LIQUIDITY AND ASSET PRICING UNDER THE THREE‐MOMENT CAPM PARADIGM

We examine whether the use of the three‐moment capital asset pricing model can account for liquidity risk. We also make a comparative analysis of a four‐factor model based on Fama–French and Pástor–Stambaugh factors versus a model based solely on stock characteristics. Our findings suggest that neither of the models captures the liquidity premium nor do stock characteristics serve as proxies for liquidity. We also find that sensitivities of stock return to fluctuations in market liquidity do not subsume the effect of characteristic liquidity. Furthermore, our empirical findings are robust to differences in market microstructure or trading protocols between NYSE/AMEX and NASDAQ.     

ESTIMATING EXPECTED EXCESS RETURNS USING HISTORICAL AND OPTION‐IMPLIED VOLATILITY

We test the relation between expected and realized excess returns for the S&P 500 index from January 1994 through December 2003 using the proportional reward‐to‐risk measure to estimate expected returns. When risk is measured by historical volatility, we find no relation between expected and realized excess returns. In contrast, when risk is measured by option‐implied volatility, we find a positive and significant relation between expected and realized excess returns in the 1994–1998 subperiod. In the 1999–2003 subperiod, the option‐implied volatility risk measure yields a positive, but statistically insignificant, risk‐return relation. We attribute this performance difference to the fact that, in the 1994–1998 subperiod, return volatility was lower and the average return was much higher than in the 1999–2003 subperiod, thereby increasing the signal‐to‐noise ratio in the latter subperiod.     

EXPECTED VOLATILITY,UNEXPECTED VOLATILITY,AND THE CROSS‐SECTION OF STOCK RETURNS

The existing literature finds conflicting results on the cross‐sectional relation between expected returns and idiosyncratic volatility. We contend that at the firm level, the sample correlation between unexpected returns and expected idiosyncratic volatility can cloud the true relation between the expected return and expected idiosyncratic volatility. We show strong evidence that unexpected idiosyncratic volatility is positively related to unexpected returns. Using unexpected idiosyncratic volatility to control for unexpected returns, we find expected idiosyncratic volatility to be significantly and positively related to expected returns. This result holds after controlling for various firm characteristics, and it is robust across different sample periods.     

THE MEAN‐GINI EFFICIENT PORTFOLIO FRONTIER

A main advantage of the mean‐variance (MV) portfolio frontier is its simplicity and ease of derivation. A major shortcoming, however, lies in its familiar restrictions, such as the quadraticity of preferences or the normality of distributions. As a workable alternative to MV, we present the mean‐Gini (MG) efficient portfolio frontier. Using an optimization algorithm, we compute MG and mean‐extended Gini (MEG) efficient frontiers and compare the results with the MV frontier. MEG allows for the explicit introduction of risk aversion in building the efficient frontier. For U.S. classes of assets, MG and MEG efficient portfolios constructed using Ibbotson (2000) monthly returns appear to be more diversified than MV portfolios. When short sales are allowed, distinct investor risk aversions lead to different patterns of portfolio diversification, a result that is less obvious when short sales are foreclosed. Furthermore, we derive analytically the MG efficient portfolio frontier by restricting asset distributions. The MG frontier derivation is identical in structure to that of the MV efficient frontier derivation. The penalty paid for simplifying the search for the MG efficient frontier is the loss of some information about the distribution of assets.     

THE EFFECT OF CROSS‐LISTING ON TRADING VOLUME: REDUCING SEGMENTATION VERSUS SIGNALING INVESTOR PROTECTION

We examine the relation between cross‐listing on the U.S. and UK regulated and unregulated exchanges and trading volume for a sample of 500 foreign firms from 34 countries. We find that the increase in trading volume is a function of both reducing segmentation and signaling investor protection. In addition, we find that home market trading volume, firm size, firm returns, and analyst forecast accuracy are the major determinants of a firm's trading volume. We also show that U.S. and UK investors trade foreign securities that originate from low‐investor‐protection countries more than they trade those from high‐investor‐protection countries, which is consistent with the bonding hypothesis.     

KEIRETSU AFFILIATION AND STOCK‐MARKET‐DRIVEN ACQUISITIONS

We examine misvaluation as a driver of takeover activity in Japan. Mirroring empirical results from the United States, we find that overvaluation is an important factor affecting the dichotomy between acquirers and nonacquirers in Japan. Being affiliated to a keiretsu group appears to reduce the probability that an overvalued firm will decide to acquire another firm. Misvaluation is also an important determinant of the likelihood of a firm becoming a target; however, there is no significant difference between keiretsu and nonkeiretsu firms in this regard. Shareholders of keiretsu‐affiliated acquirers do not gain from acquisitions, whereas acquisitions by nonaffiliated firms do seem to be value enhancing.     

