reduces wealth inequality but may raise consumption inequality. Otherwise, inflation reduces consumption inequality but may raise wealth inequality. Given persistent shocks and an inelastic labor supply, inflation may raise average welfare. The results hold when the model is extended to account for capital formation.     

Institutional Trade Persistence and Long‐Term Equity Returns

Recent studies show that single‐quarter institutional herding positively predicts short‐term returns. Motivated by the theoretical herding literature, which emphasizes endogenous persistence in decisions over time, we estimate the effect of multiquarter institutional buying and selling on stock returns. Using both regression and portfolio tests, we find that persistent institutional trading negatively predicts long‐term returns: persistently sold stocks outperform persistently bought stocks at long horizons. The negative association between returns and institutional trade persistence is not subsumed by past returns or other stock characteristics, is concentrated among smaller stocks, and is stronger for stocks with higher institutional ownership.     

Characterizing the Risk of IPO Long‐Run Returns: The Impact of Momentum,Liquidity, Skewness,and Investment

We study 6,686 initial public offerings (IPOs) spanning the period 1981‐2005 and find that the new issues puzzle disappears in a Fama‐French three‐factor framework. IPOs do not underperform in the aftermarket on a risk‐adjusted basis and do not underperform a matched sample of nonissuers. IPO underperformance is concentrated in the 1980s and early 1990s, and IPOs either perform the same as the market or outperform on a risk‐adjusted basis from 1998 to 2005. We find that outperformance in the later period is driven by large firms. Factors for momentum, investment, liquidity, and skewness help to explain aftermarket returns, although size and book‐to‐market tend to proxy for skewness. IPO investors receive smaller expected returns due to negative momentum and investment exposure and in exchange for higher liquidity.     

A Long‐Run Performance Perspective on the Technology Bubble

The events surrounding the stock price peak of March 2000 are commonly interpreted as the bursting of a technology or Internet bubble, with some researchers pointing out that the pattern could also arise in fundamental models. We inform the debate by studying the long‐run performance of Internet and technology stocks from March 2000 onward. Using calendar‐time regressions, we do not find conclusive evidence of negative abnormal returns. The results are consistent with a new interpretation of the events; namely, the price drop of the early 2000s was not warranted in light of future cash flows and risk.     

Stock Liquidity Risk and the Cross‐sectional Earnings‐Returns Relationship

We argue that a higher sensitivity to aggregate market‐wide liquidity shocks (i.e., a higher liquidity risk) implies a tendency for a stock's price to converge to fundamentals. We test this intuition within the framework of the earnings‐returns relationship. We find a positive liquidity risk effect on the relationship between return and expected change in earnings. This effect on the earnings‐returns relationship is distinct from the negative effect observed for stock illiquidity level. Notably, the liquidity risk effect is evident (absent) during periods of neutral/low (high) aggregate market liquidity. We also show that the liquidity risk effect is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book‐to‐market; and (c) are profit making.