ROBUSTNESS OF THE HEADQUARTERS‐CITY EFFECT ON STOCK RETURNS

Recent studies report that U.S. firms headquartered near each other experience positive comovement in their stock returns, a finding suggestive of local biases in equity trading activity. We investigate the robustness of these findings and find that including additional pricing factors in models for monthly stock returns materially reduces the magnitude of the headquarters‐city effect in stock returns. Additionally, we find that an implicit null hypothesis of zero local return comovement is inappropriate as there is positive comovement between a stock's return and returns on portfolios of stocks from nonheadquarters cities, on average. Nevertheless, results benchmarked against estimates based on resampling methods indicate a significant and robust headquarters‐city effect in stock returns.     

TRADE SIZE AND INFORMED TRADING: WHICH TRADES ARE “BIG”?

We find adverse‐selection spread components increase sharply in the ratio of trade size to quoted depth, and spike when trade size equals quoted depth. We find that two previously documented and prominent indicators of informed trading, raw trade size and high‐trading volume half‐hours, offer almost no explanatory power for informed trading measures beyond trade size to quoted depth, and a third indicator, time of day, offers no explanatory power among trades with high trade size to quoted depth. Our results suggest trade size to quoted depth is perhaps the single most important indicator that a trade is informed.     

INTANGIBLE ASSETS,BOOK‐TO‐MARKET,AND COMMON STOCK RETURNS

I examine two anomalies where the Fama and French three‐factor model fails to adequately explain monthly industry and index returns. Both anomalies are consistent with a bad model problem where the book‐to‐market factor introduces a negative bias in the intercepts. I propose the intangibles model as an alternative where the three‐factor model is known to have difficulty. This alternative model, which replaces the book‐to‐market factor with zero investment portfolio returns based on prior investments in intangible assets, is well specified in random samples, has comparable power, and fully explains both anomalies.     

CONVERTIBLE DEBT AND RISK‐SHIFTING INCENTIVES

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk‐shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk‐increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.     

Optimal Mortgage Refinancing: A Closed‐Form Solution

We derive the first closed‐form optimal refinancing rule: refinance when the current mortgage interest rate falls below the original rate by at least In this formula W(.) is (the principal branch of) the Lambert W‐function, where ρ is the real discount rate, λ is the expected real rate of exogenous mortgage repayment, σ is the standard deviation of the mortgage rate, is the ratio of the tax‐adjusted refinancing cost and the remaining mortgage value, and τ is the marginal tax rate. This expression is derived by solving a tractable class of refinancing problems. Our quantitative results closely match those reported by researchers using numerical methods.     

Determinants of Investor Demand for Cross‐Listed Firms

By focusing on the decisions of investors to invest in cross‐listed stocks, this paper presents new evidence on why we observe striking differences in the percentage of trade in foreign markets for cross‐listed stocks. With a large sample of Toronto Stock Exchange (TSX) stocks cross‐listed in the U.S. and Canada, we document the effect of investor recognition and risk characteristics on the distribution of trading volume. Firms that are more visible to American investors are traded more heavily in the U.S. At the same time, firms that offer diverse risk characteristics are attractive to Americans. While investors understand the benefits of international diversification, as they are attracted to stocks that are different (e.g., the stock of small firms with few assets in the U.S.), they also seek stocks that provide them with high returns.     

SHORT‐MATURITY OPTIONS AND JUMP MEMORY

We investigate jump memory using an extensive database of short‐term S&P 500 index options. Jump memory refers to the attenuation of the implied jump intensity and magnitude parameters following a crash event. We use a genetic algorithm to obtain a time series of implied parameter estimates and posit behavioral and rational explanations for parameter attenuation following a crash event. We find that a nested form of the jump‐diffusion model sharpens the remaining parameter estimates and has a negligible effect on pricing accuracy.     

THE FAMA‐FRENCH MODEL,LEVERAGE, AND THE MODIGLIANI‐MILLER PROPOSITIONS

For a cost‐of‐equity model to conform to the Modigliani‐Miller cost‐of‐capital propositions, any sensitivity coefficients in the model must be related to the firm's leverage. In this paper I apply these principles to the Fama‐French model for the cost of equity and develop the relation between its sensitivity coefficients and firm leverage. I then examine an empirical process developed by Fama and French (1997) to model the evolution through time of their sensitivity coefficients and show that this empirical process is inconsistent with the Modigliani‐Miller propositions. Separable functions are proposed for these sensitivity coefficients that are consistent with the Modigliani‐Miller propositions.     

CREDIT SPREADS AND THE ZERO‐COUPON TREASURY SPOT CURVE

We examine the relation between credit spreads on industrial bonds and the underlying Treasury term structure. We use zero‐coupon spot rates to eliminate the coupon bias and to allow for a consistent study both within and across the different credit ratings. Our results indicate that the level and slope of the Treasury term structure are negatively correlated with changes in the credit spread on investment‐grade corporate bonds. We also find that the relation between credit spreads and the Treasury term structure is relatively stable through time. This is good news for value‐at‐risk calculations, as this suggests that the correlations among assets of different credit classes are stable; therefore use of historic correlations to model spread relations can be valid.     

UNDERWRITER REPUTATION AND AFTERMARKET PERFORMANCE OF CLOSED‐END FUNDS

I find a positive relation between underwriter reputation and the initial and long‐run aftermarket performance of closed‐end funds. This relation persists even after controlling for fund characteristics, types, and investment strategies. The positive relation between underwriter reputation and initial returns supports the notion that prestigious investment bankers tend to promote a price run‐up in the immediate aftermarket to enhance their reputation with the issuers and the investors. The better long‐run performance for funds underwritten by prestigious underwriters suggests that prestigious underwriters protect their reputation by underwriting only high‐quality issues that will perform well in the long run.     

THE INFLUENCE OF FIRM‐ AND CEO‐SPECIFIC CHARACTERISTICS ON THE USE OF NONLINEAR DERIVATIVE INSTRUMENTS

We examine why firms use nonlinear derivatives (e.g., options). Our results suggest that option characteristics in investment opportunities and debt, the payoff structure of incentive compensation, and free cash‐flow agency problems influence the firm's choice. Investment opportunities, internally generated cash flow, business risk, and option compensation positively influence the use of nonlinear currency derivatives. Option feature in bonds positively influence the use of nonlinear interest rate derivatives, whereas bonus and stock compensation, and CEO tenure have a negative influence. In sum, nonlinear cash flow characteristics in investment opportunity, debt, and executive compensation all relate positively to nonlinear derivative usage.     

VOLATILITY FORECASTS,TRADING VOLUME,AND THE ARCH VERSUS OPTION‐IMPLIED VOLATILITY TRADE‐OFF

We investigate empirically the role of trading volume (1) in predicting the relative informativeness of volatility forecasts produced by autoregressive conditional heteroskedasticity (ARCH) models versus the volatility forecasts derived from option prices, and (2) in improving volatility forecasts produced by ARCH and option models and combinations of models. Daily and monthly data are explored. We find that if trading volume was low during period t?1 relative to the recent past, ARCH is at least as important as options for forecasting future stock market volatility. Conversely, if volume was high during period t?1 relative to the recent past, option‐implied volatility is much more important than ARCH for forecasting future volatility. Considering relative trading volume as a proxy for changes in the set of information available to investors, our findings reveal an important switching role for trading volume between a volatility forecast that reflects relatively stale information (the historical ARCH estimate) and the option‐implied forward‐looking estimate.     

MANAGERIAL INCENTIVES AND THE USE OF FOREIGN‐EXCHANGE DERIVATIVES BY BANKS

We examine the effect of managerial compensation and ownership on the use of foreign‐exchange derivatives by U.S. bank holding companies. We focus on derivatives used for purposes other than trading to investigate derivative use in a hedging framework. We use instrumental variables probit and sample‐selection models to estimate the effects of endogenous and exogenous factors on the probability and extent of foreign‐exchange derivatives used. We find that the use of derivatives is inversely related to option awards but positively related to managerial ownership. Finally, our results suggest that ownership by large institutional shareholders provides incentive for managers to hedge.     

TRADING‐VOLUME SHOCKS AND STOCK RETURNS: AN EMPIRICAL ANALYSIS

We examine high‐volume premiums based on weekly risk‐adjusted returns. Significant average weekly abnormal high‐volume premiums up to 0.50% per week are documented for 1962–2005. Most premiums are generated in the first two weeks and monotonically decline as holding periods are extended. Evidence of reversal is found as the holding periods are extended. Premiums depend on realized turnover in the holding period. The last finding supports the theories of Miller and Merton. Finally, we test whether premiums are compensation for taking additional risk. Negative skewness, idiosyncratic risk, and liquidity risk do not explain the high‐volume premiums.